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Tax Avoidance with
Foreign Service Corporation
QUESTION: I
live in New Jersey
and work in Angola
on a 28/28 rotation cycle. My fiancé works in NJ and we live
there together in
a home that we jointly own. We pay taxes separately.
Some of my American co-workers somehow manage to avoid the bulk of
their US
taxes by
incorporating or forming an LLC. I'm in a 28% tax bracket and it's
killing me.
Can you tell me if and how this, or some other tax avoidance plan, can
work
legally for me as well?
REPLY: An answer to this question involves some of the more ambiguous
areas of
tax law and the following comments are a substantial
over-simplification.
A lot of things that people do to avoid taxes (both onshore and
offshore)
aren't caught by the IRS simply because of the huge number of returns
they have
to process and the fact that the Congress does not give the IRS an
unlimited
budget. Some people are willing to take their chances on potential
penalties
and interest if the IRS does dispute what they are doing and imposes
back taxes
with penalties and interest. Other taxpayers are less willing to take
chances
or are terrified of being audited.
As you may know, the foreign earned income exclusion is not available
for a U.S. person
who works and lives outside the U.S.
for less than 330 days out of any
consecutive 12 months or who does not reside permanently outside the U.S.
A foreign LLC would be treated as a foreign corporation unless the
owner(s)
made an election to treat the LLC as a disregarded entity or as a
foreign
partnership. However, that would not provide any tax deferral so I'm
assuming
that the people you mention are treating their foreign entity as a
corporation
for tax purposes.
There are many taxpayers within the U.S. who form a personal
service corporation
that in turn sells their services to an employer. Any income of the
corporation
that is not distributed as a salary is subject to the highest corporate
tax
rate of 35%, and then the balance is subject to personal income taxes
when it
is distributed. (Tax code section 448(b)(2) )
If a foreign corporation is a personal service corporation, the U.S. has no authority to tax the
foreign
corporation but does have the authority to tax the U.S.
shareholder. Prior to the 2004
American Jobs Creation Act, tax code section 553 defined income from
personal service
contracts as foreign personal holding company income -- which caused
such income of the foreign corporation to be subject to tax by the U.S.
shareholder of a foreign corporation. The 2004 law repealed the foreign
personal holding company rules, but the provision dealing with personal
service
contract income was retained in tax code section 954(c )(1).
Essentially, if some person other than the corporation (such as the
customer)
can designate by name or description who is to perform the services
provided by
the foreign corporation or if the person who performs the services is
named in
the contract, then the income received by the foreign corporation will
be
treated as "subpart F" income and subject to current tax by the U.S.
shareholder of the foreign corporation.
If it is possible to provide services to unrelated foreign customers
through a
foreign corporation, where the customer isn't able to designate who is
to
provide the services, then the income received by the foreign
corporation might
not be treated as subpart F income and thereby subject to tax by the U.S.
shareholders of the foreign corporation.
Even if the income is tax deferred, the U.S. shareholders, officers
and
directors of the foreign corporation are supposed to file an annual
Form 5471
and if the foreign corporation has a bank account or other financial
accounts
the owners, officers and directors are probably required to file a bank
disclosure form TD F 90-22.1.
The penalties for not filing these forms are not merely harsh, they are
severe.
However, I suspect there are still many U.S.
taxpayers with unreported income from outside the U.S.
who continue to take their
chances and don't pay taxes on that income and don't file the required
tax information returns.