Abusive Tax Shelter
is an illegal investment strategy executed with the sole purpose of reducing one's income tax without lowering the investor's income and assets.
Abusive Tax Shelter Details
Tax shelters are legitimate and legal methods that individuals and corporations use to obtain favorable tax treatment. Most commonly, through employer-sponsored 401(k) retirement plans, municipal bonds, and some real estate investments.
On the other hand, an abusive tax shelter is a term used to describe "abusing" tax sheltering to save money on income tax. Individuals or entire companies will seek out tax shelter strategies for the sole purpose of tax avoidance. There is a whole IRS (Internal Revenue Service) branch responsible for gathering information on potential abusive tax shelters known as the Office of Tax Shelter Analysis (OTSA).
IRS regulators often penalize these individuals through analyzing businesses' self-reports. Self-reports are required when engaging in some types of transactions for this very reason. The IRS has a reporting hotline service where citizens (anonymously, if preferred) can provide information regarding abusive tax shelter transactions. The U.S. Treasury also assists by prioritizing clear and understandable regulations regarding tax shelters, as well as keeping track of any party involved in selling or organizing tax shelters and their investors.
Nowadays, most businesses must provide Form 8886 (Reportable Transaction Disclosure Statement) along with their tax returns. In this form, the taxpayer has to disclose transactions known as "listed transactions." The IRS official website states that listed transactions are what the IRS has determined to be transactions with the goal of tax avoidance or tax fraud. The IRS website lists these transactions as the following:
- 401(k) Accelerated Deductions
- S Corporation ESOP Abuse of Delayed Effective Date for Section 409(p)
- Specific Trust Arrangements Seeking to Qualify for Exemption from Section 419
- Abusive Roth IRA Transactions
- S Corporation ESOP Abuses: Certain Business Structures Held to Violate Code Section 409(p)
- Deductions for Excess Life Insurance in Section 412(i) or Other Defined Benefit Plan
Real-World Example of Abusive Tax Sheltering
The IRS has a "Whistleblower Program." Participants provide specific and credible evidence that a taxpayer avoids or underpays a tax obligation to the federal government. If their information leads to a government recovery of at least $2 million, the participant will be rewarded accordingly. These are two real-life examples of the whistleblower program from the Constantine Cannon website:
An anonymous member of the whistleblower program pointed out the illegitimate leasing and investment by Illinois Tools Works with a Swiss bank. By doing so, the company was unlawfully multiplying its tax deductions. This lead to the recovery of millions of dollars in tax money, which earned the anonymous member $2 million.
In late 2001, a whistleblower tipped the IRS of a scandal involving the company Enron. According to Constantine Cannon, the company was taking part in "establishing trusts and other vehicles to take permissible deductions more than once." The person who gave this information to the IRS was awarded $1.1 million.
Significance of Abusive Tax Sheltering
According to a 2019 report from the Government Accountability Office, on a federal level, the money lost from tax evasion and fraud is around $458 billion per year ($406 billion after the IRS takes enforcement actions). An abusive tax shelter is just one of the many schemes and illegal strategies executed to save money on taxes. Alone, it robs the government of millions per year.
Tax sheltering is a legitimate investment which in return, lowers the investors' tax liability. It is because it's a perfectly legal and regular thing to do that it's so hard to determine who's abusing the system. For this very reason, the IRS and the U.S. Government go through so much trouble to identify and punish tax shelter abusers.
Anyone who takes part in tax sheltering is in for a significant risk. The consequences of being found guilty of abusive tax sheltering fall under Section 7201 of the Internal Revenue Code, which states that anyone, who tries to avoid taxes, along with other possible penalties, can be fined up to $100,000 ($500,000 in the case of a corporation) or imprisoned for up to 5 years.