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Tax shelters are any method of reducing taxable income resulting in a reduction of the payments to tax collecting entities, including state and federal governments. The methodology can vary depending on local and international tax laws.
US tax Example
John Q. Public is a wealthy American businessman who is taxed at the 40% margin, meaning that he pays 40% of his taxable income to his government. He owes *]1200.00 in taxes on his sale of a house. John's friend Jane Doe imports shirts from China for $1.00 per shirt and sells them in the United States for $5.00 per shirt.
After the Indian Ocean tsunami, John buys 1,000 shirts from Jane for $1,000. He then donates them to the Red Cross relief effort and receives a receipt for a $5,000 donation, as each shirt is "worth" $5. On his tax return, John enters a donation of $5,000, which, under the 40% margin, gives him a tax credit of $2,000. Since he bought the clothing for $1,000 and received $5,000 value in the donation receipt, tax laws deems that he has made a capital gain of $4,000. Since the capital gain exemption rate is 50%, only $2,000 is taxable. Applying the 40% rate, he owes $800 worth of taxes. Since he has a tax credit of $2,000 and a tax owing of $800, he has a net balance of $1,200 in credits.
John would have ordinarily paid $2,000 in taxes. However, this is reduced to $800 after applying his $1,200 in tax credits. Considering that John paid $1,000 to Jane for the clothing and $800 in taxes, he paid $1,800 to relieve a $2,000 owing, and saved $200.
Types of tax shelters
Some tax shelters are questionable or even illegal:
- Offshore companies. By transferring funds to a company in another country, one may claim the transfer as an expense, and thus lowering the taxable income. Difficulties in international tax treaties often make the income not legally taxable.
- Financing arrangements. By paying an unreasonably high interest rates to a related party, one may severely reduce the income of an investment (or even create a loss), but creates a massive capital gain when they wish to withdraw the investment. The tax benefit derives from the fact that capital gains are taxed at a lower rate than the normal investment income such as interest or dividend.
The flaws of these questionable tax shelters are usually that transactions were not reported at fair market value or the interest rate was too high or too low. In general, if the purpose of a transaction is to lower tax liabilities but otherwise have no economic value, and especially when arranged between related parties, such transaction is often viewed as unethical. In the case of the clothing, the tax agency may claim that the shirts are not worth $5, since the importing company were unable to sell them at that price. The agency may re-evaluate the price, and will quickly neutralize any over tax benefits. However, in reality, such cases were rarely won. A soft drink from a vending machine can cost $1.00, but may also be bought in bulk for $0.25. To prove that the price is in fact unreasonable may turn out to be unreasonably difficult itself.
Other tax shelters can be legal and legitimate tax:
- Flow-through shares. Certain companies, such as mining or oil drilling often takes several years before they can generate positive income, while many of them will go under. This normally deters common investors who demand quick, or at least safe, returns. To encourage the investment, the US government allows the exploration costs of the company to be distributed to shareholders as tax deductions (not to be confused with tax credits). Investors are rewarded by 1) the near instant tax savings 2) the potential massive gains if the company discovers gold or oil.
- Retirement plan. In order to reduce burden of the government funded pension systems, governments may allow individuals to invest in their own pension. In the USA these sanctioned programs include Individual Retirement Accounts (IRAs) and 401(k)s. The contributed income will not be taxable today, but will be taxable when the individual retires. The advantage to these plans is that money that would have been taken out as taxes is now compounded in the account until the funds are withdrawn. With the Roth IRA and the newly introduced (*) Roth 401(k), income is taxed before the contributions are made into the account but are not taxed when the funds are withdrawn. This option is preferred by those workers who expect to be in a higher tax bracket during retirement than they currently are.
These tax shelters are usually created by the government to promote a certain desirable behavior, usually a long term investment, to help the economy; in turn, this generates even more tax revenue. Alternatively, the shelters may be a means to promote social behaviors. In Canada, in order to protect the "Canadian culture" from American influence, tax incentives were given to companies that produced Canadian television programs.
In general, a tax shelter is any organized program in which many individuals, rich or poor, participate to reduce their taxes due. However, a few indiviuals stretch the limits of legal interpretation of the income tax laws. While these actions may be within the boundary of legally accepted practice in physical form, these actions could be deemed to be conducted in bad faith. Tax shelters were intended to induce good behaviors from the masses, but at the same time caused a handful to act in the opposite manner. Tax shelters have therefore often shared an unsavory association with fraud.
External links
- Tax Shelters: Exotic or Just Plain Illegal? Knowledge@Wharton, March 9, 2006
- The Internal Revenue Service on tax shelter
- Tax Me If You Can PBS Frontline documentary on illegal tax shelters
"Tax shelter"