After receiving much attention in the news in recent years, the term "tax shelter" has a negative connotation relating to deceptive and illegal schemes to evade income tax. However, this is not always the case. A tax shelter is also any legal strategy you employ to reduce the amount of income taxes you owe.
Sheltering your income with deductions
Claiming deductions is a perfectly legal way to reduce the amount of income tax you pay to the IRS. You can easily accomplish this tax shelter by choosing to spend your income on expenses that can lead to a deduction.
For example, it’s perfectly legal and reasonable to pay college tuition expenses with a student loan rather than a credit card for no reason other than to take advantage of the student loan interest deduction. If you prefer to make a large number of charitable donations during the year with the sole purpose of reducing your income tax bill, the IRS will never challenge your charitable deduction as long as you satisfy all requirements of the deduction.
Tax shelters using investments
In addition to claiming deductions, you can also shelter income from tax by choosing investments that provide the maximum tax savings. The IRS encourages taxpayers to save for retirement by allowing them to deduct a certain amount of contributions to a traditional IRA account. In addition, you achieve tax deferral on all investment income and gains in the IRA since the IRS will not impose an income tax on those earnings until you retire and start making withdrawals.
Illegal tax shelters
When evaluating an investment, the IRS encourages you to consider the doctrine of "substance over form." What this means is that if a tax strategy is illegal, it doesn’t become legal just because you call it something else.
For example, the federal tax law prohibits you from assigning income you earn to another taxpayer who is subject to lower tax rates. If you earn $200,000 during the year as an independent contractor, you are responsible for paying all of the income tax on it.
Setting up a corporation to receive your income and adding a family member to the payroll doesn’t transform your strategy into a legal tax shelter. If you are solely responsible for earning the income, then even with a corporation, you should be solely receiving a salary. Effectively, there is no substance to adding your family member to the payroll. However, many taxpayers enter into these types of transactions only because it appears easier to hide it from the IRS.
Penalties for illegal tax shelters
The penalties for entering into illegal tax shelters are clear, but also severe. The IRS treats illegal tax shelters as fraudulent activity and can charge you a penalty that is 75 percent of the tax you underpay as a result of your illegal tax scheme. In addition, taxpayers run the risk of criminal prosecution and the possibility of a prison sentence.