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Encyclopedia > Tax shelter

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 IRS web site has a lot of information about tax shelters, including lists of transactions that the IRS considers abusive, a description of special rules that apply to taxpayers that engage in tax shelter transactions and the penalties that apply to taxpayers who don't comply with those rules, and information about IRS initiatives to allow taxpayers that have engaged in such transactions to settle their cases with the IRS. See http://www.irs.ustreas.gov/businesses/corporations/article/0,,id=97384,00.html.


An Example of a Tax Shelter


Background


1. Suppose you are one of the wealthy people who gets taxed at the 40% margin. That is, for every extra dollar you earn, 40 cents goes to the taxman.


2. Suppose the Capital Gain exemption is 50%. That is, if you buy a house for $10,000, and sell it for $16,000, your capital gain is $6,000, but 50% of that is exempt. Thus only $3,000 is taxable. Applying the 40% rate in 1., you owe $1,200 of taxes. In finance, a capital gain is profit that is realized from the sale of an asset that was previously purchased at a lower price. ...


3. Suppose you have a friend who imports clothing from China for $1 per T-shirt, and sells it in the USA for $5 to the everyday shopper. (In reality, certain clothings or shoes from China are sold for a markup of over 1000%!!!) Unfortunately, due to boycotts of Chinese goods, sales are looking pretty bad, and he is expecting a loss. This page is about boycott as a form of protest. ...


4. A Tsunami hit Thailand, and you decided to donate clothing to the unfortunate. The tsunami that struck Malé in the Maldives on December 26, 2004. ...


Preparation


5. You did your friend a favor, and buys a bulk of 1,000 T-shirts for $1,000. You go to Red Cross and donates them. Red Cross writes you a receipt for the donation. Since the clothing sells for $5 each when sold individually, Red Cross writes you a receipt for $5,000 worth of donations.


Tax Return


6. On your tax return, you enter that you have donated $5,000. Applying the 40% rate, you get a tax credit of $2,000. Look up Tax return in Wiktionary, the free dictionary For tax returns in the United States see Tax return (United States); for tax returns in Canada see Tax return (Canada). ... Within the Australian, Canadian, United Kingdom, and United States tax systems, a tax credit is an item which is treated as a payment already made towards taxes owed. ...


7. Since you bought your clothing for $1,000, and received $5,000 value in donation receipt, tax laws deems that you have a Capital Gain of $4,000. Since the Capital Gain Exemption rate is 50%, only $2,000 is taxable. Applying the 40% rate, you owe $800 worth of taxes. In finance, a capital gain is profit that is realized from the sale of an asset that was previously purchased at a lower price. ...


8. Since you have a tax credit of $2,000 (see 6.), and a tax owing of $800 (see 7.) you have a net balance of $1,200 worth of credits.


Analysis


9. Suppose you normally owe taxes of $2,000 every year. If you did not use this "Tax Shelter" (see 5. - 8.), you will normally pay $2,000 to the taxman.


10. Now, assume you DID use this tax shelter. You paid your friend $1,000. You receive $1,200 of tax credits (see 8.), so your tax owing is reduced to $800. Thus, in total, you only had to pay $1,800 to relieve your $2,000 worth of tax owing. A saving of $200 dollars.


The above is a simplified version of a tax shelter. This method has been abused in the real world using clothing, medicine, food etc. However, there are also other types of tax shelters. Some other examples includes...



Illegal or questionable tax shelters


- 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. Taxable income is the portion of income that is subject to taxation. ...


- 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. Once again, the tax benefit derives from the fact that capital gains are taxed at 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 arraged between related parties, such transaction is often viewed as unethical. In the case of the clothing, the tax agency may claim that the T-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. Clearly, a can of pop from a vending machine can cost $1.00, but may also be bought for 25 cents from the cafeteria. To prove that the price is infact unreasonable may turn out to be unreasonably difficult itself. Fair Market Value is a term in both law and accounting to describe an appraisal based on an estimate of what a buyer would pay a seller for any piece of property, assuming neither the seller nor the buyer is under any compulsion to complete such a transaction, and that...



Legal or legitimate tax shelters


- 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 demands quick, or at least safe, returns. To encourage the investment, the 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 reward by 1) the near instant tax savings 2) the potential massive gains if the company discovers gold or oil. This article or section should be merged with tax credit Tax credits are credits on tax payable given by the government for specific reasons. ...


- Retirement plan. In order to reduce burden of the government funded pension systems, the government allows individuals to invest in their own pension. The contributed income will not be taxable today, but will be taxable in when the individual retire. The reward is that elders have a higher tax exemption, lower annual income, and resulting in much lower (if any) tax owings.


These tax shelters are usually created by the government to promote a certain desireable behavior, usually a long term investment, to help the economy which in turn generates even more tax revenue. Alternatively, the shelters may be a mean to promote social behaviors. In Canada, in order to protect the "Candian culture" from the "American influence", tax incentives were given to companies that produces 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. Despite these actions may be within the boundry of legally accepted practice in physical form, these actions are 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 the opposite. Tax shelters has since been synonomous to fraud.


Note: It is important to understand that the information above is simplified, and based on tax laws akin to that of the US, UK, and some Commonwealth nations. Such information may be totally incorrect for other countries. The above information is not an advice on taxation, and consequently, users of this information should be aware that it may not be appropriate for their purposes.


External links

  • Tax Shelters: Exotic or Just Plain Illegal? Knowledge@Wharton, March 9, 2006

  Results from FactBites:
 
Tax shelter - Wikipedia, the free encyclopedia (1076 words)
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 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.
Tax shelters were intended to induce good behaviors from the masses, but at the same time caused a handful to act the opposite.
Life insurance tax shelter - Wikipedia, the free encyclopedia (402 words)
Since most other forms of income are taxable (such as capital gains, dividends and interest income), consumers are often advised to purchase life insurance policies to either offset future tax liabilities, or to shelter the growth of their investments from taxation.
Since life insurance proceeds are normally only tax free at death, tax liabilities that come due at death are often offset by a policy of the same size.
Since one normally does not know which of these will occur (see adverse selection or anti-selection) calculations must be based on expected life expectancies for people of similar gender, physical condition, and behaviour.
  More results at FactBites »

 
 

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