PrevNEXT

How Tax Shelters Work

By: John Barrymore  | 

Tax Shelter Abuse

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

Advertisement

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, look over the links that follow.

Originally Published: Aug 5, 2008

Tax Shelters FAQ

How does a tax shelter work?
A tax shelter helps reduce how much tax you pay the federal government by reducing your taxable income.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.
What qualifies as a tax shelter?
Many legitimate tax shelters are available to you. These shelters include: real estate investment pension plans 401(k) and 403(b) plans IRAs setting up your own business municipal bonds employer-sponsored health coverage employer-sponsored life insurance employer-funded education
What is the best tax shelter?
Real estate investments are one of the most popular tax shelters. Having real estate allows you to make significant deductions, like mortgage loan interest, mortgage insurance, and property taxes. It also helps individuals build wealth over the long run.
Can an LLC be a tax shelter?
An LLC can become a tax shelter because these businesses are limited in how much tax can be charged on their income. The tax limit is capped at 21 percent, and LLCs are also eligible for special small business deductions.
Can you write off property taxes?
Yes, you can write off your property taxes up to $10,000.

Related 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)