Let me start with a brief story: A friend of a friend once told another friend that he could eliminate U.S. tax on his business profits if he set up a company in a “tax haven” and never brought money back to the U.S. The friend didn’t plan to repatriate any funds to the U.S., would not be drawing a salary and/or be taking distributions from the business. What is more, no business operations would take place in the U.S. And in any event, how would the IRS ever find out about this? So it seemed that things were in good shape and he would be saving some big tax dollars!
I have heard this story so many times and I feel bad when I see people’s excitement as they describe this great “business plan”. Don’t kill the messenger, but in many instances, this wonderful tax planning structure may not work as you thought.
First of all, if you are a U.S. tax resident you must report your world-wide income on your U.S. individual income tax return (even if you keep the money outside the U.S.). In addition, the IRS has several mechanisms in place to collect taxes currently, on income that is deferred under foreign tax rules.
With respect to tax havens, you should know that there is a difference between tax avoidance and tax evasion. While the first one is legal, the hiding of income and/or assets (tax evasion) is illegal. In essence, there must be a “legitimate business reason” to create a company in a tax haven, or the IRS may conclude it’s a sham. Even subtle “consulting/management” type of structures may constitute an obvious attempt to triangulate profits with the intention to evade U.S. tax.
But let’s assume for a minute that there is a legitimate business reason to incorporate your business in a tax haven. You still need to be sure that transactions are conducted at arm’s length, certain legal agreements need to be drafted (and respected) and at some point in time profits will be recognized on a U.S. tax return (I assume you or your heirs will, at some point, want to enjoy the profits?). After consideration is given to all factors, it may not make economic sense to incorporate your business in such jurisdiction.
Wait … are you managing your foreign business’ operations, doing business development and/or meeting with clients in the U.S.? Then your business may have also created a taxable presence in the U.S. even if no operations “per-se” are conducted here. If this is the case, a U.S. foreign business tax return may be required as well.
And finally, let’s not forget about holding investments in a tax haven through “creative” legal structures. Even if you do not repatriate any profits, lo and behold, there is a law that would make such investment income currently taxable in the U.S.! It’s called Subpart F income …
There are several valid reasons to incorporate or organize a business in a foreign jurisdiction. The Wolf Group Business Tax Solutions can efficiently help you minimize your global tax, while making sure that you are fully compliant with U.S. tax rules. Be sure to call us before you make any important business decisions.