The Skinny on Tax Schemes

Congress eliminated most tax shelters for individual taxpayers with the 1986 Tax Reform Act. But that hasn’t stopped some Americans from aggressively seeking ways to reduce their tax bills. Here are some tax-reduction schemes that work, some that don’t and two whose outlook is unclear:

True

These strategies might seem suspicious, but they are legal:

* Hiring your kids: As long as the children perform legitimate jobs for reasonable wages, business owners can employ their offspring and save taxes by shifting income to the children’s lower tax brackets and writing off their wages as business expenses. If the business is a sole proprietorship or a partnership owned only by the parents, the wages of a minor child are also exempt from Social Security and Medicare taxes.

* Selling your home tax-free: Each person can exclude as much as $250,000 of home sale profit ($500,000 for a married couple) after living in a home at least two of the last five years. People who specialize in fixing up homes and selling them for a profit can reap the benefit, and some landlords are moving into rental homes to convert them to primary residences in order to take advantage of the home sale exclusion (although a depreciation tax write-off taken after May 7, 1997, is subject to recapture at a 25% tax rate).

* Transforming commuting mileage to work-related mileage: Normally, the costs of traveling from home to work are not deductible. But self-employed people whose home office is their principal place of business can write off all business-related travel costs (such as mileage to a client’s office from home).

Too Good to Be True

You may have heard these are legal, but they probably won’t work:

* Excessive write-offs for car donations: Some charities that offer vehicle donation programs imply that you can deduct an amount greater than what the donated car is worth. In fact, donation deductions are limited to the vehicle’s fair-market value--what a willing buyer would pay a willing seller. The IRS has said it is targeting excessive vehicle donations.

* Offshore asset protection trusts: The U.S. 9th Circuit Court of Appeals dealt the offshore protection industry a serious blow last year by reaffirming that U.S. courts have jurisdiction over U.S. taxpayers and their assets, said attorney Robert L. Sommers, a certified specialist in tax law and operator of the Tax Prophet Web site. Trust promoters typically claim the trusts can avoid creditors, including the IRS, but the appeals court upheld a lower court that jailed two taxpayers who refused to reveal their offshore holdings.

* Split-dollar life insurance: The IRS recently crushed this scheme, in which a taxpayer donated money to a charity for the purchase of a life insurance policy to benefit the donor’s family. Some taxpayers are suing the companies that promoted this ploy after the IRS disallowed their deductions.

Unclear

These tax strategies fall into a gray area:

* Conversion of a tax-free exchange: This maneuver takes advantage of two tax strategies: tax-free trades of commercial property, known as 1031 exchanges, and the home sale profit exclusion. The 1031 exchange is a legitimate way to trade one commercial property or rental for another, without owing taxes on the transaction. Some tax preparers say landlords can exchange one rental property for another and immediately or within a few months convert the property to a primary residence. The IRS has yet to issue rules on how such transactions should be structured, so no one knows how long a landlord must wait before the conversion or whether the IRS will challenge the exchange if a conversion is made quickly.

* Lawsuit settlements: Taxpayers can exclude from income any money they receive from a settlement or judgment related to a sickness or injury they suffered, but must pay tax on money meant to compensate for lost wages. Many settlements, however, fail to specify a division between the two, and the IRS has not issued rulings in this area.