8687 / 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 participating in certain “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 (see Q 8705 for a discussion of the current limitations imposed on the deductibility of investment interest expenses);

(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 designed to prevent the use of tax shelters as vehicles that operate solely for the purpose of tax avoidance (see “abusive tax shelters,” Q 8688), 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 that were 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.”¹ The IRS has developed an extensive set of economic effect tests and a definition of “substantiality” in the final regulations interpreting Section 704.²