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What Is a Tax Shelter?

In General

A tax shelter is any entity, investment, plan or arrangement created for the purpose of avoiding (or postponing) federal income tax. Prior to August 6, 1997, the tax shelter regulations were only triggered when the taxpayer's principal purpose was to avoid taxes. Some tax shelters must be registered under federal and/or state laws regulating securities. In the past, real estate partnerships, rolling stock (railroad box cars), and oil and gas partnerships were enormously popular tax shelters for investors. However, as a result of the Tax Reform Act of 1986 there are only a few tax shelters remaining.

What Is a Potentially Abusive Tax Shelter?

A tax shelter is deemed to be abusive when the tax losses from the tax shelter exceed any possible economic return from the venture. Abusive tax shelters may be marketing schemes that involve 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 the mischaracterization of the substance of the transaction. Usually, you risk very little when you invest in an abusive tax shelter, even though it appears otherwise.

How Do You Know If a Tax Shelter Is an Abusive Tax Shelter?

Abusive tax shelters commonly involve package deals that are designed from the start to generate losses, deductions, or credits that will exceed the present or future investments. Or the shelter's promoters may promise that inflated appraisals will enable investors to reap charitable deductions.

The following are important questions to ask yourself if you are considering investment in a tax shelter:

  • Do the tax benefits far outweigh the economic benefits?
  • 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? Are you instructed to backdate checks covering your investment?

Registration and Reporting Requirements

The Internal Revenue Service requires some tax shelters to register. If registration is required, then the IRS will assign a tax shelter identification number, which must be given to all investors. Investors are required to report the registration number on a Form 8271. The Form 8271 is filed along with the taxpayer's tax return.

Caution: The IRS requires promoters of a registered tax shelter, and other tax shelter arrangements that are considered potentially abusive, to keep a list of all of their investors for seven years. If you are an investor in an abusive tax shelter promotion, the IRS may send you a "pre-filing notification letter" if it determines that it is highly likely that there is:

  • A gross valuation overstatement, or
  • A false or fraudulent statement regarding the tax benefits to be derived from the tax shelter entity or arrangement

This letter will advise you that, based upon a review of the promotion, it is believed that the purported tax benefits are not allowable. The letter also will advise you of the possible tax consequences if you claim the purported tax benefits on your income tax return. The IRS also requires all investors in tax shelters considered potentially abusive to keep a record whenever they sell their interest in the tax shelter. It may be necessary for you to file a Form 8275 (Disclosure Statement) if you are involved in an abusive tax shelter. You make your disclosure on the form and attach it to your tax return. To disclose a position contrary to a regulation, use Form 8275-R (Regulation Disclosure Statement).

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Penalty Provisions

Accuracy-Related Penalties

A 20 percent accuracy-related penalty can be imposed for underpayments of tax due to:

  • negligence or disregard of rules or regulations
  • substantial understatement of tax, or
  • substantial valuation misstatement

This penalty will not be imposed if you can show that you had reasonable cause for any understatement of tax and that you acted in good faith. If an accuracy-related penalty is assessed against you, interest will be imposed on the amount of the penalty from the due date of the return (including extensions) to the date you pay the penalty.

Negligence or Disregard of Rules or Regulations

The penalty for negligence or disregard of rules or regulations is imposed only on the part of the underpayment that is due to negligence or disregard of rules or regulations. The penalty will not be charged if you can show that you had reasonable cause for understating your tax and that you acted in good faith. Disregard includes any careless, reckless, or intentional disregard. The penalty for disregard of rules and regulations can be avoided if both of the following are true. You have a reasonable basis for your position and you made an adequate disclosure of your position.

An understatement is considered to be substantial if it is more than the greater of:

  • 10 percent of the tax required to be shown on the return, or
  • $5,000

The understatement is the amount of the tax required to be shown on your tax return minus the amount of tax shown on the return, reduced by any rebates. Negligence includes any failure to make a reasonable attempt to comply with the provisions of the tax laws, to exercise reasonable care in preparing a tax return, to keep adequate books and records, or to substantiate them properly. The understatement penalty will not be imposed if you can show that there was reasonable cause for the underpayment caused by the understatement and that you acted in good faith. An important factor in establishing reasonable cause and good faith will be the extent of your effort to determine your proper tax liability under the law.

Valuation Misstatement

You may be liable for a penalty if you misstate the value or adjusted basis of property. In general, you are liable for the penalty if all of the following are true.

  • (1) The value or adjusted basis of any property claimed on the return is 200 percent or more of the amount determined to be the correct amount (2) The price for any property, or use of any property, or services in connection with any transaction with a related party reported on the return is determined to be 200 percent or more or 50 percent or less of the arms-length price determined to be correct, or (3) The net adjustment that must be made to transfer prices between related parties in transactions reported on the return exceeds the lesser of $5 million or 10 percent of the taxpayer's gross receipts
  • You underpaid your tax by at least $5,000 because of the misstatement (this amount is increased to $10,000 in the case of corporations other than S corporations and personal holding companies)
  • You cannot establish that you had reasonable cause for the underpayment and that you act ed in good faith

Caution: The penalty is doubled to 40 percent for gross valuation misstatements. A gross valuation misstatement occurs if the claimed value or basis for property exceeds the correct value or adjusted basis by 400 percent or more. A gross valuation misstatement also occurs if the price for any property--or use of any property or services in connection with any transaction with a related party reported on the return--is determined to be 400 percent or more (or 25 percent or less) of the arms-length price determined to be correct. This is also true if the net adjustment that must be made to transfer prices between related parties in transactions reported on the return exceeds the lesser of $20 million or 20 percent of the taxpayer's gross receipts. The penalty rate is also 40 percent if the property's correct value or adjusted basis is zero.

Civil Fraud Penalty

If there is any underpayment of tax on your return due to fraud, a penalty of 75 percent of this underpayment will be added to your tax.

Failure to Pay Tax

If a deficiency is assessed and is not paid within 10 days of demand, a taxpayer can be penalized up to 25 percent of the unpaid amount if the failure to pay continues.

Potential Problems for Corporations

As a result of recent changes to the definition of tax shelters, everyday corporate transactions may become subject to the IRS tax shelter enforcement if regulations are not carefully drawn.

Should You Invest In a Tax Shelter?

Investors should consult with their tax advisor prior to investing in a tax shelter to make sure that such investment makes sense for them. Furthermore, investing in an abusive tax shelter may be an expensive proposition when you consider all of the potential consequences.

First, the promoter generally charges a substantial fee. Second, there may be adverse tax consequences and substantial amount of penalties and interest (discussed above) if the claimed tax benefits are disallowed. Therefore you should consider tax shelters carefully, and seek competent legal and financial advice, before investing.



This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.


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