What is an Abusive Tax Shelter

Abusive Tax Shelter is an investment scheme that claims to reduce income tax without changing the value of the user's income or assets. Abusive tax shelters serve no economic purpose other than lowering the federal or state tax owed when filing. Often, these schemes channel funds through trusts or partnerships to avoid taxation.

BREAKING DOWN Abusive Tax Shelter

People who invest in abusive tax shelters can be penalized by the Internal Revenue Service (IRS). Typically, when the IRS determines someone has used such a scheme, the person will owe back taxes with accrued interest. 

To help taxpayers recognize potential schemes, the IRS has compiled a list of transactions that are abusive tax shelters. If a tax shelter resembles a listed transaction, it is considered abusive and the users may face penalties. One of the more common schemes in recent years has been a micro-captive insurance tax shelter where an entity forms its own insurance company to protect against certain risks. This structure allows the entity to claim a deduction for premiums paid and in turn allows the captive insurance company to exclude portions of premiums from income.

The U.S. Treasury maintains comprehensive regulations for the registration and reporting of certain tax shelters and transactions. Parties who organize or sell interests in these tax shelters must also be registered and maintain lists of investors in the shelters. In addition, investors are required to disclose participation in such vehicles on their tax returns.

The IRS lists five types of transactions that must be reported: listed transactions, confidential, contractual protection, loss transactions and transactions of interest. Businesses of individuals that have engaged in any of these transactions may be required to file Form 8886.    

Materials advisors, individuals who provide aid, assistance, or advice in organizing, promoting, selling, implementing, insuring, or carrying out any reportable transaction, and that earn gross income in excess of threshold amounts set by the IRS, may be required to Form 8918, Material Advisor Disclosure Statement. Material advisors are also required to maintain extensive lists of the individuals and entities where they acted as such for a reportable transaction.  

In addition to increased disclosures, the Treasury is using its regulatory authority to shut down abusive tax shelters by proposing targeted legislation to eliminate specific tax shelters and give the IRS new tools to combat abusive practices.

Contrasting Legitimate and Abusive Tax Shelters

A tax shelter is any investment designed to reduce or avoid income taxes, yet not all tax shelters are abusive or illegal. The most common legitimate tax shelters are employer-sponsored retirements plans like such as 401(k) plans as well as IRAs, which give investors the opportunity to shield investment contributions and earnings from taxation until they are withdrawn.