Once you hear the words “tax shelter,” you may immediately want to check out, and think such lofty financial terms are not for you, but the fact is that you probably own a tax shelter! A tax shelter is an investment that allows you to reduce or eliminate what you must pay in taxes, or your “tax liability.” You can put money in retirement plans or real estate, and both of these are legitimate tax shelters. The reason these investments are legitimate is because their sole purpose is NOT to lower your tax liability. Presumably you make these investments to make money. However, when these investments lose money, or when your real estate depreciates, you can reduce your taxable income based on those losses.
Understanding Tax Shelter Fraud
Not all tax shelters are legitimate and tax shelter fraud does exist. There are largely three ways that tax shelters can be fraudulent:
- Tax shelters that simply hide money to avoid paying taxes are fraudulent
- Buying or selling assets, goods, or services at far below market value to shelter income is unethical
- Charging an unusually high or low interest rate, again with the intent of hiding income from taxes, is considered an illegitimate tax shelter
There are two common illegal tax shelters: Unusual financing arrangements and Offshore accounts.
- Offshore Accounts - When you invest in or transfer money to a company outside of the United States, you can typically deduct this investment from your taxable income, so it becomes a way of sheltering income. The tax code and international rules regarding taxation in other countries may also mean that income you make on that investment, in the form of interest or other income, may not need to be taxed. Pouring money into such an offshore account with the purpose of avoiding taxation and lowering taxable income is illegal.
- Unusual Financing - If you pay very high interest on money that you have invested, you can reduce the income that comes with this investment. You do so by withdrawing your investment, resulting in a large capital gain. Because capital gains are taxed at a lower rate than incurred interest, you have effectively sheltered income using this financial arrangement.
Getting Help
Honest accounting is always the best policy! To avoid inadvertently creating fraudulent tax shelter, hire a tax attorney that you trust, and that can help make sure you uphold the law. By doing so, you may not hide as much income, but you certain stand to avoid legal worries in the future.
