Tax Shelter: Definition, Examples, and Legal Issues

What Is a Tax Shelter?

A tax shelter is a vehicle used by individuals or organizations to minimize or decrease their taxable incomes and, therefore, tax liabilities. Tax shelters are legal, and can range from investments or investment accounts that provide favorable tax treatment, to activities or transactions that lower taxable income through deductions or credits. Common examples of tax shelter are employer-sponsored 401(k) retirement plans and municipal bonds.

Understanding Tax Shelters

There are various provisions available that can be used to reduce an individual or corporation’s tax burden, whether temporarily or permanently. When these resources are implemented to lower a tax bill, we say that the entity involved is sheltering its taxes. The tax shelter route that is taken by a taxpayer to reduce or erase his tax liability can be legal or illegal, hence, it is imperative that the individual or corporation evaluate the tax reduction strategies to avoid being penalized by the Internal Revenue Service (IRS).

There are numerous tax shelters that the government has provided to help its taxpayers lower the tax burden. Tax deductions, for one, are amounts of income earned that can be deducted from an individual’s taxable income. The tax rate that is applied to the lower taxable income will translate into a lower tax bill for the individual. Some tax shelters that are provided in the form of tax deductions include deduction of charitable contributions, student loan interest deduction, mortgage interest deduction, deduction for certain medical expenses, etc.

For example, the IRS permits charitable donations to be tax deductible for up to 50% of an individual’s adjusted gross income (AGI). If a taxpayer with an annual income of $82,000 elects to donate $12,000 to a qualified charitable organization, his taxable income will be reduced to $70,000. Since he falls in the 22% marginal tax bracket, he would lower his tax bill by $2,640 (12,000 x 22%)

Types of Tax Shelters

Retirement Accounts

Tax shelters are also legally available in the form of investment and retirement accounts which shelter income from taxes. The tax shelter provided through these accounts serves as an incentive to income earners to save for retirement. Income contributions made to a 401(k), 403(b), or Individual Retirement Account (IRA) plan will not be taxable until the individual retires. This way, money that would have been taxed by the IRS accrues interest and earnings in the account until the funds are drawn.

A taxpayer who takes advantage of the tax shelter provided through a 401(k), 403(b), or IRA reduces his taxable income by the amount of his contribution into either of the accounts. For individuals who expect to be in a higher income tax bracket by the time they retire, the Roth IRA and Roth 401(k) provide a way to shelter income from higher taxes.

With these investment accounts, the contributed income is taxed before entering the accounts, but no tax applies when the funds are withdrawn. This way, if the taxpayer starts making distributions after he enters a higher tax bracket, he would already have paid taxes when he was in a lower income bracket.

Foreign Investments

Investors with foreign investments in their portfolios can take advantage of the foreign tax credit which applies to taxpayers who pay tax on their foreign investment income to a foreign government. The credit can be used by individuals, estates, or trusts to reduce their income tax liability.

Oil and Energy

To encourage investment in companies of certain sectors (oil exploration, renewable energy, and mining, for example) which require heavy capital investment and take several years to start making profits, the government allows the exploration costs incurred by these companies to be distributed to shareholders as tax deductions. The exploration and development costs are taken as the shareholders’ expenses; shareholders deduct the expenses from their taxable income as if they directly incurred these costs.

Municipal Bonds

Some municipal bonds are also tax-exempt, meaning that any interest income that is generated is exempt from federal income taxes, and in many cases, state and local income taxes as well. Note that interest income from municipal bonds is generally not subject to the Alternative Minimum Tax (AMT).

Mutual Funds

Mutual funds that invest in government or municipal bonds are also common tax shelters. Though you still pay income tax on your initial investment when those dollars are earned, the interest generated by these debt securities is exempt from federal income taxes, so your investment generates annual income tax-free.

Real Estate

Physical real estate in addition to REIT vehicles may be used as a tax shelter. Taxpayers may receive favorable treatment due to depreciation deductions. Taxpayers may also receive benefits by performing 1031 like-kind exchanges that allow for the sale of a property and avoidance of capital gains of the proceeds are used to acquire a similar asset. Landlords and real estate investors may also be able to deduct rental losses from their rental income, thereby reducing their taxable income.

Conservation Easements

In some cases, agreements between landowners and a conservation organization can result in a tax benefit. These easements often reduce the use of land in order to protect a natural resource. When a taxpayer donates a conservation easement, they may be able to claim a tax deduction based on the value of the easement.

Tax Shelter Strategies

There are two primary strategies regarding tax shelters. First, taxpayers try to minimize their tax liability. This is done most often by minimizing taxable income by offsetting taxable income against taxable losses or by simply reducing taxable income. For tax avoidance strategies, the goal is to never pay that tax and avoid taxes altogether.

The other primary strategy regarding tax shelters is tax deferral. Consider popular retirement accounts such as a traditional IRA. The gains for a traditional IRA are taxable when withdrawn. However, those taxes are deferred to the future. Therefore, a taxpayer can plan for the future and not worry about immediate tax implications. Therefore, tax shelters may either reduce the amount of taxes due permanently or reduce the amount of taxes due temporarily.

Tax Shelter vs. Tax Evasion

While tax shelters provide a way to legally avoid taxes, they can also be used to evade taxes. Tax minimization (also referred to as tax avoidance) is a perfectly legal way to minimize taxable income and lower taxes payable. Do not confuse this with tax evasion, the illegal avoidance of taxes through misrepresentation or similar means.

If an investment is made for the sole purpose of avoiding or evading taxes, you could be forced to pay additional taxes and penalties. For example, if an independent contractor or subcontractor purposely transfers all or a portion of her earned income to another individual who is subject to lower tax rates, the contractor will be evading taxes.

Also, companies who take advantage of favorable tax rates in certain countries by creating offshore companies for the purpose of evading taxes, will be heavily penalized by the IRS which treats such manipulative strategies as fraudulent activity subject to steep fees, criminal prosecution, and prison sentence. (For related reading, see "Why Delaware Is Considered a Tax Shelter")

Tax Shelter vs. Tax Haven

Whereas a tax shelter is a legal strategy or investment vehicle designed to reduce or defer tax liabilities, a tax haven is a country or jurisdiction that offers low tax rates. A tax haven may also offer taxpayers minimal or no tax reporting requirements with coinciding financial privacy laws.

Tax havens are often used by individuals or businesses to avoid or evade taxes by hiding their income or assets in offshore accounts. Taxpayers often intentionally go out of their way to seek out tax havens, especially when considering where they may geographically live. Though tax shelters may accomplish some of the same outcomes as a tax haven, tax havens are often coupled with a lack of transparency and secrecy.

The Bottom Line

A tax shelter is a legal strategy or investment vehicle that is designed to reduce or defer tax liabilities. Tax shelters can be used by individuals, businesses, or organizations. Tax shelters take advantage of deductions, credits, or other incentives provided by the tax code and are different from tax evasion or tax havens.