What Is an Abusive Tax Shelter?

An abusive tax shelter is a type of illegal investment that claims to reduce the investor’s income tax liability without changing the value of the investor’s income or assets. Abusive tax shelters serve no economic purpose other than lowering the federal or state tax owed by the investor. 

Oftentimes, these types of tax shelters rely on complex transactions involving trusts, partnerships, and other legal entities. They are not to be confused with legitimate tax shelters, such as certain pension plans or Individual Retirement Accounts (IRAs), which are not considered abusive.

Key Takeaways

  • An abusive tax shelter is an investment strategy that seeks to reduce the investor’s taxes by illegal means.
  • Not all tax shelters are abusive, such as many retirement accounts, which are legal and legitimate.
  • The Internal Revenue Service (IRS) requires investors and their advisors to file reports outlining certain types of transactions and can issue penalties when abuses are found.

Understanding an Abusive Tax Shelter

Taxation is an important consideration for all investors since taxes on corporate income, dividends, capital gains, and other sources of capital can all substantially erode an investor’s overall return. For this reason, all investors will generally seek to take advantage of all legal means to legitimately reduce their overall tax liability.

However, investors must keep in mind that certain strategies for reducing their tax liability can be considered “abusive” by regulators and that people who invest in abusive tax shelters can be penalized by the Internal Revenue Service (IRS).

Not all tax shelters are abusive, however. The most common legitimate tax shelters are employer-sponsored retirement plans, 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IRAs, which give investors the opportunity to shield investment contributions and earnings from taxation until they are withdrawn. 

Reporting of Transactions and Tax Shelters

To help determine whether a given tax shelter is abusive or legitimate, the IRS requires businesses to self-report when they engage in certain types of transactions. 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. Professionals who advise and assist in such transactions may also be required to file Form 8918 with the IRS, in addition to maintaining extensive lists of the individuals and entities whose transactions they have worked on.

Further oversight is also provided by the U.S. Treasury, which 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.

Determining an Abusive Tax Shelter

To help taxpayers recognize potential schemes that could be considered abusive tax shelters, 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 IRS Office of Tax Shelter Analysis (OTSA) is responsible for gathering information regarding potential abusive tax shelters. The division seeks to combat abusive tax shelters through "audits, summon enforcements, litigations, and alternative methods."