This blog has been updated as of March 2023 for accuracy and comprehensiveness.

When most people hear the term “tax shelter,” they think of nefarious, underhanded schemes to skirt the tax laws. Unfortunately, many legitimate business operations fall under the IRS definition of tax shelters, causing them to lose out on certain tax breaks for which they’d otherwise qualify.

Big Tax Perks for Small Businesses

The Tax Cuts and Jobs Act included several provisions intended to simplify tax matters for business with less than $25 million (adjusted for inflation) in average annual gross receipts. For example, these businesses generally are allowed to use the cash method of accounting (rather than accrual), even if they have inventory. They’re also exempt from some other tax law provisions, including:

• The uniform capitalization rules,

• Certain burdensome inventory accounting rules,

• The business interest expense deduction limit, and

• Certain long-term contract requirements.

These benefits, however, aren’t available to businesses that are tax shelters — regardless of whether their average annual gross receipts are below the threshold.

IRS Definition

Not surprisingly, partnerships and other entities are considered a tax shelter if a significant purpose is the avoidance or evasion of federal income tax. It also encompasses certain entities (other than C corporations) for which the offering of their securities is subject to federal or state registration.

So far, so good for most small businesses. But the term “tax shelter” also includes syndicates. Your business qualifies as a syndicate if more than 35% of its losses during the tax year are allocated to limited partners or limited entrepreneurs. The latter generally have an interest in the entity, other than as limited partner, but don’t actively participate in its management.

Notably, the IRS in 2021 issued final regulations that made clear losses must actually be allocated, as opposed to merely being allocable. This interpretation is more favorable, as businesses otherwise could have been deemed tax shelters simply for having losses, regardless of whether it allocated the losses to limited partners or limited entrepreneurs.

Nonetheless, the IRS’s broad definition of tax shelters means that a business could be classified as a syndicate if it sustains an unforeseen loss in an anomalous tax year and allocates those losses. In other words, your status as a tax shelter could vary from year to year. If that happens, you may, for example, need to shift from cash accounting to accrual accounting as a result.

Options to Avoid Tax Shelter Status

Fortunately, the IRS has recognized the practical concerns related to determining tax shelter status every year. In response, it established an annual “syndicate election” in the 2021 final regulations.

A taxpayer can elect in a loss year to use the allocated taxable income or loss of the prior taxable year to determine whether the taxpayer is a syndicate for the current taxable year. The election applies for all of the simplified small business tax benefits listed above.

To make the election, you must file a statement with your federal income tax return. For S corporations or partnerships, the election is made at the entity level — not by the shareholders or partners. The election is valid only for that taxable year and, once made, can’t be revoked.

Alternatively, you could avoid qualifying as a tax shelter by reducing the amount of losses you allocate to limited partners and limited entrepreneurs to no more than 35%. Or you could increase those owners’ levels of participation in management so that they’re no longer considered “limited.”

Charting the Best Course

If your business qualifies for the small business tax relief under current law, you likely want to avoid tax shelter status. Contact us for help avoiding the “danger zone.”