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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:
- Offshore companies. By transferring funds to a company in another country, one may claim the transfer as an expense, and thus lowering the taxable income. Difficulties in international tax treaties often make the income not legally taxable.
- Financing arrangements. By paying unreasonably high interest rates to a related party, one may severely reduce the income of an investment (or even create a loss), but create a massive capital gain when one withdraws the investment. The tax benefit derives from the fact that capital gains are taxed at a lower rate than the normal investment income such as interest or dividend.
Other tax shelters can be legal and legitimate tax:
- Flow-through shares/Limited Partnerships. Certain companies, such as mining or oil drilling often take several years before they can generate positive income, while many of them will go under. This normally deters common investors who demand quick, or at least safe, returns. To encourage the investment, the US government allows the exploration costs of the company to be distributed to shareholders as tax deductions (not to be confused with tax credits). Investors are rewarded by 1) the near instant tax savings 2) the potential massive gains if the company discovers gold or oil. In US terminolgy, these entities are given the generic title of “limited partnership” and in the past they may have simply been called a “tax shelter”, being an architypical tax shelter. However the IRS limited the popularity of these plans by allowing the losses to only offset passive (investment) income as opposed to earned income.
- Retirement plan. In order to reduce burden of the government funded pension systems, governments may allow individuals to invest in their own pension. In the USA these sanctioned programs include Individual Retirement Accounts (IRAs) and 401(k)s. The contributed income will not be taxable today, but will be taxable when the individual retires. The advantage to these plans is that money that would have been taken out as taxes is now compounded in the account until the funds are withdrawn. With the Roth IRA and the newly introduced ([2006]) Roth 401(k), income is taxed before the contributions are made into the account but are not taxed when the funds are withdrawn. This option is preferred by those workers who expect to be in a higher tax bracket during retirement than they currently are.
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