What is an Abusive Tax Shelter?

An abusive tax shelter is an investment strategy that illegally shields assets from tax liability.

How Does an Abusive Tax Shelter Work?

For example, let’s say John Doe and his wife have a child who begins college this year. Though John may be entitled to deduct up to $4,000 of education expenses due to his income level, if he deducts more than that or includes non-deductible expense (such as the student's car), John is abusing the tax shelter.

Why Does an Abusive Tax Shelter Matter?

Abusive tax shelters cheat the government out of millions of dollars a year. They are illegal and punishable by fines, penalties, interest and prison time. Section 7201 of the Internal Revenue Code states that “Any person who willfully attempts in any manner to evade or defeat any tax imposed by this title or the payment thereof shall, in addition to other penalties provided by law, be guilty of a felony and, upon conviction thereof, shall be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than five years, or both, together with the costs of prosecution.” It is important note, however, that tax fraud generally requires willful and intentional activity for the purpose of lowering a tax liability.

Taxes reduce the amount of cash an investor has left over to spend or reinvest (in the latter case, taxes can reduce an investor’s returns considerably over the long run). Accordingly, most people try to minimize their tax bills by making their portfolios (among other things) as tax-efficient as possible. This strategy in itself is neither illegal nor unethical.

However, there can be a fine line between tax efficiency and tax evasion. Notably, however, in order to prove tax evasion, generally there must be proof of intent and action to evade an unpaid tax liability. In the example above, the prosecution would have to prove that John Doe willfully attempted to hide or manipulate information to avoid paying taxes. If intent does not exist, the IRS may (or may not) resort to imposing fines, penalties and interest.