Tax shelters can be good–reducing your taxable income. But tax shelters can be bad–illegal and causing participants to commit tax fraud. How to know what shelters to avoid? The key is education, read the IRS forms, and pay attention. The old caveat, if it sounds too good, it’s most likely bad, is very often true. The best tax shelter for the business owner is to use sound tax planning strategies and think of your business as a legal way to avoid and rightfully reduce taxes. It is all in the deductions and keeping good records (receipts, checks, daily journals).

A tax shelter is a type of investment that allows people to reduce their tax liability. Pension plans and real estate investments are good examples. Persons can reduce taxable income if you have losses on investments. These are all legal strategies. But fraudulent or “abusive tax shelters” are considered by the IRS to use many schemes to filter or hide transactions: trusts, off-shore credit/debit cards, hedges, circular cash flows, defeasances, insurance schemes, and other activities are all attempts to hide. If investments insulate the client from significant economic risk, the courts have decided they are not appropriate.

The IRS considers tax shelters “abusive” when they are designed solely for avoiding taxes. They have no other significant business purpose. There are various means to do the abusive practices–helping clients falsify tax losses or report phony tax losses. In 2005, KPMG, a Big Four accounting firm, cost the U.S. $2.5 billion, according to the Department of Justice, by helping clients to develop tax losses. The following scenario (from Grace Wong, a reporter from CNN’s website “Money”) is a simplified explanation of one method such firms used to help clients develop tax losses.

Here’s an example:

* Joe is a new millionaire and has capital gains of $20 million. He wants to create an “artificial” loss.

* Joe places an option in identical amounts and prices on the euro /U.S. dollar for exchange rates. He buys a call option with the right to buy Euros at a certain price on or before a certain date for a premium of $20 million. He writes an option with the same strike price and expiration date for $20 million. The premiums offset each other.

* Joe then transfers the option to a partner in a friendly “accommodation” partnership, someone who paid big fees to enter into a partnership with no real business purpose.

* When he sells for zero profit, Joe claims a tax loss of $20 million, even though he’s incurred no real economic loss.

Hard to follow the details? The concepts of many bad tax shelters lack definable business purpose. An “abusive tax shelter” is a marketing scheme that offers tax transactions with little or no economic value. In the real world people invest money to make money. The bad kind of tax shelters offer inflated tax savings based on large tax write offs and tax credits out of proportion to your investment. There is no real economic investment. An abusive tax shelter often involves little risk and its tax write off ratio is frequently much greater than one-to-one. If you use a tax shelter, be sure to file Form 8271 from the IRS. Read the experts. Read the known tax shelter abusers listed on the government’s IRS site. And below are some of the worst schemes for abusive tax shelters.

Tax Shelters the IRS Dislikes
Lease In Lease Out(LILO) Sale In Lease Out (SILO) Partnership Straddle Corporation Owned Life Insurance Sham Transactions (COLI) Overseas Shelters