Is it a Tax Shelter or Tax Fraud? Learn to spot the difference.

It’s easy to blow off talk of abusive tax shelters, tax evasion, and tax fraud. After all, those things only affect the uber-wealthy, right?

Well, sort of.

Let’s face it, no one reading this blog saw their name in The Paradise Papers. And they aren’t worried about being cast as a character in The Laundromat.

But that doesn’t mean the average business owner isn’t immune to accidentally engaging in something they thought was a tax shelter, only to have it turn out to be fraudulent activity.

It just means the wealthy get the press coverage. But the average businessperson who accidentally (or otherwise) engages in fraud still faces penalties.

So, today’s post will focus on how to analyze tax avoidance opportunities to see if they are legal.

Let’s go!

What is a tax shelter?

Tax shelters for U.S. taxpayers are legal tax avoidance strategies. That’s it.

And the IRS is completely good with them, provided taxpayers don’t abuse them. More on that later.

Chances are you are using a tax shelter, maybe several. If you have a 401(K) or Individual Retirement Account (IRA), then yes, you are using a tax shelter to defer taxes right now or during retirement.

The list of potential tax shelters goes on and on and includes everything from real estate (losses and deductions) to municipal bonds (the interest is free from federal taxes).

They are all legal because they’ve been deemed to help drive the economy forward while still allowing the U.S. government to collect the necessary taxes needed to run its operations.

Tax shelters potentially degenerate into fraud when that last caveat, paying your fair share of taxes, is violated.

Defining tax fraud

It’s one thing to avoid taxes for a time.  That’s what tax shelters are designed to do.

They become fraudulent when they involve deliberate misrepresentation or manipulation of facts to evade taxes altogether.

Here’s an example. Let’s say you buy a rental property. It’s a decent property but needs work, so you lose money the first year due to repairs and interest payments. Those losses can be deducted, turning your rental property into a de facto tax shelter for a while.

It’s not fraudulent activity because you can argue the investment has substance and is designed to make a profit. After all, you lost money because you were making improvements to make the rental more appealing in the long term.

But let’s say you join a group of investors to buy highly speculative real estate financed mostly through loans that consistently cause losses with little chance of any significant profit. That could be deemed an abusive tax shelter, designed to take losses to generate deductions that offset other forms of income.

Avoiding fraud

Still, the difference between a tax shelter and tax fraud can be a pretty thin line. Sometimes people accidentally cross that line or are inadvertently lured over it by unscrupulous business people.

The best advice to avoid this fate is to approach every business offer with an old cliché in mind. That is, if it sounds too good to be true, it probably is.

The Bottom Line

If you are offered a tax avoidance opportunity you don’t understand, bring it to a qualified tax advisor first. They can tell you if it is legitimate and help you determine if it’s a good investment.

But don’t go it alone. Get help so your tax shelter doesn’t become an item of interest to the IRS.