Transcript Tax Shelter – Mercer University

Tax Shelter
Presented by:
Alice Kasubutare
Boon Ong
Agenda
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Introduction
Tax Shelter
Abusive tax shelter
Tax shelter penalties
Tax shelter FAQs
Additional readings
References
Appendix: IRC Code
Introduction
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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
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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
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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.
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Existing tax shelters (cont.)
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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.)
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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 )
Existing tax shelters (cont.)
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 .
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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?
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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.)
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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.
Potential abuse indicators (cont.)
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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?
Checklist for an abusive tax shelter (cont.)
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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
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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
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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
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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
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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
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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(c)
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
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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(C)(ii), have been
subject to the accuracy-related penalty under Code Sec.
6662A(a) at the 30 percent rate determined under Code Sec.
6662A(c); 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.
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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.
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Tax Shelter FAQs
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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
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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.
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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.
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Tax Shelter FAQs
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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.
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Tax Shelter FAQs
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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
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Tax Shelter FAQs
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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.
Additional Readings
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http://www.unclefed.com/Audit-Proofing/step4-3.html
http://www.irs.gov/businesses/corporations/article/0,,id=120633,
00.html
CCH-JOURNAL, TAXES-The Tax Magazine, March 2004,
Observations on Disclosure, Transparency and Taxpayer
Compliance.
References
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http://www.irs.gov/faqs/faq-kw195.html
http://www.ftb.ca.gov/law/tax_shelter/ats_faq.
html
http://www.irs.gov/businesses/small/article/0,,
id=106788,00.html
http://www.irs.gov/businesses/corporations/ar
ticle/0,,id=120633,00.html
Appendix
IRC Code:
IRC
§ 6111. REGISTRATION OF TAX SHELTERS
(a)(1) IN GENERAL. --Any tax shelter organizer shall register the
tax shelter with the Secretary (in such form and in such manner as the
Secretary may prescribe) not later than the day on which the first
offering for sale of interests in such tax shelter occurs.
(a)(2) INFORMATION INCLUDED IN REGISTRATION. --Any
registration under paragraph (1) shall include -(a)(2)(A) information identifying and describing the tax shelter,
(a)(2)(B) information describing the tax benefits of the tax shelter
represented (or to be represented) to investors, and
IRC
(a)(2)(C) such other information as the Secretary may prescribe
(b) FURNISHING OF TAX SHELTER IDENTIFICATION NUMBER;
INCLUSION ON RETURN.
(b)(1) SELLERS, ETC. --Any person who sells (or otherwise transfers)
an interest in a tax shelter shall (at such times and in such manner as
the Secretary shall prescribe) furnish to each investor who purchases
(or otherwise acquires) an interest in such tax shelter from such
person the identification number assigned by the Secretary to such
tax shelter.
(b)(2) INCLUSION OF NUMBER ON RETURN. --Any person claiming
any deduction, credit, or other tax benefit by reason of a tax shelter
shall include (in such manner as the Secretary may prescribe) on the
return of tax on which such deduction, credit, or other benefit is
claimed the identification number assigned by the Secretary to such
tax shelter.
IRC
(C) Tax shelter
(c)(1) IN GENERAL. --The term "tax shelter" means any investment -(c) (A) with respect to which any person could reasonably infer from the
representations made, or to be made, in connection with the offering
for sale of interests in the investment that the tax shelter ratio for any
investor as of the close of any of the first 5 years ending after the
date on which such investment is offered for sale may be greater
than 2 to 1, and
(c) (A)(B) which is -(c) (A) (B) (i) required to be registered under a Federal or State law
regulating securities,
(c) (A) (B) (ii) sold pursuant to an exemption from registration requiring
the filing of a notice with a Federal or State agency regulating the
offering or sale of securities, or
(c) (A) (B) (iii) a substantial investment.
IRC
(d) CERTAIN CONFIDENTIAL ARRANGEMENTS TREATED AS TAX
SHELTERS. –
(d)(1) IN GENERAL. --For purposes of this section, the term "tax
shelter" includes any entity, plan, arrangement, or transaction -(d)(1)(A) a significant purpose of the structure of which is the avoidance
or evasion of Federal income tax for a direct or indirect participant
which is a corporation,
(d)(1)(B) which is offered to any potential participant under conditions of
confidentiality, and
(d)(1)(C) for which the tax shelter promoters may receive fees in excess
of $100,000 in the aggregate.
IRC
§ 6112. ORGANIZERS AND SELLERS OF POTENTIALLY ABUSIVE
TAX SHELTERS MUST KEEP LISTS OF INVESTORS
(a) IN GENERAL. --Any person who -(a)(1) organizes any potentially abusive tax shelter, or
(a)(2) sells any interest in such a shelter,
shall maintain (in such manner as the Secretary may by regulations
prescribe) a list identifying each person who was sold an interest in
such shelter and containing such other information as the Secretary
may by regulations require.
IRC
(b) POTENTIALLY ABUSIVE TAX SHELTER. --For purposes of
this section, the term "potentially abusive tax shelter" means -(b)(1) any tax shelter (as defined in section 6111) with respect to
which registration is required under section 6111, and
(b)(2) any entity, investment plan or arrangement, or other plan or
arrangement which is of a type which the Secretary
determines by regulations as having a potential for tax
avoidance or evasion.
IRC
§ 6707. FAILURE TO FURNISH INFORMATION REGARDING TAX
SHELTERS.
(a) FAILURE TO REGISTER TAX SHELTER. -(a)(1) IMPOSITION OF PENALTY. --If a person who is required to
register a tax shelter under section 6111(a) -(a)(1)(A) fails to register such tax shelter on or before the date described
in section 6111(a)(1), or
(a)(1)(B) files false or incomplete information with the Secretary with
respect to such registration,
such person shall pay a penalty with respect to such registration in the
amount determined under paragraph (2) or (3), as the case may be.
No penalty shall be imposed under the preceding sentence with
respect to any failure which is due to reasonable cause.
IRC
(a)(2) AMOUNT OF PENALTY. --Except as provided in paragraph (3),
the penalty imposed under paragraph (1) with respect to any tax
shelter shall be an amount equal to the greater of -(a)(2)(A) 1 percent of the aggregate amount invested in such tax
shelter, or
(a)(2)(B) $500.
(a)(3) CONFIDENTIAL ARRANGEMENTS. --
(a)(3)(A) IN GENERAL. --In the case of a tax shelter (as defined in
section 6111(d)), the penalty imposed under paragraph (1) shall be
an amount equal to the greater of --
IRC
(a)(3)(A)(i) 50 percent of the fees paid to all promoters of the tax shelter
with respect to offerings made before the date such shelter is
registered under section 6111, or
(a)(3)(A)(ii) $10,000.
Clause (i) shall be applied by substituting "75 percent" for "50 percent" in
the case of an intentional failure or act described in paragraph (1).
(a)(3)(B) SPECIAL RULE FOR PARTICIPANTS REQUIRED TO
REGISTER SHELTER. --In the case of a person required to register
such a tax shelter by reason of section 6111(d)(3) -(a)(3)(B)(i) such person shall be required to pay the penalty under
paragraph (1) only if such person actually participated in such shelter,
(a)(3)(B)(ii) the amount of such penalty shall be determined by taking into
account under subparagraph (A) (i) only the fees paid by such person,
and
(a)(3)(B)(iii) such penalty shall be in addition to the penalty imposed on
any other person for failing to register such shelter.
IRC
(b) FAILURE TO FURNISH TAX SHELTER IDENTIFICATION NUMBER. (b)(1) SELLERS, ETC. --Any person who fails to furnish the identification
number of a tax shelter which such person is required to furnish under
section 6111(b)(1) shall pay a penalty of $100 for each such failure.
(b)(2) FAILURE TO INCLUDE NUMBER ON RETURN. --Any person who
fails to include an identification number on a return on which such
number is required to be included under section 6111(b)(2) shall pay a
penalty of $250 for each such failure, unless such failure is due to
reasonable cause.