Types

• Despite the pejorative connotation, there are many legitimate tax shelters. Charitable donation and writing off business expenses are perfectly legal ways to avoid taxation, as is investment in real estate. Authorities monitor tax shelters quite closely, though, because tax avoidance becomes illegal tax evasion when legitimate shelters are used fraudulently. This most frequently occurs when artificial means are used to inflate deductible expenses or to inappropriately transfer investment income to the lower tax capital gain category.
  
  

Function

• Sometimes, using a tax shelter can be as simple as making a single transaction to a lower tax or non-tax account, like an IRA, to lower the taxable income for that year. Other tax shelters are structural, like an offshore account or office for a business, which must be maintained perpetually. Certain kinds of businesses receive tax benefits, so investors put their money into these activities to enjoy the lower tax rate.
  
  

Features

• The prime feature of any tax shelter is that it reduces taxable income. This can be done either by writing off expenses, or by transferring funds to a retirement account or an investment with legitimate tax benefits. Some corporations avoid taxes by conducting transactions with related companies at a lower tax bracket or in a lower tax area.
  
  

Considerations

• Though some types of assets, like municipal bonds, are exempt from federal income taxes or receive other preferential treatment, the economic effect of a tax shelter should be well understood before it is used. An asset that loses more in value than is saved in taxes is probably not a good idea. Some tax shelters, like real estate, cattle ranching and art reproduction, are sufficiently complex that novices should consult a professional or avoid them altogether.
  
  

Significance

• Tax shelters were created as an incentive to good behavior, things like saving for retirement or starting a business. That they can be abused is simply a consequence of loopholes and the desire to save money. In evaluating the legality of tax shelters, judges have looked to the intent of transactions and their economic effect, holding that, absent some legitimate business purpose, a transaction designed solely to reduce tax liability is not legal. Courts have also grouped serial transactions together to make their determination.