Structuring a transaction to result in minimizing income tax does not mean it is an abusive tax shelter. As the famous quote from Judge Learned Hand says: "Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible."
In general terms, a tax shelter is any investment designed to reduce or avoid income taxes. This is not bad and certainly can be legal. There are many ways to save income taxes, and there are many legitimate tax shelters. One example of a legitimate tax shelter is a real estate investment. As your property appreciates in value (at least that's the plan), you can take a deduction for depreciation. If a loss is generated by operating rental real estate, it may be used to offset other income.
The single most common tax shelter in the country today are employer sponsored retirement plans like 401(k)s and IRAs. These plans give employees the ability to defer income taxes on the plan contribution and its earnings until retirement. Probably the most attractive shelter of all time is the Roth IRA. Money is contributed on an after-tax basis, and the funds and their earnings are not taxed when withdrawn in retirement.
When do you cross the line between arranging your affairs to pay the least possible taxes, and participating in abusive tax shelters? The line is the same as the one between avoiding taxes and evading taxes. The IRS considers participation in abusive tax shelters as tax evasion which is illegal.
The main difference between a legitimate tax shelter and an abusive tax shelter is the shelter's economic reality. Legitimate shelters, such as retirement accounts, usually generate income and have economic substance. An abusive tax shelter is simply a way to keep money from being taxed.
An abusive tax shelter is an attempt to reduce the amount of taxes owed, but it does not provide any means to gain actual money - it has no economic substance. Here is an example: a promoter offers a $10,000 investment that you will lose, but you will get $50,000 in tax write-offs. The IRS says abusive tax shelters are "marketing schemes that involve artificial transactions with little or no economic reality. They often make use of unrealistic allocations, inflated appraisals, losses in connection with non-recourse loans, mismatching of income and deductions, financing techniques which do not conform to standard commercial business practices, or the mischaracterization of the substance of the transaction." The IRS has a list of types of transactions that it considers to be abusive: Foreign Trusts, International Business Corporation transactions, Stock Compensation Transactions, Lease in/Lease Out or LILO Transactions, Offsetting Foreign Currency Option Contracts.
If you are offered a deal that you think may be questionable, have it reviewed by your own tax advisor. If the promoter balks at that, you have a clear sign that the deal may not be legitimate. Some promoters ask you to sign confidentiality agreements to keep the deal secret - another sign the deal may not withstand scrutiny.
Money-zine.com offers three simple rules of thumb that can be used to help separate legitimate from questionable tax shelters:
1. 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.
2. 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.
3. 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.
On October 4, 2011 the Department of Justice prevailed on three abusive tax shelter cases on the same day. Who were the offenders? D. Andrew Beal (a billionaire Dallas banker), Principal Life Insurance Co. and Wells Fargo & Co. "These three significant decisions are further evidence that the courts will not countenance abusive tax shelters, no matter who designs them or how complicated they are," said John A. DiCicco, Principal Deputy Assistant Attorney General of the Justice Department's Tax Division. "Large corporations and wealthy individuals should think twice before pouring money into these sham arrangements."
