As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.
What is a tax shelter?
In the traditional sense, a tax shelter is simply a method that a taxpayer uses to generate tax deductions and credits by investing in “investment activities” that often are not expected to generate any real profits. Historically, taxpayers specifically entered into these transactions with the anticipation of producing losses that could be used to offset a taxpayer’s otherwise taxable gains.
The basic concept is presented in the example below, which illustrates the potential results of tax shelters that were available to investors before the enactment of legislation designed to curb the use of these shelters.
Example: Simon has annual income of $450,000 and dividend income of $30,000. He invests $40,000 in a 10 percent interest in ABC partnership (“ABC”), which is in the business of breeding racehorses (Simon had no active role in ABC’s business). ABC, through the use of $800,000 in nonrecourse financing and $200,000 in cash, purchased several horses as a part of this breeding program. After depreciation, interest and other deductions relating to the breeding program, ABC experiences a loss of $500,000. Simon’s share of the loss is $50,000 (10 percent). Even though Simon only actually invested $40,000 in the partnership (and could have only lost $40,000 if the investment subsequently became completely worthless), he would have been entitled to deduct his entire $50,000 share in ABC’s loss.
Although characteristics of a tax sheltered investment may vary depending on the form and type of vehicle employed, several common features are:
(1) Leverage. This refers to the maximization of investment return through the use of borrowed capital;
(2) Depreciation and Depletion. The tax shelter vehicle, such as an equipment leasing venture, may use the accelerated cost recovery system or accelerated depreciation with respect to the cost of the property. This is true even though all or part of the cost of the asset has been financed by other parties.
A depletion deduction may be available for an investment in natural resources such as oil, gas, timber and minerals. Although deductions for depreciation and depletion may create a loss from a tax standpoint, the investment's cash flow may still be positive. Thus, the investor may benefit from both a currently deductible loss and the receipt of cash flow for other investment or business endeavors;
(3) Deferral. If an investment is made in a venture which initially operates at a loss, the loss may be available to shield other income from current taxation. The tax liability is effectively deferred to later years when the investment is producing income.
Timing is important in this regard to avoid having deferred income taxed at a steeper rate in a later taxable year. Obviously, it is desirable that deductions are available in current high-income years while gain or investment income is realized in later low bracket years.
In recent years, the IRS has enacted legislation to prevent the use of tax shelters as vehicles that operate solely for the purpose of tax avoidance (see “abusive tax shelters” below), but one of the key elements of tax shelter partnerships prior to this legislative reform was the allocation of annual operating losses among the partners in such a manner that the investors seeking tax shelter were allocated losses disproportionately greater than their true relative economic interest in the partnership.
IRC Section 704(a) generally permits a partner’s distributive share of income, gain, loss or deduction to be determined by the partnership agreement. IRC Section 704(b)(2), however, provides that a partnership agreement’s allocation provisions that are different from the partners’ "interests in the partnership" (taking into account all facts and circumstances) will be effective only in situations in which the allocations have "substantial economic effect”. The IRS has developed an extensive set of economic effect tests and a definition of "substantiality" in the final regulations interpreting Section 704.
What is an abusive tax shelter?
While Congress has recognized that the loss of revenue is an acceptable side effect of special tax provisions designed to encourage taxpayers to make certain types of "tax shelter" investments that yield tax benefits, losses from tax shelters oftentimes produce little or no benefit to society, or the tax benefits are exaggerated beyond those intended. These cases are called “abusive tax shelters,” and are described by the IRS in Publication 550 as follows:
"Abusive tax shelters are marketing schemes involving artificial transactions with little or no economic reality. They often make use of unrealistic allocations, inflated appraisals, losses in connection with nonrecourse loans, mismatching of income and deductions, financing techniques that do not conform to standard commercial business practices, or mischaracterization of the substance of the transaction. Despite appearances to the contrary, the taxpayer generally risks little.
Abusive tax shelters commonly involve package deals designed from the start to generate losses, deductions, or credits that will be far more than present or future investment. Or, they may promise investors from the start that future inflated appraisals will enable them, for example, to reap charitable contribution deductions based on those appraisals. They are commonly marketed in terms of the ratio of tax deductions allegedly available to each dollar invested. This ratio (or “write-off”) is frequently said to be several times greater than one-to-one."
The IRS has taken steps to combat abusive tax shelters and transactions. A comprehensive strategy is in place to:
- Identify and deter promoters of abusive tax transactions through audits, summons enforcement and targeted litigation;
- Keep the public advised by publishing guidance on transactions and shelters that are determined to be abusive;
- Promote disclosure by those who market and participate in abusive transactions; and
- Develop and implement alternative methods for resolving abusive transactions claimed by taxpayers.
Planning Point: An investment that is considered a tax shelter is subject to restrictions, including the requirement that it be disclosed and registered. The regulations require taxpayers to disclose certain reportable transactions involving abusive tax shelters in which they participate. These transactions include transactions that are the same as, or substantially similar to, a transaction specifically identified by the IRS or state tax agency as a tax avoidance transaction (a so-called "listed transaction."
For more tax planning stories, check out our Special Report 21 Days of Tax Planning Advice for 2014 home page.