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What is a Tax Shelter?
Tax shelter is any legal method used by taxpayers in minimizing taxable incomes. This in turn reduces the payments made to tax collecting bodies. This can be through investment accounts or by engaging in activities or transactions that minimize taxable income.
Tax shelter should not be mistaken for tax evasion. While tax shelter is a legal way of lowering tax payable by minimizing taxable income, tax evasion, on the other hand, is an illegal way of avoiding taxes. If a corporation is formed with a sole purpose of avoiding tax, then it becomes an illegal means of avoiding tax.
Also, tax shelters must be listed with Canada Revenue Agency (CRA) and should have an identification number. Otherwise, one cannot claim for deductions. CRA deals with illegal tax schemes and audits the returns got from tax. Together with international task forces, its purpose is to identify any crack down any promoter who sells illegal tax shelters.
A Little More on What is a Tax Shelter
Taxation started way back in Ancient Rome. However, they had some tax free enterprise zones. Rome started having Tax Havens to reward friends and punish enemies. Loyal cities were granted tax-free status which cities which were not loyal paid tributes. Muslim conquerors used taxation policy as a way of religious conversion. They imposed a tax on whoever refused to be converted to Islam.
The European colonialists used tax policies to attract settlers. The Spanish, the Dutch and the English imposed low taxes as an incentive to those who could brave the long journey in the ocean and start live in the wilderness. There was an attempt by the European governments to impose taxes to the American colonies citizens so as to pay for their defense.
After the great war in the 1990s, the European government raised taxes in order to recover from the losses incurred and help in reconstruction. Switzerland was neutral during Great war and therefore didn’t bear the increased cost of recovering and rebuilding the infrastructure. Most economic observers concluded that legal tax avoidance started in Switzerland.
Reducing Taxable Income
There are various ways by the government to help the taxpayers reduce their taxable income. This can be temporary or permanent measures. Some of these provisions are tax deductions, charitable contribution deduction, and others. However, some methods are illegal and therefore an individual or corporate should be able to evaluate the best tax reduction approaches to avoid penalties by the Internal Revenue Service (IRS).
It is important to expound more on ways provided by the government on reducing taxable income. One of them is tax deductions; these are the amount of income made that can be subtracted from the taxable income of an individual. These include student loan interest deductions, charity contribution deduction and certain medical expenses deductions.
Charitable donations that are allowed to be deducted from taxable income should be up to 50%of the adjusted gross income. Also, it is legal and rational to use student loan to pay college tuition instead of using credit card. This allows the student to take advantage of the student loan interest deductions.
Types of legal tax shelter investment
There are two main types of legal investments that enjoy tax shelter benefits.
- Tax-deferral shelters – This suspends taxes to a later date but continues to generate cash flow.
- Tax-reduction Shelters – these are some of the expenses that can be reduced from the taxable income e.g. donations.
For the taxpayers considering tax shelter, it is important to consult a financial adviser so as not to fall into illegal tax shelters. Below are some factors that should be considered about tax shelters:
- Risky – tax deductions and tax credits are offered as an incentive to investment in products that are not popular. If a taxpayer invests in a bad investment, it will not be converted into a good investment through tax shelter.
- The investor should be able to treat income as capital gain. Capital gain is the rise of the value of an asset that gives it a greater worth than the initial purchase price. The gain is only realized when an asset is sold.
- Boost the investors’ collective net investment loss balance. This minimizes the possibility capital gain deductions.
- Limiting interest deductions – interest expenses on an investment that yield only capital gain is not deducible while the interest on investment is deducible only when the tax shelter earns income.
- Create other alternatives that will reduce the amount of taxable income to a lower level.
Legal Tax Shelters
- Legal tax shelters can be in the form of retirement accounts or investments. This is also used as a way of motivating income earners to save for their retirement. The income contributions made to the retirement accounts and employers sponsored is not taxed till the taxpayer retires. This makes the money that would otherwise be taxed accumulate interest in the account. Any individual/taxpayer who takes the tax shelter advantage through these plans will have his/her taxable income reduced by the amount of contribution he makes.
- Roth IRA and Roth 401(k) are also ways of sheltering tax. This is for taxpayers who anticipate their tax brackets to be advanced by the time they are retiring. With all these investment accounts, the contributed amount is taxed prior to hitting the account and no further taxing is done during withdrawal. In this case, the taxpayer will have paid the tax while still in a lower tax bracket.
- There are also other types of assets that can be invested in to offer tax shelter. This is used by investors who invest on foreign country. In this case, there is flow of capital from one country to another granting the investor ownership of company and the assets. These investors with foreign investments gain from foreign tax credit. This is non-refundable income paid to the foreign government. The tax credit is used to reduce taxable income of an individual, estates or trusts.
- There are also certain municipal bonds that can be used as tax shelters. This is by exempting tax from any interest income generated from these bonds.
- In business sectors like those that deal with oil exploration, mining and renewable energy sectors, tax shelter can be employed. These sectors require very heavy capital investment and also it takes long for the company to start making profits. In this case, the government allows the incurred exploration costs to be distributed to the investors as tax deductions. The exploration costs are assumed to be investors/shareholders expenses and are deducted from the taxable income.
- Another way to reduce the taxable income is by opening Health Savings Account and setting an estimated amount aside for the medical expenses. With this account, one can use the funds (nontaxable) to cover for the medical and health expenses.
Illegal Tax Shelters
- The federal tax law forbids a taxpayer from assigning his income to another taxpayer in a lower tax bracket.
- Setting up a company or business to receive income on your behalf.
- Adding a family member to the payroll.
The Internal Revenue Services are very strict on illegal tax shelter and treat it as a fraud activity. The offender is charged 75 percent of the underpaid tax and in addition he / she risks criminal trial and prison sentence.
Advantages of tax shelter
- Tax shelter encourages investors to invest in business sectors that require a lot of exploration and developmental cos
- Help one to save money by reducing the taxable income. The taxpayers are saving money while at the same time allocating their money into an investment.
Disadvantages of tax shelter
- The money used for investment does not require source information. So many investors who acquire money through illegal ways are able to convert it into a legal investment.
- Transfer pricing – this is where the firms charge low prices when selling to the low tax affiliates and pay high amount when buying from them.
- Loss of tax revenue by a country.
References for Tax Shelter
Academic Research on Tax Shelters
An examination of corporate tax shelter participants, Wilson, R. J. (2009). The Accounting Review, 84(3), 969-999.
What does tax aggressiveness signal? Evidence from stock price reactions to news about tax shelter involvement, Hanlon, M., & Slemrod, J. (2009). Journal of Public Economics, 93(1-2), 126-141.
Do publicly disclosed tax reserves tell us about privately disclosed tax shelter activity?, Lisowsky, P., Robinson, L., & Schmidt, A. (2013). Journal of Accounting Research, 51(3), 583-629.
Lost in translation: Detecting tax shelter activity in financial statements, McGill, G. A., & Outslay, E. (2004). National Tax Journal, 739-756.
Sheltering Lawyers: The Organized Tax Bar and the Tax Shelter Industry, Rostain, T. (2006). Yale J. on Reg., 23, 77.
The tax shelter battle, Bankman, J. (2004). The tax shelter battle. The crisis in tax administration, 9, 13.
Lawyer Responsibility in Tax Shelter Opinions, Sax, P. J. (1980). Tax Law., 34, 5.
The tax shelter problem, Bankman, J. (2004). National tax journal, 925-936.
The corporation as a tax shelter: Evidence from recent Israeli tax changes, Romanov, D. (2006). Journal of Public Economics, 90(10-11), 1939-1954.