Ask the average business owner if they have a tax shelter and they’d probably have a chuckle while wistfully thinking about how nice it would be to swim in crystal clear waters while their offshore bank accounts grew, unencumbered by state and federal taxes.
After all, the idea of a tax shelter is largely based on a caricature. Maybe it’s that auto repair shop around the corner that never seems to have any customers, set up by a shadowy accountant as a way for a nefarious client to show a business loss. Or it could be a shell company headquartered in the Cayman Islands that stashes away valuable assets from being subjected to tax. But the reality is far more nuanced than that.
There are many arrangements that lack any evil motive that the tax code still labels as a tax shelter. In fact, many business owners may have a tax shelter and not even know it.
Among other things, the IRS labels a tax shelter as a pass-through syndicate where more than 35 percent of losses are allocated to passive investors (like limited partners). If that sounds like a broad definition, that’s because it is. And because there’s so much ambiguity, it opens up various businesses, large and small, to classification, particularly many family businesses. That’s significant because there are serious consequences that can arise from being labeled a tax shelter.
Before we get into potential penalties, it’s worth exploring just how easy it is to fall under the broad scope of the tax shelter classification. Let’s say the proprietor of an interior design business formed an S corporation in 2019. She owns 50 percent of the S corporation’s stock. The remaining 50 percent is owned by her adult nieces. The nieces aren’t involved in the day-to-day operations of the business. If the company generates a tax loss in 2019, it will be considered a tax shelter because more than 35 percent of the loss is allocated to the nieces (who are limited entrepreneurs).
This is a very real scenario for startup businesses, which often have limited investors and frequently experience losses in their first year. The phenomenon could be even more pronounced in 2020 when several companies will be reporting losses stemming from the COVID-19 pandemic.
Once a company is labeled as a tax shelter, it faces a variety of hurdles. One of the biggest challenges is that the IRS prevents firms designated as tax shelters from using the cash method of accounting. Instead, they would need to use the accrual method, which is harder to administer and can be burdensome for a business that lacks the resources to commit to their accounting departments.
Furthermore, once a small business gets tagged with that tax shelter label, it can’t get out of the interest expense deduction limitation rules. Small businesses (those with average annual gross receipts for the three prior tax years of $26 million or less) can deduct business interest expenses without limitations, but a tax shelter cannot do that.
This can all blindside the vast majority of businesses that meet these criteria, especially if the business has debt and passive investors. And that’s not just mom and pop interior design shops and hardware stores, but also real estate firms and virtually every pass-through venture in the history of Silicon Valley. In fact, preparers and CFOs alike were shocked when it was included as part of the Tax Cuts and Jobs Act.
Fortunately, being a syndicate doesn’t, by itself, subject businesses to the arduous tax shelter penalties. However, if the principal purpose of the entity is to avoid or evade federal income tax, the penalties will apply. Also, there are penalties for promoting abusive tax shelters and aiding and abetting in an understatement of a tax liability. According to the IRS’s
As the whole world fixates on the COVID-19 outbreak and wrestles with the realities of the ensuing economic fallout and the extensions to pay taxes that the federal government is doling out, these are the intricacies that could catch a business (that is already stretched to the limit) off-guard. It will be up to everyone from preparers to proprietors to make sure that they are fully compliant; otherwise they could be in for an unwelcome surprise the next time the IRS comes calling.
