- What is a Tax Shelter?
- How are Tax Shelters Abused??
- Tax Shelter Abuse Consequences
- How to Avoid Tax Shelter Abuse
What is a Tax Shelter?In order to understand tax shelters, it’s important to first understand a central feature of taxes, known as tax liability. Tax liability is the amount of tax payment you are responsible to pay the IRS. Your tax liability is based on a percentage of your taxable income, or the portion of money that you make that you are obligated to pay taxes on. A great way to lower your tax liability and therefore pay less in taxes is to reduce the portion of your income that is taxable. In order to do so, many taxpayers put their income directly into places where they cannot be taxed. These places are known as tax shelters. Tax shelters can come in many forms. Those include:
- Tax deductions: The IRS has designated a number of expenses that are considered to be for the betterment of a community. Those are things like charitable donations, student loan payments, and more. In order to incentivize taxpayers to take on these expenses, they have designated them as tax shelters. That means that taxpayers can deduct the cost of these expenses from their taxable income, therefore lowering their overall tax liability.
- Retirement accounts: Contributions to 401(k) accounts are also considered tax shelters. Tax payers who contribute to retirement accounts can deduct the amount they’ve contributed from their taxable income for the year. Additionally, the interest and earnings of the money in your retirement account are not taxable.
- Home equity: The sale of your home is another type of tax shelter. When you sell your home ,the first $250,000 to $500,000 is exempt from taxes.
How are Tax Shelters Abused?While there are plenty of completely legitimate and credible forms of tax shelters, many individuals and tax scammers use tax shelters to illegally lower their tax liability. Any tax shelter that is used solely for the purpose of lowering tax liability is considered abusive. Let’s say you’re an independent contractor and you make $500,000 a year in taxable income. In order to avoid paying taxes on the full $500,000 a month, you set up a fake corporation and “hire” 5 of your friends and family as employees of that corporation. You split $250,000 of your taxable income into 5 smaller payouts for each of your friends and family, lowering your taxable income to $250,000. They, in turn, hand the money right back to you. You maintain your $500,000, but through a tax shelter only pay income tax on half of it. Your fraudulent company would be known as an abusive tax shelter.
Abusive Tax Shelter ExamplesThe tricky thing about tax shelters is that the line between a legitimate tax shelter and an abusive tax shelter can be very thin. In order to help taxpayers stay in the clear, the IRS has published a list of “Listed Transactions”, i.e. IRS recognized abusive tax shelters, on IRS.gov. Those include things like:
- Guam trusts
- Debt Straddles
- Stock Compensation Transactions
- Inflated Partnership Basis Transactions
- Basis-Shifting Transactions