What is a “tax shelter” and what is an “abusive” tax shelter?

This post is designed to provide the reader with general information concerning tax shelters as a concept and what constitutes an abusive tax shelter.  Please keep in mind that this information is being provided for informational purposes only and is not designed to be complete in all material respects.  Thus, it should not be relied upon as providing legal or investment advice.  If you have any questions concerning this post or its contents, you should seek a qualified professional.

Tax Shelter:

This is a method used by many investors as a means to legally reduce or avoid tax liability.  Legal tax shelters include those investment vehicles using depletion allowances for oil and gas exploration or using depletion of assets such as real estate or equipment.  Limited partnerships have traditionally offered investors limited liability and tax benefits.  However, the Tax Reform Act of 1986 dealt a severe blow to such tax shelters.  The effect of this act and current regulations relating to these types of investments should be discussed with a qualified professional.

There are also investment vehicles that allow tax-deferred capital growth such as various types of IRA accounts, life insurance annuities and Keogh Plans.  Again, specific questions relating to these or other types of investments offering some type of tax advantage should be directed to a qualified professional.

Abusive Tax Shelter:

An abusive tax shelter is any investment used to avoid taxes that is not in compliance with the law or the rules and regulations adopted, from time to time, by the Internal Revenue Service. 

An example of an abusive tax shelter would be a limited partnership that the IRS deems to be claiming illegal tax deductions or inflates the value of acquired property beyond its fair market value.  If these write-offs are deemed excessive, by the IRS, investors must pay severe penalties and interest charges, on top of the required back taxes.

If you suffer damages as a result of a tax shelter in which you have invested being determined abusive, you must seek qualified counsel to determine what your options are, which would include seeking indemnification from whomever either recommended or sold the investment to you.  Because of the fact that it usually takes a few years, after the investment has been made, for the IRS to make this determination, you should seek immediate assistance because claims against third parties may be impacted by statute of limitation issues.