The "Bush tax cuts" are now a memory. Now that 2013 has arrived, marginal tax rates on high-earning Americans have increased substantially, especially those that earn more than $250,000 annually.
However, if you own a bona-fide offshore business, you can legally defer a substantial chunk of its income from current U.S. tax. What's more, if you live in another high-tax country, you can successfully invoke the same strategy, although the details are likely to be different.
Here’s a simple example. You contract with an incorporation company on the Caribbean island of Nevis to establish an international business company (IBC) to operate a website that sells discount toys. Let’s call it “Toys, Inc.” (Nevis happens to be where The Nestmann Group, Ltd. incorporates a lot of IBCs… but it could be Belize, the British Virgin Islands, or numerous other offshore jurisdictions.)
Let’s say that Toys, Inc. is a success. It generates $200,000 in profits the first year. If these profits represent the actual net proceeds of a genuine offshore trade or business, the entire $200,000 can qualify for tax deferral. Assuming you’re the 100% owner of Toys, Inc., that means you could save up to $70,000 in federal income tax in 2011, at a 35% top tax rate.
That’s a hefty savings, but to achieve it, you need to know how to navigate the U.S. Tax Code properly.
A Tax Expert’s Guide to Business Tax Savings
Toys, Inc. isn’t a U.S. corporation. So the IRS has no authority to tax it. However, in certain circumstances, it has the authority to tax the U.S. owners of a foreign corporation on income the corporation generates, with no opportunity for deferral.
This is a consequence of the controlled foreign corporation (CFC) rules. These are among the most complex rules in the entire U.S. Tax Code. If “U.S. shareholders” own more than 50% of the shares in a foreign corporation (e.g., an IBC), by vote or value, the foreign corporation is classified as a CFC. U.S. shareholders are U.S. natural persons, partnerships, corporations, trusts, and estates that own, respectively, 10% or greater interests in the foreign corporation.
If you’re a U.S. shareholder in a CFC, and it generates income from passive investments, personal services, related U.S. persons or entities, and certain industries such as insurance, you generally can't defer tax on that income. Fortunately, if you pay tax on the undistributed income of a CFC, you won’t generally be taxed a second time when you actually receive the income.
However, Toys, Inc. is a bona-fide business, and it generates business income. That means you may be able to defer tax on the income, in some cases, indefinitely, regardless of its CFC status. Even if Toys, Inc. achieves tax deferral for its offshore profits, there may be unpleasant tax results down the road. However, if you can defer tax on the profits for a long enough time, you may be willing to deal with these results, which include:
* Profits repatriated as dividends are taxed at your marginal income tax rate, up to 35% (or more if taxes increase in future years). If your corporation is organized in a jurisdiction with a tax treaty with the United States, it may be possible to reduce the 35% rate to a lower rate.
* If your foreign corporation is a CFC, you can’t deduct business losses until you liquidate it.
* If you die while you’re a shareholder of a CFC, your U.S. heirs lose the ability to step up the basis of the stock to its fair market value. When they sell the shares, they’ll pay tax on their value when you acquired them, not when they inherited them.
The IRS also has the authority to tax businesses that generate “effectively-connected income” within the United States. That means Toys, Inc. must be a bona-fide offshore business. Ideally, it should have a staffed office that operates the business outside the United States.
After you set up the company, your role (if you live in the United States) should be limited to being a passive investor. Toys, Inc. shouldn’t have a U.S. office or employees working in the United States. Nor should it have any U.S. agents working exclusively to market or distribute its goods in the United States.
Complex reporting requirements also apply to U.S. taxpayers with interests in foreign corporations. At minimum, you’ll need to file the following reporting forms:
* Form 5471 (tax return for a foreign corporation)
* Form 926 (when you capitalize the corporation)
* Form TD F 90-22.1 (to report the corporation’s offshore accounts over which you have signatory or “other” authority). You’ll need to file two copies of this form; one for Toys, Inc., and one for yourself, as signatory over Toys, Inc’s offshore account or accounts.
Tax deferral is becoming increasingly difficult in a time of government “cash grabs.” But there are still legal loopholes for U.S. citizens willing to go the extra mile.
Those who do their homework, keep it legal, and are willing to pay the price of setting up proper structures will benefit in the long-run.
Copyright (c) 2013 by Mark Nestmann
(An earlier version of this post was published by The Sovereign Society, https://banyanhill.com/).
