Tax Shelter Penalties

Contemporary financial planners generally consider the impact of taxes on their clients' bottom line. One popular strategy is the use of tax shelters to help minimize their tax liabilities. Unfortunately, the tax savings realized from this strategy has encouraged the formation of an ever-growing number of illegal tax shelters. In response, the Internal Revenue Service (IRS) has taken a closer look at all tax shelters and is now aggressively pursuing tax cheats through increased audits and vigorous litigation.

An initial test that the IRS uses to establish a tax shelter's compliance with current tax code is the taxpayer's income status. To shelter that business' income from taxes, the taxpayer must have participated in its business activity in an active and substantial manner. Anything less is considered passive income and will be disallowed by the IRS. Within that context, however, any passive real estate rental income loss can be legitimately deducted, with some limitations, from active income.

Unscrupulous tax advisors have long touted the use of trusts as tax shelters in which personal expenses and certain taxes are depreciated to minimize or altogether eliminate taxes. Service equipment trusts and business and personal trusts are examples of the types of trusts generally used to defraud the government.

Offshore tax shelters have also been used by American expatriates who counted on their renunciation of their U.S. citizenship as a means of evading their tax responsibilities. American courts, however, have ruled that American citizens remain responsible for their taxes on income earned overseas. Once proven that their expatriation was done to avoid paying taxes, courts have levied severe civil and criminal penalties on these tax frauds.

The proclivity of an ever-increasing number of Americans choosing to work from home has seen the explosive growth of home offices. They provide legitimate business deductions for many honest taxpayers but unfortunately are also being used by tax cheats as bogus tax shelters. Illegal home offices are used to deduct travel expenses, meals and entertainment, educational costs, medical reimbursements and payments to family members as business expenses.

Legitimate tax shelters also suffer financial penalties if they are registered illegally or untimely. In those instances the fine can either be $500 or one-percent of the total amount of the money that is invested in the enterprise, whichever is greater. The total fine may not exceed $10,000 unless it can be proven that criminal intent was in play, in which case the courts are free to raise the fine or to impose incarceration.

In previous years the IRS showed restraint when dealing with illegal tax shelters. They offered taxpayers an opportunity to work out their tax difficulties in an amicable manner. Recently, however, the Appeals Division and the Large and Mid-Size Business Division of the IRS have become less tolerant with non-compliant tax shelters and have restricted their work-outs with only those taxpayers who concede to 100 percent of their claimed losses minus up to only ten percent of the shelter's legitimate costs.

Lawful tax shelters remain a legitimate way of minimizing taxes. The IRS, however, is aware of the abuse of these methods and is actively scrutinizing an ever-increasing number of tax shelters to ensure their full compliance.