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UI Research Shows Why Some Firms Skip Using Tax Shelters

Jaron WildeTax shelters are tax planning tools that help strengthen corporate bottom lines by reducing tax obligations, providing such significant benefits that many have questioned why more companies do not engage in them.

A new study coauthored by a University of Iowa researcher suggests it has to do with a firm’s overall investment strategy. For instance, the study suggests that firms with broader investment strategies invest less in tax shelters because they have other, more profitable investment opportunities. Firms with difficult-to-plan futures are also less likely to utilize tax shelters because their uncertainty means the firm may not save any money through sheltering.

“Overall, we find that factors that influence firms’ investment behavior help to explain why more firms do not invest in tax shelters,” says Jaron Wilde, assistant professor of accounting in the Tippie College of Business.

Tax shelters are investments that a firm can use to reduce, defer, or change the character of its income, and thus its taxation, potentially increasing profit and stock prices. Shelters can range from retirement plans to overseas tax shelters to company owned life insurance (COLI), where a firm can take out life insurance policies on key employees and deduct the premiums.

They rarely acknowledge using shelters, however, for fear of inviting IRS investigations or bad media coverage because such activity often skirts what is legal or accepted under tax rules.

Still, Wilde says these investments can legally shelter huge amounts of income and substantially reduce tax obligations, which has raised questions as to why some firms do not engage in them. To find out why they take a pass, the study looked at 45 firms that were accused of using tax shelters between 1981 and 2000 to examine the likelihood a firm invests in tax shelters. The firms in the study invested in such tax shelters as COLI, offshore intellectual property havens, foreign investments, and liability accelerations.

The study found that firms with broader investment strategies used tax shelters less because they had opportunities available with other investments that would provide greater returns than would a lower tax bill. It also found that businesses that had less financial stability were less apt to invest in shelters because they didn’t want to commit themselves to any one strategy because of their uncertainty.

“If a firm invests in a tax shelter subsequently does not generate significant levels of pre-tax income, the tax benefits associated with investing in a tax shelter are reduced,” Wilde says. He says shelters also pose a risk because the IRS may find a shelter illegal and assess fines and penalties.

The study also found that some firms are more likely to take advantage of shelters. For instance, firms that are under a great deal of shareholder pressure will use shelters in such a way that can help their stock performance meet market expectations.

Wilde’s study, “Investment Opportunity Sets, Operating Uncertainty, and Capital Market Pressure,” was coauthored by Sean McGuire of Texas A&M University and Thomas Omer of the University of Nebraska. It will be published in a forthcoming issue of the Journal of the American Taxation Association.

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