Tax shelters are often promoted as opportunities to invest in potentially lucrative deals while getting a tax break.  Though they take different forms and can utilize many structures, analysis of the investment is crucial in determining whether your tax return will survive IRS scrutiny.  Some of the questions the IRS will ask about the tax shelter are the same ones you should ask before investing.

Is it profitable?  The IRS will likely disallow a tax shelter that is based solely on deductions of interest and depreciation with only a remote possibility of earning revenues. To determine the tax shelter’s actual profit potential, measure the potential after-tax return against the after-tax cost. By doing so, you can compare the cost of a tax shelter opportunity with other investment vehicles such as stocks and bonds that are acquired with after-tax dollars. Also, factor in how long it will take to get the yield from the after-tax dollars. For example, a three-to-one return ($3 of cash received for each $1 invested) will not pass muster with the IRS if it takes several years longer to realize the full profit. Practically speaking, look at the time value of your money coupled with the fact that longer term returns will be less predictable than shorter term returns.

Does the Prospectus Detail a Deal with Economic Substance?  The prospectus provides a summary of the investment opportunity. It should detail the history of the participants, and provide a legal opinion letter or memorandum  about the projected tax consequences. Read the prospectus thoroughly. Don’t make the mistake of just reading the summary that is in the front of most prospectuses. Review the section detailing the  sources and intended uses of the proceeds. It should tell you who receives what and how much of the proceeds will be distributed to promoters and their affiliates versus being invested in the primary objective of the partnership. Most importantly, review the tax risks and considerations section very carefully; consider even obtaining your own second opinion from a lawyer independent of the tax shelter about the various tax considerations set forth in the prospectus and the veracity of those statements as they relate to you as an investor.

Promoters usually have a varied history of success, so examine the promoter’s track record. In addition, examine the financial statements of the general partner and learn what the arrangements are for front-end fees of the general partner. The general partner’s share of revenues should be reasonable in comparison to the services provided to the program. If the program allows for additional assessments to be paid, it must be disclosed in the prospectus. Additional assessment disclosures should include: (i) the maximum amount of additional capital that the general partner can assess for unexpected expenses; (ii) when the assessment can be made; (iii) the tax consequences of meeting the assessment; and (iv) the penalty, if any, should you fail to comply.

The level of risk of the IRS disallowing a tax shelter significantly increases if any of the following factors exist:

1. •Lack of Economic Substance.  A lack of economic risk or potential for gain occurs when you are making a significant investment, yet the risk of loss or gain is illusory.
   
   

2. •Inconsistent Financial or Accounting Treatment. Financial accounting treatment of a shelter item is inconsistent with its federal income tax treatment.
   
   

3. •Novel Investments.   Complexity, coupled with unnecessary steps or novel investments, usually occurs with the creation of entities or use of structures to achieve the desired tax result such as with corporate tax shelters that use innovative financial instruments to facilitate the exploitation of tax law inconsistencies.
   
   

4. •Unfavorable Promoter Activities. An example would be promoters who are aggressively selling the shelters as "products" to a varied clientele or network to maximize their own return, as opposed to an offering to a few clients in the circumstances of tax planning.
   
   

5. •High Transaction Costs. These can include fees paid to the promoter and expenses incurred in connection with the shelter activity.
   
   

6. •Risk Reduction Arrangements.   These are arrangements where contingent or refundable fees are in place to reduce the risk to the participants.
   
   

Will the tax shelter trigger an audit? When considering whether to invest in a tax shelter, do not ignore your own audit-comfort level. Many people are not temperamentally suited for investments that increase the possibility of an IRS audit. Therefore, it is important for you to decide whether you can live comfortably with this added potential risk.

In sum, if the tax deductions control the decision to invest in a tax shelter, then it is likely that the IRS will disallow those same deductions if you are audited. So, be prepared to explain why the factors above do not apply to your investment if your tax returns are audited.

© 2007 The Banking & Tax Law Group LLP.  Please note that the information included in this section of the website is intended to be general information only and is not provided in the context of an attorney-client relationship nor does it constitute legal advice.   None of this information is intended to be a substitute for obtaining legal advice for how the law applies to the particular facts and circumstances of your matter.  Changes in laws or other factors could affect, on a prospective or retroactive basis, the information contained herein.  We assume no obligation to inform the reader of any such changes.  In accordance with IRS Circular 230 governing the standards of practice for tax practitioners, any tax advice contained herein is not intended or written to be used as condoning, marketing, promoting or recommending any product or transaction and cannot be used for the purpose of avoiding penalties that may be imposed under the IRC or applicable state or local tax law provisions.

Tax Shelters