Tax Shelter

1
Tax Shelter

• Presented by
• Alice Kasubutare
• Boon Ong

2
Agenda

• Introduction
• Tax Shelter
• Abusive tax shelter
• Tax shelter penalties
• Tax shelter FAQs
• Additional readings
• References
• Appendix IRC Code

3
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.

4
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

5
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

6
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

7
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.

8
Existing tax shelters (cont.)

• 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

9
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 )

10
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
  .
• 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

11
Whats 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.

12
Whats 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.
  

13
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.

14
Potential abuse indicators (cont.)

• 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.

15
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?

16
Checklist for an abusive tax shelter (cont.)

• 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?

17
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

18
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.

19
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 clients return and the other two on
  another clients tax return. The preparer and the
  client "selling" the dependents split a fee.

20
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.

21
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.

22
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

23
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(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.

24
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.

25
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.

26
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

27
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.

28
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.

29
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.

30
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.

31
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.

32
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.

33
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

34
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.

35
Additional Readings

• http//www.unclefed.com/Audit-Proofing/step4-3.htm
  l
• http//www.irs.gov/businesses/corporations/article
  /0,,id120633,00.html
• CCH-JOURNAL, TAXES-The Tax Magazine, March 2004,
  Observations on Disclosure, Transparency and
  Taxpayer Compliance.

36
References

• 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/article
  /0,,id120633,00.html

37
Appendix

• IRC Code

38
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

39
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.

40
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.

41
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.

42
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.

43
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.

44
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.

45
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 --

46
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.

47
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.