Gimme Shelters

The ins and outs of tax shelters

You've probably heard that death and taxes are the only certainties in life. However, the saying may be wrong.

I am not proposing a new certainty (nor am I offering immortality). My objection to the saying is that your tax bill is not a burden ordained by fate; it is something you choose, just as you choose the speed of your car. You can reduce the burden if you know how to work the controls. One set of controls is called tax shelters.

A tax shelter is an investment that enables the investor to claim deductions or credits that lower his tax bill. Most investments have to be made with after-tax dollars; but a tax-shelter investment, in effect, can be made with before-tax dollars. For this to be possible, most or all of the amount invested must be deductible from the current year's taxable income.

With the more aggressive tax-shelter programs, the value of the tax deductions and credits may actually exceed the cost of the investment. In such a case even a mediocre investment becomes exciting because the government, in effect, is buying it for you.

Some shelters exist because the government deliberately encourages certain industries. A more general source of tax-shelter opportunities is the government's inability to write rules that precisely measure your true income.

Most tax-shelter programs are complicated, because tax shelters operate primarily by exploiting discrepancies between economic reality and the tax laws and regulations.

A large portion of the tax rules amount to a formula for calculating the net taxable income of a business, and this is where the discrepancies between the rules and economic reality are greatest—and are most readily exploitable. Consequently, most tax shelters are organized around business ventures. So we'll begin by taking a look at the problem the government faces in trying to measure the income of a business.

Because the values of a business's assets and liabilities are in constant flux, the cash register alone cannot indicate whether the business is making money or losing it. To compute the business's income or loss precisely, one must know the value of everything it owned and owed on the first day of the year, and everything it owned and owed on the last day of the year. The difference between the two, plus anything that was paid out to the owners, would be the true profit, or net income.

But there is no way for anyone, least of all the government, to collect this information. To raise just one question: What is the value, on any day, of the equipment and machinery the business owns? The business's books provide some figures, but these numbers are only a formality—numbers created by following the government's rules. These numbers say nothing about the true wear and tear the machinery has undergone since it was acquired by the business, nothing about its actual resale or replacement cost, and nothing about its present and future usefulness to the business.

And the government's rules don't allow for the goodwill and reputation the business has built up. Even the owners of the business would be hard-pressed to put a value on it. But in many cases goodwill is the most valuable asset the business owns. Any change in its value during the year means an element of profit or loss that is invisible to the tax rules.

The government's rules are not much more successful in measuring business liabilities, since the rules ignore the effect of inflation on the value of the money the business might owe. The rules also ignore the effects of changes in prevailing interest rates on the present dollar value of long-term debts. Nevertheless, any decrease in the value of debts adds to profit—an addition invisible to the IRS.

Most tax shelters depend on one or more of three elements of expense that the tax rules poorly measure. They are interest expense, depreciation, and capital expenditures.

• Interest expense. During a time of high inflation, interest rates about match the rate at which the value of money is declining. Consequently, when inflation is high, an interest payment is really a repayment of a loan's purchasing power, rather than an actual cost of doing business.

Nevertheless, the tax rules ignore inflation. In determining the year's profit, the tax rules say, "Subtract interest payments (but ignore the shrinkage in the debt's purchasing power)." The tax rules include an important limitation on interest deductions. The limitation rests on a distinction between interest paid in the course of running a business and interest paid to finance investments.

Interest paid as an expense of running a business is deductible each year without limit. For the purpose of this rule, "business" is defined very broadly to include the "business" of renting out real estate.

But interest paid on loans taken to purchase investments (stocks, bonds, precious metals, foreign currencies, etc.) is deductible each year only up to a limit of $10,000 plus the total income earned from investments (dividends, interest, royalties, and short-term capital gains). Any investment interest paid beyond the above limit is carried forward to the following year, when it can then be deducted—subject to the overall limitation for that year, also.

To avoid the limitation on deductions for investment interest expense, most tax shelters involve either real estate or an operating business.

• Depreciation. Buildings and machines gradually wear out from use and from the effects of time. The decline in value each year is a cost of doing business and should be subtracted in determining true net income. The tax rules attempt to do this by allowing a fraction of the original cost to be deducted each year as depreciation. Eventually, over a period of years, the entire cost is deducted.

Within the rules, the taxpayer has considerable latitude to choose the annual rate at which the total depreciation allowance will be used up. If he wishes, he can choose a rate that far exceeds the equipment's true deterioration.

However, the total depreciation deductions claimed for a machine (or a building or anything else) may not exceed the amount paid for the asset. Consequently, if the depreciation deduction in the first year is greater than the machine's true deterioration, later years' deductions inevitably will fall short of the true deterioration in those years.

Thus, tax shelters usually are new businesses—drilling a new oil well, becoming the new owner of equipment to be leased, or becoming the new owner of an apartment building. Even if the assets purchased are not new, the new owner can begin claiming depreciation deductions all over again. In this way, assets are "recycled" for tax-depreciation purposes.

• Capital expenditures. The tax rules make an artificial distinction between capital goods (the cost of which may be deducted as depreciation only over a period of years) and consumable goods and services (the cost of which may be deducted in full each year).

Generally, in the thinking of the IRS, anything is a consumable if it will be used up within 12 months from the date it was purchased and its total cost can be deducted as soon as it is paid. Thus a taxpayer can deduct an expenditure made on the last day of the year, even though the expenditure will be contributing to profits that will not be taxable until the following year.

In fact, an expenditure deductible in full for one year may contribute to profits that do not become taxable for many years to come. An extended delay is possible because the tax rules take a rather simple-minded approach to what constitutes being "used up."

According to the rules, the hay eaten by a calf gets used up somewhere between the mouth and the tail. In a physical sense, that is true enough. But it isn't an accurate description of economic reality. The hay has not been used up at all; it has added to the value of the calf. But the increase in value will not be recognized as income by the tax rules until the calf is sold (perhaps two or three years later, as a steer).

The tax benefits possible with capital expenditures are a second reason that most tax shelters are new businesses. An old business may have expenses that were prepaid and deducted years ago that will show up as taxable income this year. But a new business has no history of prepaid expenses to haunt it. An old business could be used as a tax shelter only if it had, for some reason, understated its expenses in past years, thus providing the opportunity to deduct those expenses now.

Because the opportunities for tax sheltering involve creating and running a new business, shelters usually require a full-time manager. But the investor does not want to assume, without limit, the liabilities that might be incurred by the manager. Organizing the project as a corporation would limit the liabilities, but it also would prevent the investor from including his share of the tax deductions and credits on his own tax return each year.

Consequently, most shelters are organized as limited partnerships. A limited partnership is a legal structure consisting of a "general partner" and a group of "limited partners." The general partner has complete authority to run the business and is himself liable for all the partnership's debts if the venture should go bankrupt. The limited partners are the investors. They have no say in running the business and have no liability for the partnership's debts or other obligations beyond the amount they invest. The agreement between the general partner and the limited partners will spell out the compensation the general partner is to receive, which usually includes a share of the profits.

A partnership pays no income tax. Instead, each partner (general or limited) includes his share of the partnership's income and expenses in his own personal tax return. Thus the investors are relieved of the need to run a business, but they receive immediate tax deductions, and their liabilities are limited.

Early each year, the general partner files a partnership "information" return (form 1065) with the IRS. He also sends a form K-1 to each limited partner, showing the partner's share of income and deductions for the year. The partner then includes his share of net income (which will be a negative number if deductions exceed income) on his personal tax return.

Tax shelters are complicated. But there is more to the problem than just picking through the available shelters. Even the best shelters have serious drawbacks that, depending on your circumstances, may outweigh the tax savings. We'll cover six major drawbacks here.

1. Dependence on inflation. Nearly all tax shelters are organized around either a real-estate investment or an operating business. Any sustained slowdown in inflation would be ruinous for real estate. And, unless the slowdown were gradual, it would be harmful for most operating businesses as well. If you already are overly dependent on continuing inflation, a tax shelter probably would add to your portfolio's overall risk.

2. Low before-tax rate of return. Low rates of return are the norm in tax shelters for two reasons. First, investment assets that lend themselves to use in tax shelters tend to get bid up by investors competing for tax benefits. Real estate is a good example of this. The large interest deductions and generous depreciation rules for real estate are features that high-income investors are willing to pay for. As a result, real-estate prices have been pushed up to a point at which the before-tax rental return on many properties is very low.

The second reason for low rates of return is the promotional cost. If the marketplace has overlooked a tax-shelter opportunity, so that the underlying asset has not been bid up, the tax-shelter promoter who discovers and markets the opportunity will charge for his service, reducing the before-tax rate of return on your investment.

3. Illiquidity. There is no ready resale market for most tax-shelter investments. This is not so important if a large share of your portfolio is in a marketable form. But if you are short of liquid assets, a tax-shelter investment will aggravate the problem.

4. Recapture risk. If the business around which a tax shelter is constructed goes bankrupt, it may generate a flood of "recaptured" taxable income—without providing any cash to pay the tax bill.

A failing business can produce taxable income because, in the course of failing, its assets are sold to satisfy the claims of creditors. Since the business is a tax shelter, it probably has been claiming depreciation deductions at the fastest rate the rules will allow.

For tax purposes, at this point, the depreciated value of each asset the business owns is the original cost of the asset minus all the depreciation deductions that have been taken for it. If the asset is sold for more than the depreciated value, the difference is taxable income—even though the business is going broke. The ugly result for the investor is the reverse of his original intention. He now has phantom income on which he must pay real taxes.

5. Disallowance. The tax rules are full of gray areas, and the IRS has its own way of interpreting the rules. It may say no to the deductions you purchased a tax shelter in order to claim. Then, unless you contest the matter and win, you will have an additional tax to pay, plus interest, and perhaps even penalties.

6. Audit risk. The IRS computer system scans all returns for signs of questionable deductions. Even if you have not claimed any deduction that cannot be easily defended, the figures you report for your tax shelter investment increase the chance that your return will be selected for an audit. The nuisance cost could be considerable.

Using any tax-shelter investment involves a compromise between the disadvantages that are associated with most shelters and the desire to save on taxes. There are a number of steps the taxpayer can take in searching for an intelligent compromise.

• Easier alternatives. First, check out other possibilities before deciding on a tax shelter. Look for ways to prevent the income you earn from actually reaching your hands in a taxable form. Depending on how you earn a living, it may be possible to convert what is now salary into pension plan contributions or corporate profits—money that gets taxed at a low rate or even at no rate at all.

• Risk ratios. There are three calculations that determine how easily your portfolio can absorb a tax-shelter investment without unduly increasing its overall risk: 1) The real-estate ratio is the gross value (disregarding any mortgages) of all the real estate you own, divided by your net worth. 2) The business-asset ratio is the gross value of all the business assets you own (including stocks, equipment and inventories in an operating business, equipment leased to others, and interests in oil and gas programs), divided by your net worth. 3) The dollar ratio is your net position in dollar assets (the cash, bonds, notes, mortgages, etc., that you own, minus the debts you owe) divided by your net worth. If your debts exceed the dollar assets you own, then the dollar ratio will be a negative number.

To calculate the three ratios, you'll need to draw up a personal balance sheet to find out how your net worth is distributed among various investment categories. Don't try for too much precision; this is a balance sheet that no one is going to audit, and round numbers will do.

But include every substantial asset and liability that affects you directly or indirectly: your home and any mortgage owed against it, your personal investment holdings and any debts you have incurred to purchase investments, your interest in a pension plan, your share of the gross assets and liabilities of any partnerships you have invested in. (Use the gross value of each asset, even if there is a loan against it. Enter debts separately.)

After you have drawn up the balance sheet, figure your net worth by subtracting the amounts of all your debts from the value of the things you own.

What the ratios should be is another large topic. Generally, a high real-estate ratio (50 percent or more) represents a bet that inflation will continue to rise in the gradual fashion of the last 20 years and that there will be no change in the features of the tax code that now favor real estate over other investments.

A high business-asset ratio is a bet that inflation is going to decline gradually—or at least not get any worse. A low (or large negative) dollar ratio is a bet that inflation will rise, either gradually or rapidly. A high dollar ratio is a bet that inflation will decline.

You probably have some standards in mind for those ratios. In considering the kind of tax shelter to buy and how much to put into it, you need to recognize whether the investment will push your portfolio closer to the target ratios or pull it further away.

• Adjust the portfolio. Although it might not be necessary, you may be able to change the ratios to make room for a tax shelter by selling the "excess" investments. To do so, you will have to identify something in your holdings that you are willing to let go and whose sale will not itself add to your tax problems.

• Decide on a tax rate. Make a tentative decision about what you want your marginal tax rate to be. By putting enough into tax shelters, it would be a simple matter to get your tax rate down to zero. But, because of the disadvantages that come with most tax shelters, this probably would be overdoing it.

You will have to choose the point at which any additional tax saved with a shelter is no longer worth the low return, illiquidity, hazards of recapture and disallowance, audit risk, and possible portfolio imbalance that come with the shelter. (If you don't have an opinion on this, I suggest a marginal tax rate of 35 percent. A marginal rate of 35 percent means that a $1 change in taxable income would result in a $.35 change in your tax bill.)

Now let's take a look at what the tax-shelter marketplace has to offer.

• Real estate. The main types of real-estate shelters are houses, apartments, shopping centers, and low-income housing. A house is the simplest, most straightforward tax shelter of all. It is small enough to purchase by yourself (rather than in partnership with others) and it is comparatively easy to manage. The house will be a tax shelter because deductions for interest and depreciation will exceed the net rental income (rents minus maintenance and property taxes).

A house purchased with a down payment of 20 percent (and a mortgage of 80 percent) will generate a tax loss equal to about 12 percent of its value in the first year. That means a tax loss in the first year of 60 percent of your cash investment. After the first year, the house will continue to produce tax losses, but they will gradually decline and reach zero in about the sixth year.

The operation of an apartment house as a tax shelter is about the same as for a house. There are a few differences to consider, however.

– Rent controls. A house can be converted from rental property to owner-occupied property simply by selling it. Thus it is easy to rescue a house from rent controls. The conversion of an apartment house into condominiums (to be sold to owner-occupants) is not so simple. The conversion may require zoning or other permits and may have adverse tax consequences. And even if the government does nothing to hinder the conversion, the physical character of the building may rule out the change.

– Partnership. Because of the size of an apartment house, you may find that investing in apartments means investing in a partnership. Thus you will have the job of evaluating the skill and trustworthiness of the managing partner as well as evaluating the building itself. On the other hand, the partnership arrangement can relieve you of all management burdens.

– Limitation of liability. If you become a limited partner in an apartment-house shelter, you will have no personal liability for the mortgage (or for any other partnership debt).

As with houses and apartments, shopping centers operate as tax shelters because deductions for interest and depreciation outrun net rental income and because appreciation is not taxed until the property is sold.

Credit terms are similar to those for apartments—a 20 percent down payment and an 80 percent mortgage. The tax deductions also are similar—about 60 percent of your cash investment in the first year, declining to zero in about the sixth year.

However, shopping centers differ from apartments in two ways. First, it is unlikely that a shopping center would ever be subject to rent controls except as part of a program of wage and price controls encompassing the entire economy.

Second, a shopping center often has a large share of its space rented out on non-cancellable leases that run for 30 years or more. Such a lease, if it sets the rent to a fixed number of dollars, is a long-term dollar asset that helps to balance your portfolio against the mortgage debt incurred with the shopping center. It also serves to reduce the amount of real estate the shelter introduces into your portfolio, since the tenant's right to use the property for 30 years amounts to a partial ownership of the property.

The government offers special incentives, including tax advantages, for investing in low-income housing. If a housing project is built for persons with less than a specified income, and if various other requirements are met, the government will guarantee the mortgage taken to construct the building (making it easy to borrow at a low rate), and will allow the investors to take depreciation deductions for the full cost of the project over a short period.

The low down payments (available because the government guarantees the mortgage) and the rapid depreciation of the building result in deductions that amount to a much higher percentage of the cash investment than with most real-estate shelters.

The disadvantage of low-income housing shelters is that they are considerably riskier than most real-estate programs. The projects tend to have high operating and maintenance costs and high rates of tenant delinquency, especially during recessions. And when a low-income housing project does go under, the tax results are ugly: most of the depreciation deductions from earlier years are recaptured as taxable income.

• Oil and gas. The tax benefits of oil-and-gas-drilling programs come primarily from deducting expenses that are really capital investments. The cost of drilling a well is deductible as an ordinary expense. Because this is where most of the investment goes, the investor can deduct 80–90 percent of his cash investment in the first year and most of the rest in the following year.

In addition, the income that is eventually earned from a successful oil and gas program is taxed under favorable rules that allow the taxpayer to claim a deduction (the depletion allowance) of up to 20 percent of the value of the oil or gas being produced. The depletion allowance is based on the project's gross income, not on its net income.

After the original drilling costs, the major operating expense is the payment of royalties to the owner of the property on which the drilling takes place. However, these costs are paid only when the wells actually produce income.

There are two types of oil and gas shelters—exploration programs and development programs. An exploration program drills wells in an area where oil and gas have not yet been found in commercial quantities. Exploratory drilling is far riskier than developmental drilling, but it also holds out the possibility of vastly greater profits. The profits are higher because the property owner cannot ask for high royalties when the drillers are taking a large risk.

A development program drills wells in locations close (perhaps within a few hundred yards) to wells that are already producing oil and gas in commercial quantities. The geological risk is much less than with exploration drilling. Also less is the chance of an outsize profit, since the owners of land close to wells that are already producing oil or gas ordinarily demand large royalties.

• Mining programs. A mine can be operated much like an oil-and-gas-drilling program. However, expenses incurred to prepare a mine for production are deductible only if it has already been proven that minerals are present in commercial quantities. If so, costs for labor, equipment rental, etc., are deductible immediately, allowing nearly all the investor's cash investment to be deducted in the year it is made.

In addition, some partnerships that mine for gold or silver defer their income simply by not selling the metal they produce. Instead of sending it to market, they physically distribute it to the investors (the limited partners). The metal an investor receives does not represent taxable income for him until he sells it. If he sells it within five years, the profit on the sale is treated as ordinary income; after five years, it is a long-term capital gain.

A gold- or silver-mining tax shelter that distributes its production to the investors is particularly attractive to someone who wants to add to his holdings of gold or silver. It enables him to buy the metal with before-tax income.

• Equipment leasing. In an equipment-leasing tax shelter, the investor purchases equipment or machinery and leases it out for use by someone else. The investor receives deductions for depreciation and interest expense, plus an investment tax credit.

In the first year of the lease, the investor might show a tax loss (rental income minus interest and depreciation expense) equal to 20 percent or so of the value of the equipment. He also may receive a tax credit equal to 10 percent of the equipment's value. If the equipment is purchased with a 25 percent down payment, the investor can get deductions equal to 80 percent of his cash investment and tax credits equal to 40 percent.

In principle, an equipment-leasing venture can be a tax shelter, because the interest deduction is greater, during a time of inflation, than the true (after inflation) cost of credit. In addition, in the early years of the program, the depreciation deductions allowed by the government's rules may exceed the actual deterioration of the equipment. However, two factors make equipment leasing unattractive.

First, the tax benefits for the investor are merely benefits shifted from someone else. The company that leases the equipment for its own use must give up the tax credit it could have earned by buying the equipment. It also gives up the depreciation and interest deductions. These disadvantages to the company using the equipment normally result in a low rental rate.

Second, equipment programs depend for most of their tax benefits on tax credits and accelerated depreciation expense. If a program fails and must be liquidated, much of these benefits may be recaptured, as discussed earlier. Recapture can cause the investor to report income on which he must pay tax, without providing the cash to pay it.

• Multiple-deduction shelters. The ideal tax shelter is one whose tax benefits are so great that the project will yield an after-tax profit to investors even if the underlying business turns out to be a complete failure. To do this, the deductions or other tax benefits must exceed the investment actually made.

For example, if a shelter can allow investors to claim deductions equal to 300 percent of their investment, an investor in a 331/3 percent tax bracket will break even from the deal even if the business loses every penny put into it. An investor in a 50 percent tax bracket would show a profit no matter what the commercial result.

Such programs are called multiple-deduction shelters, and Congress has enacted rules aimed specifically at them. The most serious attack in recent years was included as part of the Tax Reform Act of 1976. It is known as the "at-risk rule," and it applies to all investments except real estate.

The essence of the at-risk rule is that an investor may not claim deductions for more than the amount he is risking in the investment. The amount that he has at risk includes his cash investment, any notes he has signed, and any business obligations for which he has accepted personal liability.

The at-risk rule was intended to be a wooden stake in the heart of multiple-deduction tax shelters; it would make the world safe for tax collectors. It hasn't worked out that way. The tax-shelter industry has produced a number of devices that allow a taxpayer to claim tax benefits equal to many times his true at-risk investment.

Unhappily, the multiple-deduction shelters are a mixed bag. Many of the programs claim benefits that more likely than not will be disallowed by the IRS. However, if the investor finds a multiple-deduction program that is not flawed, the rewards can be enormous. With a valid multiple-deduction tax shelter, the investor can save more in taxes than he risks on his investment and can have a businesslike prospect of earning a return on his investment in later years.

We'll look at some of the possibilities here.

– Minimum royalty oil and gas programs. Most of these involve low-risk development drilling. They differ from standard development drilling programs in their tax structure, enabling investors to take tax deductions equal to about 300 percent of their cash investment and 200 percent of what they actually have at risk.

This bit of magic begins with organizing the drilling partnership as an accrual-basis taxpayer. Unlike a cash-basis taxpayer (which probably is what you are, even if you don't know it), an accrual-basis taxpayer does not deduct an expense when it is paid in cash, but rather when he incurs a binding, unconditional obligation to make the payment.

Next, as with a normal drilling program, the partnership promises the owner of the drilling site a royalty equal to a fixed percentage of the oil and gas that is produced. However, this program also promises the landowner a minimum annual royalty. The minimum royalty is incurred every year until the project is abandoned, no matter how little oil and gas are actually produced. But the minimum royalty is payable in cash each year only out of the actual production from the wells. If there is a deficiency, any unpaid minimum royalty can be deferred until a stated date in the future, usually at least 12 years after the start of the lease.

The final step is for each investor to assume personal liability for his share of the minimum royalty. Usually there is a strict ceiling on the investor's liability, such as twice the amount of his cash investment. Because the investor has put himself at risk for the minimum royalty, he can personally claim a deduction for it. Nevertheless, even in the worst case of oil and gas wells that fail to produce anything, the investor would not have to pay any part of the royalty in cash out of his own pocket until 12 years later.

On the surface, the minimum annual royalty program is only a one-for-one deduction. The investor deducts his share of drilling costs (paid for by his cash investment) and also deducts his share of the liability for the minimum annual royalties on a dollar-for-dollar basis. However, the arrangement in fact results in a multiple deduction because the present value of an obligation due in 12 years is only a fraction of its face value.

You could put cash equal to just one-fourth the potential liability into an interest-earning investment with a 12¼ percent yield, and in 12 years the interest would compound into the full amount of the potential obligation. This reserve would be waiting for you down the road, in case you actually had to pay the minimum royalties yourself. Meanwhile, you can immediately deduct the full amount of the potential obligation. Your immediate total deductions can equal 200 percent of the cash you put into the reserve and the cost of the drilling combined.

It should be noted in addition that the investor will actually pay the minimum royalty out of his own pocket at the end of the 12 years only if the drilling program has failed to produce as expected.

– Minimum royalty mining programs. Some mining programs are handled in the same way. By promising the owner of the mining site a minimum royalty, it is possible to obtain deductions that exceed the amount investors have placed at actual risk (even after allowing for the present value of the royalty obligation).

– Art masters. An investor who purchases machinery or equipment for use in a business is entitled to a tax credit for up to 10 percent of the amount of the purchase. Since the tax benefit is a credit (rather than a deduction from income) it reduces the investor's tax bill dollar for dollar. But an investor can claim a tax credit on an equipment purchase only to the extent to which he is at risk for the purchase price of the equipment.

In an art-master shelter, a company purchases a lithographic plate of an art work—from which prints can then be produced and sold—giving the original plate owner in exchange a full-recourse note (payable in full regardless of what is earned from selling prints of the master). The purchaser, being at risk for the full price, claims a tax credit based on the full price. Then he leases the plate to an investor (who is not at risk for the note) and passes the tax credit to him.

– Book, movie, and record deals. Some of these programs are similar to the minimum royalty oil and gas programs. They achieve large deductions by promising the author a minimum royalty that may not actually be paid in cash for many years.

Others resemble the art-master programs: the asset involved is purchased by a go-between in exchange for a full-recourse note, a large tax credit is claimed, and then the tax credit is passed out to an investor who leases the plates.

The multiple-deduction programs are the most attractive of today's tax-shelter schemes. However, the IRS does not like them. If it can find a way to disallow the deductions or credits an investor claims, it will. This does not mean that you should avoid multiple-deduction shelters, only that you should be especially cautious.

The key element to look for in a multiple-deduction shelter is economic substance. Does the project make sense as a business deal? Does it have a reasonable chance of turning a profit? If it does not, it is not really a business, so far as the tax rules are concerned, and it cannot be the basis for deductions or credits.

A proposal that offers you deductions equal to four or more times your investment is difficult to turn down. Promoters know this. Thus most bad shelters (programs that are unlikely to yield either profit or the promised tax benefits) are dressed up as multiple-deduction deals.

Opinions differ, but I regard the art-master programs as a particularly bad joke—a joke that may have been played on the investors rather than on the IRS. An art master is difficult to appraise; the popularity of living artists changes rapidly, the values of different works by the same artist vary widely, and the relationship between original, one-of-a-kind and limited-edition reproductions is conjectural until the reproductions are actually offered for sale.

This uncertainty seems like an opportunity to place a high value on a lithographic plate and thus claim a large tax credit. But many art-master programs carry the matter too far. To achieve a large tax credit, they assign an implausibly high value to the masters.

The IRS has attacked some programs by insisting that the plates are worth only the cash that was paid for them, thus wiping out most of the tax credit. A number of such controversies are now in the courts, where they probably will stay for the next six or seven years. If the investors lose, they will have to pay back taxes plus interest.

A large fraction of the book, movie, and record deals are in the same class as the art-master programs. To argue that the project has any hope of turning a profit, you must make ludicrously optimistic assumptions about how many books, records, or movie tickets will be sold. Don't invest in one unless you are good at keeping a straight face.

The oil and gas area has its own share of bad multiple-deduction programs—programs so poorly conceived or loaded down with promotional costs that they make no sense as business undertakings. Because they are not bona fide businesses, it is likely that the investors' deductions will be disallowed.

Nevertheless, it is within the oil and gas area that you are most likely to find a multiple-deduction shelter that will stand up to the IRS, since developmental drilling programs are comparatively easy to evaluate as business projects.

Being developmental (rather than exploratory), it is comparatively easy to determine the likelihood that the drilling will be successful and to estimate the amount of petroleum that successful wells will yield. Thus it is possible to demonstrate that an oil and gas program is in fact a business and not a fairy tale dreamed up for tax avoidance.

Unfortunately, there is no way I can provide guidelines to evaluate every program that might be offered to you. But keep in mind two points: First, the program must have a reasonable chance to succeed as a business in order to qualify for tax benefits. People lose money every day in business ventures, but they don't get tax benefits for their efforts unless there were plausible reasons to assume the ventures would succeed. And second, if the tax-shelter promoter makes it appear that his program is putting something over on the IRS, it's more likely he's putting something over on you.

Terry Coxon is the coauthor (with Harry Browne) of Inflation-Proofing Your Investments; president of Permanent Portfolio Fund; and president of Sonoma Petroleum Corporation. This article is adapted from an article published in Harry Browne's Special Reports. Copyright © 1984 by Harry Browne's Special Reports, Inc.