OBSERVATIONS ON TAX SHELTERS
This discussion is not intended as legal or tax advice, and cannot be relied upon for any purpose without the services of a qualified professional.
Effective tax planning = 90% tax deferral and 10% tax avoidance. When a billion dollar corporation engages in serious minimization of their taxes, a route often taken is moving their headquarters to an offshore tax haven. Also moved, are assets such as trademarks, logos, patents and formulas. The U.S. operation pays royalties (an expense) to the foreign operation and suddenly, incurs a loss on their U.S. tax return.
If the same corporation wanted to preserve their love of the U.S. image, they might instead purchase a “comfort letter” from one of the U.S. “big 4” accounting firms. For $1,000,000 and up, one can purchase a 100 page analysis of a multi-tiered set of foreign entities that “in their opinion” complies with all I.R.S. regulations for avoiding U.S. taxes
Fast forward three years: The Corporation is audited and determined to owe $250,000,000 in taxes. Its attorneys argue in tax court that the corporation acted in “good faith and relied” on the top accounting firm’s “reasonable” analysis. Two years later, the tax bill is negotiated down to half with minimal interest. The best part is no penalty is assessed and the corporation had 5 years to invest the $125,000,000.
Offshore tax shelter promoters are taking fragments from the above argument to promote their products. Most are offshore themselves and out of reach of U.S. authorities. They certainly will not be at your side in tax court. Keep in mind the fact that many of these offshore promoters are on the I.R.S. hit list. Some have been forced by the I.R.S. to disclose their client lists. Not declaring the income is playing audit roulette. Without a “comfort letter”, penalties and interest will be assessed.
Offshore corporations and bank accounts are legal but their existence must be disclosed to the I.R.S. and the income declared. Each year, more tax shelter countries are seeing the advantages of working with the U.S. in reporting financial activity. They then provide the IRS with current and prior year’s detailed information on foreign owned bank accounts, debit/credit card activity and foreign owned entities.
In March of 2010, congress passed the Foreign Account Tax Compliance Act (FATCA). It requires U.S. citizens to report their non-U.S. financial accounts. It also encourages all foreign financial institutions to search their records for US persons/entities and report their assets and their names to the US Treasury. FATCA also requires foreign stock brokers, hedge/pension funds, insurance companies, and trusts to provide this information. Any foreign institution that fails to comply faces a 30% withholding penalty and being frozen out of U.S. financial markets. For added coercion, the IRS hired 800 new international enforcement employees.
In spite of the current IRS position that “nothing offshore is a shelter”, some investors employ an offshore entity as part of their corporate capital structure.
In its notice 2009-7, the U.S. Internal Revenue Service determined that controlled foreign corporations (CFC) structure is a “transaction of interest”. So, gone are the days when a U.S. taxpayer could simply place assets or a bank account in a “tax haven” country and not report the income.
In the past, discretionary trusts provided shelter. In allowing the trustee to determine when and how much the beneficiary would receive, the practice was not to report income until that moment. Controlled foreign trust laws now enable the IRS to tax the trust. Some individuals still use a discretionary trust; believing they are “under the radar” of the IRS because their trustee decides when and how much they are to receive.
INTERNATIONAL BUSINESS CORPORATIONS
What has been done recently is the use of a more complex entity to potentially allow assets to appreciate in value as well as allowing a business to earn income while being sheltered. An IBC (international business corporation) can be established in almost any foreign country. Tax shelter providers recently touted the Seychelles, Belize, St. Kitts/Nevis and Hong Kong. According to them, these countries do not participate in TIEA (tax information exchange) with the U.S. The only true statement they make is that these countries do not tax income from operations or gains from sales in that foreign country. The problem is that more countries agree to information sharing with the U.S. Treasury each month. Half of the above countries now participate. In all, more than 110 countries share financial information with the U.S.
Setting up a private interest foundation and including it in the corporate structure of your IBC appears to be the latest tax shelter strategy. According to its promoters, the foundation owns the asset and the business and the recipient reports income and pays taxes only if and when it is received. Assets grow faster due to compounding, without taxes being paid, the principal grows more quickly. The I.R.S. website at www.irs.gov provides clearly worded guidance for tax shelter enthusiasts. There you will find that a foundation is taxable as a trust, partnership, corporation or disregarded entity (a single member LLC for example).
If these routes are chosen, quite a number of firms advertise a packaged international business corporation on the internet. As in the U.S., the savings of a packaged corporation allow more to be spent paying attention to subsequent years current events, legal and accounting issues.
If your tax preparer recommends one of these packages, be mindful that the tax shelter provider pays referral fees to preparers who forward them clients. Even though referral fees are accepted practice in many businesses, the true professional will disclose them, and better yet, reduce the client’s bill by the same amount.
The following are approximate fees for a packaged international business corporation:
Fees for a self-managed Seychelles IBC for the first year are approximately $1,000 with about three-quarters of that for each subsequent year.
A full nominee Hong Kong IBC, first year, from approximately $3,800 with the second year, again, about three quarters of that.
Holding a foreign asset generates the burden to file all required forms:
Form 3520 should be filed within 90 days of forming a foreign trust (or receiving distributions from one) or on the date of the filing of the taxpayer’s income tax return file if earlier.
- Form 3520-A – Must be filed every year if you have created a foreign trust.
- Form 5471– May be required if you or your foreign trust have a10% or more interest in a foreign corporation.
- Form 8621 – Must be filed if you or your offshore trust or controlled foreign corporation have an interest in any offshore investment entity.
- Form 8865 – May be required if you or your foreign trust has an interest or changes in an interest in a foreign partnership or LLC.
- Form 926 – To report transfers of property to a foreign corporation.
- Form 8858 – Transactions Between Foreign Disregarded Entity of a Foreign Tax Owner and the Filer or Other Related Entities.
- Form TD F 90-22.1 (FBAR) – Must be filed when you have a foreign bank/financial account or trust over $10,000 US.
- Form 2555– Foreign Earned Income – To exclude a certain amount of foreign earnings from taxes and/or to claim the housing exclusion.
- Form 8938 – Statement of Foreign Financial Assets – For those with in interest exceeding $50,000 in foreign financial assets, including bank and brokerage accounts.
Penalties for failure to disclose foreign assets is severe. Willful violators face fines up to $500,000, 10 years in prison and forfeiture of 50% of the account value per year. Even accidently forgetting to file a FBAR subjects one to a $10,000 fine.
Ok, enough bad news. Now for the good. Aggressive tax practitioners will help you to maximize deductions and some will help you build a complex international paperwork trail.
Audits take more time than Congress funds. The I.R.S. has ever more limited resources to audit but its agents have the same need to file statistical reports (successes) to their superiors.
Layers of overseas partnerships/corporations can only be audited by the most trained and motivated agent with time to kill. An audit of the wrong layer will find nothing as will the right layer but the wrong year. As an example, some partnerships fail to file a return for the final year when the assets are sold. Others report it as capital gain when it is actually ordinary income. The I.R.S. matches K-1s to 1040s but an audit of the specific overseas partnership return is required to determine if K-1s were filed correctly, filed at all and if travel, entertainment and other business expenses are legitimate. Also, what if one of the partners is a tax-exempt organization? Even worse for the I.R.S., what if one of the partners turns out to be an important campaign contributor?
So, faced with a complex international audit with an unknown amount of tax to collect, the IRS supervisor must decide to commit the time of an experienced agent or move on to more lucrative pastures.
As an alternative, one might establish a domestic tax-exempt organization. Being the C.E.O. of one of the 200 largest U.S. charities earns you in excess of $300,000 per year. Travel and entertainment expenses with a true business purpose are not taxable. Ne’er-do-well relatives can be employed and their motivation could be induced with a commission based compensation plan. The more charitable donations they bring in, the higher their pay. Then there is the after life to consider. Doing a good deed may help balance the scale if there ends up being a judgment day.
Per the I.R.S., dividends, interest, certain other investment income, and certain rental income of the charity are exempt from tax. Appreciated property may be contributed and its fair market value is a deduction for the contributor. The charity may then sell it and remain exempt from Federal Income Tax.
Some charities have been known to then loan the proceeds to the contributor. This is obviously tax evasion but paying salaries and limited retirement plan contributions would not be. Another non-allowed activity is the use of donor-advised funds to claim a contribution deduction while the charity pays for non-deductible items, such as private school tuitions.