Tax Shelters

Generally, a tax shelter is a program that allows individuals or businesses to permanently reduce or defer the payment of income taxes.  Certainly tax shelters are not right for everyone; even legitimate tax shelters involve a level of risk that not every investor will be comfortable undertaking.

Legal and Illegal Tax Shelters

In this publication, we're going to discuss the overall concept of a tax shelter.  This includes legal / legitimate shelters, as well as those that are considered questionable or even illegal.

The IRS takes a very close look at tax sheltering because it has traditionally been an area subject to abusive practices.  So how can individuals recognize what is a legitimate tax shelter?

The IRS and Tax Shelters

The IRS defines tax shelters as an investment that usually requires substantial contributions, often associated with a commensurate degree of risk.  To the investor, a tax shelter usually means an investment that involves losses in the near-term, with the hopes of significant gains over the long-term.

For example, if you were to invest in property located in a low-income neighborhood, the depreciation benefits of that property would be viewed as a legitimate tax shelter.

The amount of deductions or losses you can take on a potential tax shelter is limited to the total amount you have invested, or at risk.  For example, the amount considered "at risk" for any tax shelter activity might be limited to:

• The adjusted basis of the property you have contributed to the shelter.
• The cash you have invested in the shelter.
• Any loans you have taken out to invest in the shelter that you are personally liable for paying back.

Treatment of Tax Shelter Losses

It is important to understand that tax shelter / business activity credits or losses are very likely considered passive activity credits or losses.  Passive activity losses can only be used to offset income from other passive tax shelter activities.  This means that they cannot be used to offset other income sources such as wages, interest, or dividends.

Any excess passive losses generated from these passive activity tax shelters may be carried forward until you can use them, or until you dispose of the tax shelter.

Be wary of tax shelters that are marketed with promises of write-offs larger than the amount invested.  The IRS considers these Abusive Tax Shelters, and we will discuss this topic later on.  Most of this is common sense; people invest with the hope of making money.  A legitimate tax shelter involves some risk, reduces taxes fairly, and does produce income.  If the IRS catches you in an abusive tax shelter scheme, you will be paying the tax owed plus interest and penalties.

Legitimate Tax Shelters

The following are some of the more common legitimate tax shelters used by individuals as well as businesses.  While any one of these can be twisted into an illegal form, these plans and programs are generally viewed as legal.

Retirement Plans

Perhaps the single most common tax shelter in the United States today has to do with individual retirement plans.  Both individual retirement accounts and employee sponsored plans such as the 401k and 403b plans offer individuals the ability to defer payment of income taxes until their retirement years.

With the Roth IRA, Roth 401k, and Roth 403b, money is contributed on an after-tax basis, and the funds are not taxed when withdrawn in retirement.  This is arguably one of the most attractive tax shelters of all time.

Limited Partnerships / Flow-Through Shares

There are certain heavy industries, such as mining or oil drilling operations, that can spend a lot of capital money on exploration, and dedicate years of effort before generating real income for investors.

To encourage investment in these types of industries, the U.S. tax code allows the cost of exploration to be distributed to shareholders in the form of a tax deduction.  This mechanism allows investors an immediate income tax savings, as well as the ability to realize future gains from the exploration effort.

The IRS allows individuals to claim these exploration losses only as an offset to passive investment income, not all earned income.

Questionable Tax Shelters

Perhaps the two most common examples of illegal, or questionable, tax shelters today involve certain types of financing arrangements and offshore investments.

Financing Arrangements

The most common tax shelter of this type involves a financing arrangement whereby one person pays an extremely high rate of interest on money invested.  By doing so, the individual can reduce the income associated with the investment.  When the investment is withdrawn, a large capital gain is then realized.  The tax shelter occurs because capital gains are taxed at a lower rate than interest or dividend payments.

Offshore Investments

If an individual transfers funds to an offshore company, then that transfer is considered a deductible expense, thereby lowering taxable income.  Because of certain international tax agreements or treaties, income realized from these countries may not be taxable.  In this example, the tax shelter exists for the sole purpose of avoiding the payment of income taxes.

Identifying Illegal Tax Shelters

It's important to understand why a tax shelter might not be legitimate, because it's not always clear to the casual investor.  Here are three simple rules of thumb that can be used to help separate legitimate from questionable tax shelters:

• If the sole purpose of a particular transaction is to lower taxes, and not provide any other economic benefit to the parties involved, then the transaction should be considered questionable or unethical.
• If a transaction involves the exchange of assets, goods, or services at prices that are below fair market value, then this type of tax shelter should be considered questionable.
• Finally, if the rate of interest paid to another party is unusually low or high, and the intention of charging this unusually high or low interest rate is to shelter income from taxes, then this type of arrangement should be considered unethical.

About the Author - Tax Shelters

Bill Sharlow is the Editor of Money-Zine.com.  Copyright © 2004 - 2011 Money-Zine.com