Another type of tax shelter involves financing arrangements. If a taxpayer pays excessively high interest rates to a related party, the income of an investment can be substantially lowered, possibly even resulting in a loss. However, a huge capital gain could occur when the investment is withdrawn. This results in a tax benefit, since capital gains are taxed at more favorable rates than ordinary interest or dividend income from an investment.
The reason these two types of tax shelters are questionable is mostly because the transactions are not reported at the true fair market value, or that the interest rate is not reasonable.
However, there are some tax shelters that are legal and valid. One such tax shelter deals with flow-through shares for limited partnerships. These are mainly seen involving investments in oil drilling or mining. Another legal tax shelter involves retirement plans, such as IRAs and 401(k)s. In these cases, the amounts contributed are not taxable until such time as they are withdrawn from the account. There are also legal tax-sheltered annuities known as 403(b) plans. These plans are available to employees of state or local government public schools, or a tax-exempt religious, scientific, charitable, or educational organization. A 403(b) is also available to the civilian staff or faculty of the Uniformed Services University of the Health Sciences Department or to self-employed ministers.
Regulations governed by the Department of the Treasury state that certain tax shelters and transactions must be registered. Also, it is required that lists of all investors must be kept by those who organize or sell interests in the tax shelters. In addition, investors in specified tax shelters and transactions must disclose their participation on their personal income tax returns.
Obviously, if you can get involved in a legitimate tax shelter, it can benefit you on your income tax return. However, if you get involved in a questionable or illegal tax shelter, the penalties will not be worth the trouble.
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