A tax shelter is defined as any sort of action taken to reduce the amount of taxes paid. In case of an abusive tax shelter, the Internal Revenue Service (IRS) feels that the tax shelter is illegal, and that the taxpayer is engaging in an activity with the sole goal of reducing taxes. A number of abusive tax sheltering schemes have been heavily prosecuted by the IRS, which began to heavily crack down on the practice in the late 1990s, when many consumers began to explore various less than legal ways of avoiding taxes.
In some cases, a tax shelter is entirely legal. Many tax schedules are designed to help people pay for college, buy a new home, save for retirement, or start a business. These schedules include built in tax shelters to reduce the tax burden paid by people who are trying to engage in these practices, as a reward for their fiscally sound behavior. These shelters take the form of allowable deductions. For example, a student can deduct the interest paid on student loans from his or her taxes.
When people use abusive tax shelters, they take advantage of this system of deductions. Some common examples of abusive tax shelters include overvalued property, or the use of offshore bank accounts to conceal income. In some cases, consumers use an abusive tax shelter unwittingly, often because they are encouraged to do so by a company which may profit from the practice. In the United States, there is a long history of abusive financial transactions which are designed to defraud the IRS, and often to defraud consumers as well.
If the IRS suspects that a consumer is using an abusive tax shelter, it will conduct an audit, a careful inspection of the taxpayer's financial activities and accounts. If the audit reveals that an abusive tax shelter is being used, the taxpayer faces heavy fines and possibly jail time as well. In some cases, a consumer may be able to prove that he or she was defrauded into a financial decision, in which case the IRS will prosecute the individual or company who promoted the abusive tax shelter in the first place. As a general rule, however, the consumer is still liable for back taxes and other fines.
Tax deductions can get quite complex, which is why accountants and lawyers are especially well paid during tax season. Consumers can protect themselves by working with a reputable accountant, and bringing any proposals for trusts, real estate purchases, and other financial transactions to a lawyer. The lawyer can review the proposal to determine whether it is a legitimate tax shelter, like a retirement account, or if it is potentially fraudulent.