How Tax Shelters Work


On October 21, 2003, IRS Commissioner Mark Everson discusses abusive tax shelters before the Senate Finance Committee in Washington, D.C. See more tax pictures.
Alex Wong/Getty Images

Tax shelter. It sounds like a nice idea. After all, if you want to take shelter from something, storms and taxes are the first two things on the list.

A tax shelter helps reduce how much tax you pay the federal government by reducing your taxable income. There are many legitimate tax shelters. But, as with most things, tax shelters can be used for wrongdoing.

Taxes Image Gallery

In the United States, the Internal Revenue Service keeps close tabs on the use of tax shelters. This surveillance has grown in recent years as the IRS has learned more about the often complex workings of popular tax shelters.

Why the concern? The IRS considers the abuse of tax shelters a form of tax evasion, which is illegal. To give you an idea of how much money the IRS suspects is being illegally hidden through abusive tax shelters, in 2003, the IRS teamed up with the state of California to crack down on abusive shelters that may have cost the state $1.3 billion in tax revenue [source: Berthelsen].

What constitutes a tax shelter? What makes one tax shelter legitimate and another abusive? In this article, we'll answer these questions and provide you with examples of shelters you can use to legally reduce your tax liability. Go to the next page to learn about the fine line between avoidance and evasion.

 

 

 

Types of Tax Shelters

Panelists participate in the Senate Finance Committee on tax shelters on October 21, 2003.
Panelists participate in the Senate Finance Committee on tax shelters on October 21, 2003.
Scott J. Ferrell/Congressional Quarterly/Getty Images

A tax shelter is a legal technique used by taxpayers, whether individuals or businesses, to reduce taxable income. The lower your taxable income, the less you pay in taxes. When you use a legal, legitimate tax shelter, you are avoiding taxes, which should not be confused with evading taxes.

Tax shelters include investments or deposits in accounts that are not heavily taxed, such as retirement accounts. Other shelters include "transactions that lower taxable income," such as charitable donations [source: Investopedia].

The primary difference between a legitimate tax shelter and an abusive tax shelter is the shelter's financial benefit. Legitimate shelters, such as retirement accounts and side businesses, usually generate income. An abusive tax shelter is simply a way to keep money from being taxed.

Many legitimate tax shelters are available to you. These shelters include:

Investing in real estate is a common tax shelter. In addition to the deductions it allows you to make -- mortgage loan interest, mortgage insurance and property taxes -- a real estate investment can help you grow wealth over time.

Retirement plans, such as pensions, 401(k) and 403(b) plans, and Individual Retirement Accounts (IRAs), have legitimate tax shelter qualities. A worker (and his or her employer) can make pretax contributions to these plans, which consist of a portion of the worker's income before it's assessed for federal withholding. Every plan is different and has its own regulations and contribution caps. The caps are there to keep people from dumping all of their money into a plan to avoid taxation.

When you withdraw money or receive payments from one of these plans, the IRS assesses the tax on the amount withdrawn, but often at a lower rate than it would have taxed the original income.

Putting a portion of one's primary income into a side business is a popular way to shelter oneself from federal income tax. For example, Mr. Boxcar, an insurance salesman with a knack for restoring old model trains, could set up a business to market his repair and restoration skills. Mr. Boxcar will take money from his primary income as an insurance salesman to fund his model train restoration business, which could reduce his taxable income. As long as Mr. Boxcar can prove to the IRS that he is attempting to make a profit with his side business, he can write off many business expenses, including equipment and supply costs.

Municipal bonds are used by smaller governments (state, municipal, county) to fund public works projects, such as taking care of those potholes left after a bad winter. Interest you earn on municipal bonds is not taxed by the IRS.

If your employer provides benefits like health coverage, life insurance and education benefits, you can reduce your taxable income by taking advantage of these opportunities. Typically, you contribute part of your income to the benefit before your tax withholding is calculated.

So now that you know what's legal when it comes to tax shelters, read on to find out about abusive tax shelters.

Tax Shelter Abuse

At a March 2005 press conference, IRS Senior Advisor to the Commissioner John C. Klotsche ponders the "Son of Boss" tax shelter settlement.
At a March 2005 press conference, IRS Senior Advisor to the Commissioner John C. Klotsche ponders the "Son of Boss" tax shelter settlement.
Chip Somodevilla/Getty Images

An abusive tax shelter reduces the amount of tax a taxpayer owes to the government, but does not provide any means to gain actual money. In practice, it's like hiding the money you owe the IRS in a piggy bank under your bed.

Abusive tax shelters are often "multi-layer transactions" that mask the owner of the money by "flowing" the money through entities specifically set up to receive and store the money, such as International Business Corporations (IBCs) [source: IRS]. When the IRS determines that a taxpayer has participated in an abusive transaction, it assesses penalties and issues bills for unpaid taxes and interest on the unpaid amount.

The IRS has compiled a list of transactions it has deemed to be abusive tax shelters, such as

  • Foreign trusts
  • IBC transactions
  • Stock Compensation Transactions
  • Lease In/Lease Out or LILO Transactions
  • Offsetting Foreign Currency Option Contracts

Let's look at some other abuses in more detail.

Variable Prepaid Forward Contracts

Mr. Jones wants to sell his stock while it's still valuable but does not want to pay taxes on the profits. So he puts the stock in a bank for safekeeping, promising to sell the stock to the bank later. The bank gives him a handsome sum of cash, a significant percentage of the stock's value. But the stock has not yet been officially sold, only pledged. Stock fluctuates in value, so, to prevent a loss on the "pledged" transaction, the bank reinvests the stock elsewhere. The result is that Mr. Jones gets a bunch of cash and doesn't have to pay capital gains taxes.

Offshore Tax Havens

Companies form corporations, banks and trust providers in foreign countries called "tax havens," where taxpayers can hold their money and assets to avoid paying U.S. federal income tax on them. These entities are designed to make it difficult to trace ownership -- and therefore tax liability -- of the assets. Popular tax havens include Panama, Belize, the Cayman Islands, St. Kitts and Nevis, the British Virgin Islands, and the Isle of Man [source: McCoy].

Inflated Partnership Basis Transactions (Son of Boss)

This complex transaction, popular in the 1990s, involved the formation of partnerships and the artificial inflation of business losses in these partnerships. When the IRS cracked down, it offered a settlement to participants in the scheme. The average participant in Son of Boss paid $1 million to the IRS; one participant paid over $100 million. All told, the IRS restored over $3 billion in unpaid taxes, interest and penalties through this settlement [source: IRS].

Abusive Roth IRA Transactions

Roth IRAs are retirement accounts with contribution caps. You can contribute a certain amount of your earnings within a certain time period. Anything over the cap is subject to an excise tax. To get around this limit, participants create separate businesses whose sole purpose is to make contributions to the IRA. The participants run their money through these businesses to make it look like they're not violating a contribution cap. Income that should be taxed flows tax-free into the IRA.

To learn more about tax shelters, legitimate and abusive, follow the links on the next page.

­

Related HowStuffWorks Articles 

More Great Links 

Sources:

  • Berthelsen, Christian. "IRS, state focus on tax shelter abuse." San Francisco Chronicle. 9/17/03. http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2003/09/17/BUG5R1OCMV1.DTL&type=business (Accessed 4/20/08)
  • Browning, Lynnley. "U.S. Wonders if Stock Deal Is Tax Abuse." New York Times. 2/11/08. http://www.nytimes.com/2008/02/11/business/11tax.html?ref=business (Accessed 4/20/08)
  • Investopedia. "Tax Shelter." http://www.investopedia.com/terms/t/taxshelter.asp (Accessed 4/20/08)
  • Investopedia. "Tax-Sheltered Annuity." http://www.investopedia.com/terms/t/taxshelteredannuity.asp (Accessed 4/20/08)
  • Investopedia. "Abusive Tax Shelter." http://www.investopedia.com/terms/a/abusive-tax-shelter.asp (Accessed 4/20/08)
  • Investopedia. "Tax Evasion." http://www.investopedia.com/terms/t/taxevasion.asp (Accessed 4/20/08)
  • Investopedia. "Tax Avoidance." http://www.investopedia.com/terms/t/tax_avoidance.asp (Accessed 4/20/08)
  • IRS. "Bulletin No. 1999-52." 12/27/99. http://www.irs.gov/pub/irs-utl/notice_1999-59.pdf (Accessed 4/23/08)
  • IRS. "Frequently Asked Questions: I am considering a tax shelter investment. How can I recognize an abusive tax shelter?" http://www.irs.gov/faqs/faq16.html (Accessed 4/20/08)
  • IRS. "IRS Collects $3.2 Billion from Son of Boss; Final Figure Should Top $3.5 Billion." 3/24/2005. http://www.irs.gov/newsroom/article/0,,id=137095,00.html (Accessed 4/20/08)
  • IRS. "Listed Abusive Tax Shelters and Transactions." http://www.irs.gov/businesses/corporations/article/0,,id=120633,00.html (Accessed 4/20/2008)
  • IRS. "Overview - Abusive Tax Schemes." http://www.irs.ustreas.gov/compliance/enforcement/article/0,,id=105820,00.html (Accessed 4/20/08)
  • IRS. "Publication 936." http://www.irs.gov/publications/p936/ar02.html (Accessed 4/23/08)
  • IRS. "What are some of the Most Common Abusive Tax Schemes?" http://www.irs.ustreas.gov/compliance/enforcement/article/0,,id=105822,00.html (Accessed 4/20/08)
  • McCoy, Kevin. "Offshore tax shelters not just for the rich." USA Today. 9/14/06. http://www.usatoday.com/money/perfi/taxes/2006-09-13-tax-shelter-usat_x.htm (Accessed 4/20/08)
  • Schnepper, Jeff. "8 types of income the IRS can't touch." MSN Money. 12/27/2007. http://articles.moneycentral.msn.com/Taxes/CutYourTaxes/8typesOfIncomeTheIRScantTouch.aspx?page=2 (Accessed 4/20/08)
  • Schnepper, Jeff. "The ultimate tax shelter: Owning your own business." MSN Money. http://articles.moneycentral.msn.com/Taxes/TaxShelters/TheUltimateTaxShelterYourOwnBusiness.aspx (Accessed 4/20/08)
  • U.S. Treasury. "TREASURY CURBS "BOSS" TRANSACTION TAX SCHEME." 12/9/99. http://www.ustreas.gov/press/releases/ls286.htm (Accessed 4/23/08)
  • Wong, Grace. "Anatomy of a tax shelter." CNNMoney.com 9/12/2005. http://money.cnn.com/2005/09/09/news/fortune500/scandal_taxshelters/index.htm (Accessed 4/20/08)
  • Yafie, Roberta C. "Clever, Effective, and Legal." Portfolio.com. 3/31/08. http://www.portfolio.com/resources/business-intelligence/2008/03/31/Income-Tax-Shelters-That-Work (Accessed 4/20/08)