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 methodology can vary depending on local and international tax laws.

In North America, a tax shelter is generally defined as any method that recovers more than $1 in tax for every $1 spent, within 4 years.

Types of tax shelters

Some tax shelters are questionable or even illegal:

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 arranged between related parties, such transactions are often viewed as unethical. The agency may re-evaluate the price, and will quickly neutralize any over tax benefits. However, such cases are difficult to prove. A soft drink from a vending machine can cost $1.00, but may also be bought in bulk for $0.25. To prove that the price is in fact unreasonable may turn out to be reasonably difficult itself.

Other tax shelters can be legal and legitimate:

These tax shelters are usually created by the government to promote a certain desirable behavior, usually a long term investment, to help the economy; in turn, this generates even more tax revenue. Alternatively, the shelters may be a means to promote social behaviors. In Canada, in order to protect the Canadian culture from American influence, tax incentives were given to companies that produced 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.[1] However, a few individuals stretch the limits of legal interpretation of the income tax laws. While these actions may be within the boundary of legally accepted practice in physical form, these actions could be 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 in the opposite manner. Tax shelters have therefore often shared an unsavory association with fraud.

Judicial doctrines to combat tax shelters

Aside from the attempts to stop tax shelters in the United States through provisions of the U.S. Internal Revenue Code, U.S. courts have several ways to prevent tax sheltering activities from happening. The judicial doctrines have a basic theme: to invalidate a transaction that would achieve a result contradictory to the intent or basic structure of the tax code provisions at issue. The following are the judicial doctrines:

1) The Substance over form doctrine

This doctrine is based on the premise that if two transactions have the same economic result, they should have the same tax result. To achieve this similar tax result, it can be necessary to look at the substance of the transaction rather than the formal steps taken to implement it.

2) The Step transaction doctrine

Similar to the substance doctrine, the step transaction doctrine treats a series of formally separate steps as a single transaction to determine what really was going on with the transaction.

3) The Business Purpose Doctrine

Courts will invalidate a transaction for tax purposes under this doctrine when it appears that the taxpayer was motivated by no business purpose other than to avoid tax or secure some tax benefit. This judicial inquiry largely is dependent on the taxpayer’s intent.

4) The Sham Transaction Doctrine

This doctrine looks for transactions where the economic activities giving rise to the tax benefits do not occur. A clear example of this doctrine is seen in Knetsch v. United States, 364 U.S. 361. Sham transactions are classified as being one of two types, sham-in-substance, or sham-in-fact.

5) The Economic Substance Doctrine

Under this doctrine, courts will invalidate the tax transaction if the transaction lacks economic substance independent of the tax considerations. This doctrines questions whether the purported economic activity would have occurred absent the tax benefits claimed by the taxpayer.

Donaldson, Samuel A. (2007), Federal Income Taxation of Individuals: Cases, Problems and Materials (2nd ed.), St. Paul: Thompson West .pg. 730-734

See also


  1. ""The Investment Puzzle: IRA vs. TSA" . Virginia L. Bean, W. Peter Salzarulo, Richard F. Bebee and Josiah T. S. Horton Academe. Vol. 68, No. 3 . May - Jun., 1982, pp. 15-20 Published by: American Association of University Professors". JSTOR 40248939.

External links

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