The idea of a smaller tax bill for your business can be appealing. Remember, not all tax shelters are created equally.
Tax shelters are once again facing aggressive scrutiny by tax and law enforcement officials. The former CEO of BDO Seidman, one of the largest accounting and consulting firms in the country, was recently convicted along with several high profile co-defendants of “conspiring to defraud the IRS and to evade taxes and of corruptly endeavoring to obstruct and impede the Internal Revenue laws.” These convictions are extremely serious. The maximum penalties on all the charges total over 30 years in prison plus huge fines and restitution.
The defendants operated a tax shelter scheme for a decade that hid or sheltered $7 billion in income from taxes. The defendants engineered the schemes between 1994 and 2004 to achieve a specific tax result. The schemes were marketed to their clients who were seeking advice on how to minimize their tax bills.
You may not be a celebrated tax accountant, but you could very well be a business owner looking for ways to minimize your tax bill. Many people would have believed them. Ignorance, however, won’t protect you from the IRS. You have to be on guard.
What is a tax shelter?
Tax shelters are transactions used to reduce taxable income which in turn lower tax bills. Some tax shelters, like IRAs and 401(k)s are perfectly legitimate and their adoption is encouraged by the government. Partnership structures in certain industries, like mining, are also quite common. These tax shelters have a purpose other than just reducing taxes. When it comes to determining the legitimacy of a tax shelter it’s the intention that counts.
If you are presented with the opportunity to participate in a tax shelter, be very careful. If a tax shelter is questionable or raises any doubt, don’t use it. Consider asking these questions to discern between legitimate and bogus tax shelters:
1. What is the substance of the transaction?
This is based on the judicial doctrine of “substance over form.” It compares two transactions that have the same economic result. If the economic result is the same then the tax liability should be the same. This basically means that you can’t execute a transaction in a complex way simply to avoid taxes if there is a simpler way to execute it. Many tax shelters do just that.
2. What if these transactions were one transaction?
Another dubious way to shelter income is to break a single transaction into multiple steps or stages. The sole purpose is to engineer a result that will pay less in taxes. What if the steps taken to execute the transaction were done in a single step? Would the end result be different? If so, the tax shelter may not be valid.
3. What is the business purpose of the transaction or transactions?
Any transaction to which you are a party must have a business purpose. You cannot simply enter into a transaction to shelter income from taxes. A tax court will invalidate a transaction if it is shown that your intent was simply to reduce your tax bill and not to achieve some business purpose.
4. Is this transaction a sham?
It should be fairly obvious, but if the transaction is a sham used to create an excuse for tax sheltering purposes then don’t do it.
