What Is an Abusive Tax Shelter?

An abusive tax shelter is an investment scheme that attempts to reduce income tax without serving any other economic purpose. The value of income or assets is not changed, so the sole purpose of an abusive tax shelter is to avoid tax.

The IRS attempts to deter participations in abusive tax shelters through tax audits, summons enforcement, litigation and other methods. There is also an abusive tax shelter hotline, where anyone can anonymously provide information about abusive tax shelter transactions.

Analyzing an Abusive Tax Shelter

There is no clear definition of what constitutes an abusive tax shelter. The IRS looks at many factors to determine if a transaction is an abusive tax shelter. Publication 550 lists some of the questions the IRS will ask about a transaction include the following:

•Do the tax benefits far outweigh the economic benefits?

•Is this a transaction you would seriously consider, apart from the tax benefits, if you hoped to make a profit?

•Do shelter assets really exist and, if so, are they insured for less than their purchase price?

•Is there a non-tax justification for the way profits and losses are allocated to partners?

The IRS also provides a list of transactions that they have found to be commonly used tax shelters, which includes debt straddles, sale-in lease-out transactions, basket options contracts, and many more complex transactions that are designed to avoid tax.

All of the listed transactions must be reported to the IRS. There are other types of reported transactions as well, including certain loss transactions and “transactions of interest” to the IRS.

The IRS will carefully scrutinize any reportable transactions, so consult your tax attorney before participating in any of these tax shelters. There are many scams that are promoted as legitimate tax reduction transactions, but are actually illegal tax shelters.

Penalties for Abusive Tax Shelters

There are several tax penalties associated with promoting or participating in an abusive tax shelter. The penalty for promoting an abusive tax shelter is $1,000 for each organization or sale of an abusive plan or arrangement (or, if les, 100 percent of the income derived from the activity). There is also a penalty of $1000 ($10,000 if the conduct relates to a corporation’s tax return) for aiding and abetting in an understatement of a tax liability. Because there are generally multiple sales involved the penalties can add up quickly.

Tax practitioners that are subject to discipline by the IRS Office of Professional Responsibility (OPR) can expect an OPR investigation if they have been found to be associated with promoting an abusive shelter.

Contact a tax litigation lawyer if you have been accused of  promoting or participating in an abusive tax shelter, or if OPR has begun an investigation that could threaten your livelihood.