Many investment strategies enable taxpayers to legally decrease or avoid taxation. The goal of many of these “tax shelters” is to create offsetting losses to other taxable income.
An investment scheme that claims to reduce income tax without changing the value of the user's income or assets is a so-called “abusive tax shelter.” Abusive tax shelters serve no economic purpose other than lowering the federal or state tax owed when filing. The IRS has compiled a list of transactions that it considers abusive tax shelters. If the IRS conducts an audit of a taxpayer’s return and an abusive tax shelter is identified and challenged, the IRS will disallow the tax benefits of the transaction which will lead to the determination of a tax deficiency. In that case, the taxpayer will be faced with payment of the tax deficiency (i.e. underpayment of tax), interest on the underpayment, failure to pay penalty, an accuracy-related penalty of 20% to 40% of the underpayment, or a 75% civil fraud penalty.