Offshore Tax F.A.Q.  By Vernon K. Jacobs, CPA  & J. Richard Duke, J.D., LLM

Can I save taxes with a secret offshore bank account?

Not legally, if you are a U.S. citizen or permanent resident.

You might be able to save a little bit of taxes only if you are willing to commit a felony and perjury.

Failing to report income - even when it is not reported to the IRS - is a felony. The size of the omission doesn't really matter, or at least there isn't anything in the tax code that specifies any dollar amount or percentage amount. In addition, there is no statute of limitations on a tax return where there is an intentional omission of income. Therefore, if the IRS finds out about the omission twenty years later, you would be subject to accumulated penalties and interest, plus potential criminal charges. For small amounts, the IRS won't usually pursue a criminal charge, but that's entirely at their discretion. If they want to put you in jail for any reason, failing to report some income will give them an excuse.

Secondly, if you have an account at any time during the year with a balance of more than $10,000, you are required to disclose that fact on your federal form 1040, schedule B, part III. Failure to disclose the existence of a foreign bank account is treated as perjury on your tax return. If you do have a foreign account in excess of $10,000 at any time during the year, you are then required to file form TD F 90-22.1. Failure to file that form exposes you to additional criminal penalties.

As a practical matter, let's say that you have an account with a balance of $8,000 and that it earns 8% in interest - which is far more than is available in U.S. bank accounts at this time. Then let's assume you are in the top federal tax bracket of almost 40% and that you are in the state income tax bracket of 10%. Since the state taxes are deductible from the federal (ignoring the alternative minimum tax), the effective state tax rate would be 6%. Thus, the tax savings would be 46% of $640, or $294.40. We admit that there are legal ways to have multiple accounts of less than $10,000 each, but isn't that a lot of effort and trouble for the tax savings - even if you can get a higher yield offshore?

There are other alternatives to having to pay interest on savings accounts. When you compare them to the potential of criminal charges, penalties and accumulated interest, they might look more attractive.
 

Can I defer taxes with a foreign mutual fund?

The U.S. tax code put a stop to that device many years ago. Any U.S. shareholders of a foreign corporation that is a passive foreign investment company (PFIC) are required to either,

1. pay current income taxes on their share of the income of the PFIC (if it is known), or
2. pay high tax rates and an interest charge on deferred distributions from the fund.

Neither option is financially attractive. You would be better off to invest in foreign stocks and bonds directly (in your own name) or to invest through a U.S. mutual fund. If you do have funds in an offshore trust and you are subject to income taxes on the income of that trust (a grantor trust), then you can legally defer taxes and invest in offshore funds through a variable annuity contract issued by a foreign insurance comany. However, tax deferral is not available for annuity contracts purchased in the name of a corporation or partnership.
 
 

If my foreign trust forms a foreign corporation, can the corporation be tax free?

This question is based on the understanding that a U.S. person who owns 10% or more of the stock of a foreign corporation (that is controlled by five or fewer U.S. shareholders) must pay current income taxes on the investment income of the foreign corporation. The assumption (which is not entirely correct) is that if the corporation is not controlled directly by U.S. shareholders, it can accumulate investment income tax free outside the U.S. There are two problems with this arrangement.

First, if the foreign corporation is a passive foreign investment company, the rule that requires that the U.S. shareholders own 10% or more of the corporation stock does not apply. Nor does the rule that requires that five or fewer U.S. persons own more than 50% of the foreign corporation stock.

Second, the tax law includes provisions that attribute the ownership of certain kinds of assets by related persons to those with whom they are related. Thus, the ownership of stock by a father or mother is attributed to their children and even to their parents. The assets owned by a trust or estate are attributed to the beneficiaries. So, if you are the beneficiary of a foreign trust, and if the foreign trust owns 90% of a foreign corporation, then you are treated as owning 90% of the foreign corporation - as if the trust did not exist. The same is true for partners of a partnership and for certain shareholders of some corporations. The rules are complex and sometimes overlap, and they are very difficult to avoid. The attribution rules can reach through an almost unlimited number of intermediate entities. It just doesn't matter how many trusts or foreign corporations stand between you and a foreign investment company over which you have effective control.
 

I know a lot of people with offshore income who aren't paying taxes on it. How come they're getting away with it?

The same way that a lot of people get away with it in the U.S. It's called the audit lottery. The Congress doesn't give the IRS enough money to audit everyone, every year. Only about 1/2% of low income taxpayers are audited each year. For higher income taxpayers, the odds may be as high as 20% per year. 

Some people get caught for cutting a few corners in the only year when they ever tried to cheat. A few others get away with massive cheating for an entire lifetime. But most people who aren't accustomed to the fine art of lying and hiding assets as part of their everyday existence (as are certain criminals) will often be caught by some curious incident that causes an IRS auditor to get suspicious and to follow up on a hunch.

Do you really want to spend most of your waking moments looking over your shoulder to see if the long arm of the IRS is reaching out for you? Or would you rather focus on legal methods of tax avoidance or deferral and on being more efficient at making a living?   

About the authors: Vernon Jacobs is a CPA who provides tax accounting and consulting services for clients with international interests.   J. Richard Duke, JD, LLM is an attorney who specializes in international tax law and is an Adjunct Professor of international tax law. Sponsored by Offshore Press, Inc., Copyright, 2004, all rights reserved. Offshore Press, Inc., Box 8194, Prairie Village, KS 66208. Phone (913) 362-9667. Email to Offshore Press  Vernon K. Jacobs, Webauthor