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Introduction
A tax shelter is a type of investment that allows someone to reduce their tax liability. Examples include investments in pension plans and real estate. You can also reduce your taxable income if you have losses on investments.
But when shelters are designed solely for the purpose of avoiding taxes, they become abusive Tax shelters.
The vast majority of tax shelters are in full compliance with the tax laws, but an increasing number of them have crossed the bounds into being "abusive tax shelters". These are cases where the revenue loss to the government produces little or no tax benefit to society.
Definition of a Tax Shelter
is any investment strategy that enables you to legally decrease or avoid taxation
is an investment with tax deductions and tax benefits of greater value than the investment itself
A device used by a taxpayer to reduce or defer payment of taxes
Transactions promoted for the promise of tax benefits with no meaningful change in the taxpayer's control over, or benefit from the taxpayer's income or assets. These are transactions that typically have no economic purpose other than reducing taxes
Characteristics of a Tax Shelter
There are many methods by which taxpayers shelter their losses, but these three characteristics are usually found in tax shelters, either separately or in combination:
Taxes are deferred to later years.
Ordinary gains (100 percent taxable) are converted to capital gains (only 40 percent taxable), or capital losses (only 50 percent deductible), are converted to ordinary losses (100 percent deductible); in both cases producing a lower tax liability (valid until 1987).
Leverage is obtained through various financing arrangements
Common Tax Shelter Strategies
Lower your current taxable income — Placing your money in certain investments is one way to lower your taxable income.
Lower the tax rate of certain income — For example, hold onto an investment long enough to be taxed at long-term rather than short-term capital gains rates.
Increase your itemized deductions — Sometimes, you can combine deductions in one year to gain a higher benefit.
Defer income to years when you expect to be in a lower tax bracket
Existing tax shelters
Tax Deferred Programs-allows you to select an amount by which the gross salary can be reduced and tax-sheltered. The tax deferred portion of the gross income is not included as part of your gross earnings for State and Federal tax purposes. Thus, the employee receives a current tax advantage (401k or IRA plans)
401K Plans- Each participating employee decides the amount to be withheld as a 401k contribution each month from his or her pay.
-- The employer withholds these amounts BEFORE calculating income taxes on the employee's pay.
-- The employer forwards the money to a third party administrator, who invests the employees' contributions per specific instructions provided by the employees.
Traditional IRA -designed as a tax shelter to hold money contributed by individuals for their retirement. Because most funds in these accounts were deposited on a pre-tax basis, when you retire and begin withdrawing the funds, you will pay income taxes on the withdrawals at your then-current tax rate
Roth IRA -contributions for this type of IRA typically come directly from your wallet or bank account and NOT as deductions from your income via work. The main advantage of a Roth IRA is that when you retire and begin withdrawing the money you pay NO TAXES on the withdrawals
Existing Tax shelters (cont.)
Deductions for Owning Your Home
1. Mortgage Interest
Joint tax filers can deduct all the interest on a maximum of $1 million in mortgage debt secured by a first and second home.
2. Equity Loan Interest
deduct some of the interest you pay on a home equity loan or line of credit.
3. Property Taxes
property taxes are fully deductible from your income.
4. Capital Gains Exclusion
Married taxpayers who file jointly now get to keep, tax free, up to $500,000 in profit on the sale of a home used as a principal residence for two of the prior five years. Single folks and married taxpayers who file separately get to keep up to $250,000 apiece tax free (Taxpayer Relief Act of 1997 )
Deductions For Legitimate Business Activity
Business must have a “profit motive”
To qualify as business deductions, expenses must be:
Ordinary and necessary,” This is defined as any activity that is associated with that business
Paid or incurred during the taxable year, and connected with the conduct of a trade or business .
Gifting
you can give up to the annual exclusion amount ($11,000 in 2004) to a person, every year, without facing any gift taxes, and without the recipient owing an income tax on the gifts. And you can give up to $1,000,000 in gifts total, in your lifetime
What’s an Abusive tax Shelter?
Definition: a transaction, or series of transactions, created for the sole purpose of avoiding taxes. Unlike legal tax planning techniques, abusive tax schemes often use "multi-layer transactions for the purpose of concealing the true nature and ownership of the taxable income and/or assets," according to the Internal revenue service.
What’s an abusive tax shelter ? (cont.)
An "abusive tax shelter" is a marketing scheme that involves tax transactions with little or no economic value. An abusive tax shelter offers you inflated tax savings on your tax return based on large tax write offs and tax credits. The tax write offs and tax credits on your tax return are often out of proportion to your investment. An abusive tax shelter exists solely to reduce tax on your tax return with no real economic benefit.
Potential abuse indicators
Tax examiners are taught to investigate the following situations for possible abusive financial maneuvers:
Investments made late in the tax year indicate there may be deductions for prepaid expenses that are not allowable.
A very large portion of the investment made in the first year indicates the transaction may have been entered into for tax purposes rather than economic motivation.
A loss exceeding a taxpayer's investment indicates the possibility of a nonrecourse note.
If the burdens and benefits of ownership have not passed to the taxpayer, the parties have not intended for ownership of the property to pass at the time of the alleged sale.
A sales price that does not relate comparably to the fair market value of the property indicates the value of the property has been overstated.
If the estimated present value of all future income does not compare favorably with the present value of all the investment and associated costs of the shelter the economic reality of the investment may be questionable.
Checklist for an abusive tax shelter
The IRS has also issued the following as a checklist for determining whether a particular offering is an abusive tax shelter. These questions will help to provide a clue as TO THE abusive nature of the plan:
Do the benefits far outweigh the economic benefits?
Is this a transaction you would seriously consider, apart from the tax benefits, if you hoped to make a profit?
Do shelter assets really exist and, if so, are they insured for less than their purchase price?
Is there a nontax justification for the way profits and losses are allocated to partners?
Do the facts and supporting documents make economic sense? In that connection, are there sales and resales of the tax shelter property at ever increasing prices?
Does the investment plan involve a gimmick, device, or sham to hide the economic reality of the transaction?
Does the promoter offer to backdate documents after the close of the year and are you instructed to backdate checks covering your investment?
Is your debt a real debt or are you assured by the promoter that you will never have to pay it?
Does the transaction involve laundering United States-source income through foreign corporations incorporated in a tax haven and owned by the United States shareholders?
Abusive Tax Shelters
Offshore Transactions. Some people use offshore transactions to avoid paying United States income tax. Use of an offshore credit card, trust or other arrangement to hide or underreport income or to claim false deductions on a federal tax return is illegal.
Phony Tax Payment Checks. In this scheme, con artists sell fictitious financial instruments that look like checks to pay a tax liability, mortgage and other debts. The con artists may also counsel their clients to use a phony check to overpay their taxes so they can receive a refund from the IRS for the overpayment. The false checks, called sight drafts, are worthless and have no financial value. It is illegal to use these sight drafts to pay a tax liability or other debts
Abusive Tax Shelters
No Taxes Withheld From Wages. Illegal schemes are being promoted that instruct employers not to withhold federal income tax or employment taxes from wages paid to their employees. These schemes are based on an incorrect interpretation of tax law and have been refuted in court
Improper Home-Based Business. This scheme purports to offer tax “relief” but in reality is illegal tax avoidance. The promoters of this scheme claim that individual taxpayers can deduct most, or all, of their personal expenses as business expenses by setting up a bogus home-based business. But the tax code firmly establishes that a clear business purpose and profit motive must exist in order to generate and claim allowable business expenses.
Abusive Tax Shelters
Share/Borrow EITC Dependents. Unscrupulous tax preparers "share" one client's qualifying children with another client in order to allow both clients to claim the Earned Income Tax Credit. For example, one client may have four children but only needs to list two to get the maximum EITC. The preparer will list two children on the first client’s return and the other two on another client’s tax return. The preparer and the client "selling" the dependents split a fee.
Tax shelter penalties
Enhanced penalties
Last year's big tax cut, the American Jobs Creation Act of 2004 (2004 Jobs Act), boosted the penalties for failing to disclosure abusive transactions .The penalty for failing to disclose a reportable transaction is $10,000 for individuals and $50,000 for businesses and other entities. The penalty for not disclosing a listed transaction is higher: $100,000 for individuals and $200,000 for all other taxpayers. Taxpayers also risk accuracy-related penalties.
Tax shelter penalties
The 2004 Jobs Act did not go far enough for some in Congress. The Tax shelter and Tax Haven Reform Act of 2005, which was recently introduced in the Senate, would impose hefty fines on promoters, either 150 percent of the promoter's gross income from the transaction or the amount assessed against the taxpayer, whichever is greater. "Effective penalties should make sure that the peddler of an abusive tax shelter is deprived of every penny of profit earned from selling or implementing the shelter and is fined on top of that," Senator Carl Levin, D-Mich., one of the bill's sponsors, said.
Tax shelter penalties
Types of penalties
The following tax shelter penalties must be disclosed to the SEC:
The penalty imposed by Code Sec. 6707(a) in the amount determined under Code Sec. 6707A(b)(2) for failing to disclose a listed transaction
The accuracy-related penalty imposed by Code Sec. 6662A(a) at the 30 percent rate determined under Code Sec. 6662A© for a reportable transaction understatement with respect to which the relevant facts affecting the tax treatment of the item were not adequately disclosed under Code Sec. 6011 regs;
Tax Shelter penalties
The accuracy-related penalty imposed by Code Sec. 6662(a) at the 40 percent rate determined under Code Sec. 6662(h) for a gross valuation misstatement if the person would, but for the exclusionary rule of Code Sec. 6662A(e)(2©(ii), have been subject to the accuracy-related penalty under Code Sec. 6662A(a) at the 30 percent rate determined under Code Sec. 6662A©; and
The penalty imposed by Code Sec. 6707A(e) for failing to disclose the above three penalties to the SEC.
Caution. The IRS treats not disclosing any of the first three penalties the same as failing to disclose a listed transaction Consequently, the taxpayer is liable for additional penalties.
Tax Shelter FAQs
If I want to withdraw my 401(k) from my old job, what are the tax consequences?
If you are under 59 and 1/2, the entire amount withdrawn will be taxable and is generally subject to the 10% penalty on early distribution unless you rollover the distribution to another retirement plan or an IRA within 60 days of receiving the distribution.
Tax Shelter FAQs
I had a 401(K) plan in my prior job. Can my retirement money be transferred to my current 401(k) plan?
Yes. It's called a rollover from one qualified plan to another qualified plan. The distribution will not be taxable when the rollover is made within 60 days. In order to avoid the 20% withholding tax, the transfer should be made directly from one trustee to another.
Tax Shelter FAQs
Can I withdraw funds penalty free from my 401(k) plan to purchase my first home?
If you are under the age of 59 1/2, you cannot withdraw funds from your 401(k) plan to purchase your first home without being subject to a 10 percent additional tax on early distributions from qualified retirement plans. However, depending on the rules for your 401(k), you may be able to borrow money from your 401(k) to purchase your first home. Your plan administrator should have written information about your particular plan that explains when you can borrow funds from your 401(k) as well as other plan rules
Tax Shelter FAQs
If I sell my home and use the money I receive to pay off the mortgage, do I have to pay taxes on that money?
It is not the money you receive for the sale of your home, but the amount of gain on the sale over your cost, or basis, that determines whether you will have to include any proceeds as taxable income on your return. You may be able to exclude any gain from income up to a limit of $250,000 ($500,000 on a joint return in most cases). If you can exclude all of the gain, you do not need to report the sale on your tax return.
Tax Shelter FAQs
If I take the exclusion of capital gain on the sale of my old home this year, can I also take the exclusion again if I sell my new home in the future?
With the exception of the 2-year waiting period, there is no limit on the number of times you can exclude the gain on the sale of your principle residence so long as you meet the ownership and use tests.
Tax Shelter FAQs
What is the amount of capital gains from the sale of a home that can be excluded if sold in less than the two-year waiting period?
If you owned and lived in the property as your main home for less than 2 years, you may still be able to claim an exclusion in some cases. The maximum amount you can exclude will be reduced.
Tax Shelter FAQs
Is interest on a home equity line of credit deductible as a second mortgage?
You may deduct home equity debt interest, as an itemized deduction, if you are legally liable to pay the interest, pay the interest in the tax year, secure the debt with your home, and do not exceed your home equity debt limit.
Tax Shelter FAQs
I took out a home equity loan to pay off personal debts. Is this interest deductible? Where do I enter this amount on my tax return?
A loan taken out for reasons other than to buy, build, or substantially improve your home, such as to pay off personal debts may qualify as home equity debt. The interest would be deducted on line 10, Form 1040 Schedule A Itemized Deductions. You may not deduct interest on any amount of home equity debt that exceeds your home equity debt limit, which generally is $100,000.
Tax Shelter FAQs
Who invests in abusive tax schemes?
Individuals and business entities with large, constant streams of income or with substantial gains from one-time events may invest in abusive tax schemes.
Tax Shelter FAQs
Why did abusive tax schemes become so common?
Abusive tax schemes multiplied in the 1990's for various reasons:
Taxpayers had large capital gains or other income subject to income tax.
Internal Revenue Service compliance activity decreased.
Promoters increased the marketing of abusive tax schemes as 'legally defensible' ways to minimize tax burdens.
Penalties for participating in abusive tax schemes were too small to have a deterrent effect.
There was no efficient disclosure and reporting system for abusive tax schemes
Tax Shelter FAQs
I am considering a tax shelter investment. How can I recognize an abusive tax shelter?
Tax shelters reduce current tax liability by offsetting income from one source with losses from another source. The IRS allows some tax shelters, but will not allow a shelter which is "abusive." An abusive shelter generally offers inflated tax savings which are disproportionately greater than your actual investment placed at risk. Generally, you invest money to generate income. However, an abusive tax shelter generates little or no income, and exists solely to reduce taxes unreasonably for tax avoidance or evasion. In comparison, a legitimate tax shelter often produces income and involves a risk of loss proportionate to the expected tax benefit. Abusive tax shelters are often marketed in terms of how much you can write off in relation to how much you invest. This "write off" ratio is often much greater than two-to-one as of the close of any of the first five year ending after the date on which the investment is offered for sale. A series of tax laws have been designed to halt abusive tax shelters. An organizer of a potentially abusing tax shelter who doesn't maintain a list of investors is subject to penalty of $50 per failure, per person, unless due to a reasonable cause and not willful neglect.