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tax shelter


n.

A financial arrangement, such as the use of special depletion allowances, that reduces taxes on current earnings.

taxsheltered tax'-shel'tered (tăks'shĕl'tərd) adj.
 
 

A legal method of minimizing or decreasing an investor's taxable income and, therefore, their tax liability. Tax shelters can range from investments or investment accounts that provide favorable tax treatment, to activities or transactions that lower taxable income. The most common type of tax shelter is an employer-sponsored 401(k) plan.

Investopedia Says:
Tax authorities watch tax shelters carefully. If an investment is made for the sole purpose of avoiding or evading taxes, you could be forced to pay tax or even penalties. Tax minimization (also referred to as tax avoidance) is a perfectly legal way to minimize taxable income and lower taxes payable. Do not confuse this with tax evasion, the illegal avoidance of taxes through misrepresentation or similar means.

Related Links:
We give you seven guidelines to help you keep more of your money in your pocket. Tax Tips For The Individual Investor
Keeping thorough records and knowing the penalties make this experience easier than you'd expect. Surviving The IRS Audit
We clarify some rules that often puzzle taxpayers. Common Tax Questions Answered
Learn to profit by following the lead of some of Wall Street's most ruthless investors. Activist Hedge Funds


 

Method used by investors to legally avoid or reduce tax liabilities. Legal shelters include those using Depreciation of assets like real estate or equipment, or Depletion allowances for oil and gas exploration. Limited Partnerships traditionally offered investors limited liability and tax benefits including "flow through" operating losses which offset income from other sources. The Tax Reform Act of 1986 dealt a severe blow to such tax shelters by ruling that passive losses could only offset passive income, lengthening depreciation schedules, and extending At Risk rules to include real estate investments. Vehicles that allow tax-deferred capital growth, such as Individual Retirement Accounts (IRAs) and Keogh Plans (which also provide current tax deductions for qualified taxpayers), Salary Reduction Plans, Simple Iras, and Life Insurance, are also popular tax shelters as are tax-exempt Municipal Bonds. The Roth Ira, created in the Taxpayer Relief Act of 1997, allows tax free accumulation of earnings on assets held in the account for at least five years.

 

An investment that produces after-tax income that is greater than before-tax income. The investment may produce Before-Tax Cash Flow while generating losses to shield, from taxation, income from sources outside the investment.
Example: Dunn purchases an income-producing property that provides a tax shelter. In the first year, the property produces a Net Operating Income of $100,000. Debt Service is $80,000, of which $75,000 is Interest. Dunn's Before-Tax Cash Flow is $20,000. First-year Depreciation is $50,000, so that a tax loss is generated as shown in Table 53.

Table 53 Tax Shelter

$100,000 Net operating income

- 75,000 Interest deduction

- 50,000 Depreciation deduction

________

($25,000) Taxable income (loss)

Dunn not only pays no tax on the $20,000 cash flow but might be allowed to shelter $25,000 of income from other sources. The Tax Reform Act of 1986 places limits and restrictions on the deductibility of passive losses. See Passive Income, Active Participation, Material Participation.

 
Law Dictionary: Tax Shelter

A transaction by which a taxpayer reduces his or her tax liability by engaging in activities that provide deductions or tax credits to apply against his or her tax liability. In such cases, the activities engaged in are said to "shelter" the taxpayer's other income. Abuses in the use of these devices have led to amendments to the Internal Revenue Code, which have sharply curtailed the availability and usefulness of these devices, such as the "at-risk" rules and the penalties imposed on abusive tax shelters, I.R.C. §6700.

at-risk rules provisions of the Internal Revenue Code that limit the amount of loss from business and investment activities that a taxpayer may deduct to the total amount that he or she has "at risk" in the activity. A taxpayer is "at risk" in an activity only to the extent of the cash or other property he or she has invested in the activity and to the extent he or she is personally liable for the debts of the activity secured by his or her property. A taxpayer is not at risk for amounts of nonrecourse debt. The at-risk rules are generally applicable to most business activities except real estate investment. I.R.C. §465. Chirelstein, Federal Income Taxation §13.02 (8th ed. 1997).

 
Economics Dictionary: tax shelter

A type of investment that allows a reduction in one's taxable income. Examples include investments in pension plans and real estate.

 
Word Tutor: tax-sheltered
pronunciation

IN BRIEF: A type of investment made for a purpose other than gain or profit.

 
Wikipedia: tax shelter
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 project

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.

In North America, a tax shelter is generally defined as any method that recovers more than $1 in tax for every $1 spent, within 4 years.

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 unreasonably high interest rates to a related party, one may severely reduce the income of an investment (or even create a loss), but create a massive capital gain when one withdraws 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. 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 reasonably difficult itself.

Other tax shelters can be legal and legitimate:

  • Flow-through shares/Limited Partnerships. Certain companies, such as mining or oil drilling often take 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. In US terminology, these entities are given the generic title of "limited partnership" and in the past they may have simply been called a "tax shelter", being an archetypical tax shelter. However the IRS limited the popularity of these plans by allowing the losses to only offset passive (investment) income as opposed to earned income.
  • 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 ([2006]) 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 individuals 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.

William J. Casey is credited with coining the term 'tax shelter'.

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Dictionary. The American Heritage® Dictionary of the English Language, Fourth Edition Copyright © 2007, 2000 by Houghton Mifflin Company. Updated in 2007. Published by Houghton Mifflin Company. All rights reserved.  Read more
Investment Dictionary. Copyright ©2000, Investopedia.com - Owned and Operated by Investopedia Inc. All rights reserved.  Read more
Financial & Investment Dictionary. Dictionary of Finance and Investment Terms. Copyright © 2006 by Barron's Educational Series, Inc. All rights reserved.  Read more
Real Estate Dictionary. Dictionary of Real Estate Terms. Copyright © 2004 by Barron's Educational Series, Inc. All rights reserved.  Read more
Law Dictionary. Law Dictionary. Copyright © 2003 by Barron's Educational Series, Inc. All rights reserved.  Read more
Economics Dictionary. The New Dictionary of Cultural Literacy, Third Edition Edited by E.D. Hirsch, Jr., Joseph F. Kett, and James Trefil. Copyright © 2002 by Houghton Mifflin Company. Published by Houghton Mifflin. All rights reserved.  Read more
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Wikipedia. This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Tax shelter" Read more

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