Tax Shelters The Difference Between Illegal and Legal Tax Shelters

By on | Tax & Bankruptcy Law Information.

Tax shelters are legal ways of decreasing an investor’s taxable income and tax liability. They are typically investments that provide a beneficial transaction to lower taxable income. The tax shelters are carefully monitored by tax authorities to make sure an investment is not made primarily to avoid taxes. If you are using a tax shelter to avoid taxes, you can run the risk of paying additional taxes and fees if you are caught. It is important to understand the difference between illegal and legal tax shelters and the types of tax shelters available through retirement plans, owning a home, and incorporating your business.

Illegal Tax Shelters

Using a tax shelter illegally can result in lowered taxes and are typically tax shelters in offshore companies or through financial agreements. A tax shelter in an offshore company occurs when you transfer funds to a company on foreign soil. The international tax treaties can make the income not legally taxable, therefore avoiding taxes. Tax shelters in financial agreements are when capital gains are taxed at an interest rate lower than the normal interest.

Legal Tax Shelters

Legal tax shelters generally lie in limited partnerships and retirement plans, both created by the federal government to help the economy. Tax shelters in limited partnerships result when a company—typically a mining or oil company where positive income may take time—distributes the exploration costs to shareholders. The investors in the company receive massive gains if the company they invest in is successful.

Using a retirement plan as a tax shelter is the most common legal tax shelter. By investing in your own pension, the income is not taxed during the contribution. Instead, the investment is taxed when you retire. Many people also opt to invest in their homes by deducting mortgage interest, home equity loan interest, home improvement loan interest, and property taxes.

Personal Tax Shelters: Retirement Plans

Personal tax shelters are essentially what the name describes: a way to protect your money from income tax collectors. These income tax shelters keep a portion of your income free from being taxed. The most common personal tax shelters are 401(k) plans and an Individual Retirement Account (IRA). Tax sheltered annuity allows you as an employee to make a contribution from your income in a retirement plan. These contributions are not taxed until withdrawn from the plan. In certain plans, the employer can also make a direct contribution to the employee’s plan, increasing the tax fee funds. The most common tax sheltered annuity plan is the 403(b) retirement plan, which allows employees of tax-exempt organizations, public education teachers, or self-employed ministers to participate.

In retirement plans, each $1 you contribute to the plan is divided into two separate amounts. The first amount is what you save on taxes, and the second amount is the investment which will grow tax-free for years. There are different types of IRAs, including traditional, Roth, and educational. The IRA has a low fee schedule and has tax free distributions after you turn 59 and a half years old.

Personal Tax Shelter: Owning a Home

Another important income tax shelter lies in owning a home. When you own a home, you can deduct mortgage interest and property taxes from your taxes. The taxes you can deduct include everything associated with the real estate, but do not include homeowner association fees. In addition to this deduction, you can also deduct interest up to $100,000 on home equity debt. If the house has equity and the debt is secured by the equity, you can do anything with the borrowed money.

If you work at home and use the property jointly for your business, you have the opportunity for this to become a greater tax shelter than it being only for personal use. In the event you use a portion of your home for a home office, you can deduct the expenses from that section of the house. It is important to remember that this section of the house must not be lived in and can only be used for a business.

Personal Tax Shelter: Business

By using a tax shelter incorporating your business, you are able to take advantage of tax write offs available to business owners. In order to have a business tax deduction, you need to have a profit motive for your business. Thanks to modern technology, you can incorporate your business or form a Limited Liability Company (LLC) by simply using the Internet.

Before you invest in a tax shelter, it is important to talk with your local IRS office to make sure that the tax shelter is legal. The last situation you want to face is additional fines in the event that a tax authority finds out your tax shelter is illegal. By using illegal means of tax shelters, you run the risk of becoming imprisoned if caught. Remember that although saving money on your taxes is always a good thing, it is highly important to keep it legal and avoid trouble with the IRS.