How to avoid buying an abusive tax shelter
By Kay Bell • Bankrate.com

The deal sounded sweet. The investments would save tons of tax dollars and were recommended by a highly respected international accounting firm. Hundreds of investors confidently signed up for the KPMG tax shelters.

It didn't sound so sweet, however, after a ruling from the Internal Revenue Service that the arrangements didn't meet tax-law muster. The investments were, according to the IRS, abusive shelters that deprived the U.S. Treasury of billions in evaded taxes.

KPMG has acknowledged wrongdoing and agreed to pay $456 million in a settlement that defers any criminal prosecution. The entire investigation certainly put accountants and investment firms on notice, but it also raises an important issue for individual investors:

How can you tell if a proposed tax-saving arrangement is really an abusive tax shelter?

Questioning conventional wisdom
Conventional wisdom used to be that as long as you stuck with a reputable company with solid and long-standing financial and tax experience, you were OK. The KPMG incident, however, turned conventional wisdom on its head.

"That's one of the dilemmas here," says Mark Luscombe, principal federal tax analyst with CCH, a provider of tax and accounting information and software. "A lot of things in the tax world are subject to interpretation. You hire some clever accountant or tax lawyer to take a careful reading of the tax code and come up with something that works under the letter of the law. Then the IRS comes along with a different interpretation.

"I'm not sure it pays to be too clever."

Those might be good words to heed since the IRS is making it clear that it is looking more closely at tax shelters nowadays. Tax law provisions that took effect late last year give the agency more latitude in tracking down and penalizing those involved in abusive shelters. So what exactly is the IRS looking for?

An abusive tax shelter is a marketing scheme that involves tax transactions with little or no economic value, says Michael C. Provine, managing director of Tradition Capital Management in Summit, N.J. "It is often marketed in terms of how much you can write off against tax on your tax return, in relation to how much you invest."

"Some shelters are advertised as you're not going to get all your money back, but you'll more than make up for it with tax savings," says Bob D. Scharin, editor of Warren, Gorham & Lamont/RIA's monthly tax journal "Practical Tax Strategies." "For example, you invest $10,000 and lose it but will get $50,000 in tax breaks that will make up for the loss."

Expect that type of investment to get IRS attention since its examiners look at whether you would enter into the transaction if it didn't promise tax savings. In the eyes of the IRS, a legitimate shelter is one you invested in expecting to make a few bucks and the tax savings just made it even better.

Investment intentions matter
That's why it's important, says Provine, for an investor to consider whether the proposal can stand on its own as a money-making investment without the tax consequences. Can you make money by investing in the arrangement?