What it is:
A tax shelter is a means of minimizing one's tax liability. Tax shelters can be both legal and illegal.
How it works/Example:
The most widely used tax shelter in the United States is the 401(k) employer sponsored plan. It is generally available to an employee to both reduce the amount of taxes paid on his income as well as to save for his future retirement.
The Internal Revenue Service (IRS) investment vehicles such as 401(k)s and IRAs as legal tax avoidance mechanisms.
Limited partnerships are also considered legal tax shelters. They can avoid taxes because the business -- for example mining companies --require several years and heavy capital investment before a real income is realized. Taxes are levied as soon as the company starts to make income.
Why it matters:
While retirement plans and limited partnerships are legal, many investment vehicles are illegal. A series of tax laws have been implemented to put a stop to abusive tax shelters.
The will attach a fee if one places money into an "abusive" shelter. Abusive shelters are those that "exist primarily to reduce taxes unreasonably for tax avoidance or evasion... A legitimate investment produces income or capital appreciation and involves a risk of loss proportionate to the investment."
Illegal tax shelters include offshore companies which beguile the tax system.
More information on tax shelters may be found at the IRS website.