Offshore Tax Planning - When Does Legal Avoidance Become Criminal by Golding & Golding

Offshore Tax Planning – When Does Legal Avoidance Become Criminal by Golding & Golding

The differences between Legal and Illegal Offshore Tax Planning typically boils down to the timing of the planning.

In other words, was the tax planning implemented before the individual started earning income, or was it an afterthought (Read: Why should I pay tax on foreign income?)

Offshore Tax Planning

What is the difference between Legal Tax Planning vs. Illegal Offshore Fraud, Evasion and Money Laundering?

This is a question we receive often, and it is a very good question. How someone determines whether the activities they are doing is a form of tax planning (which is creative and perfectly legal) or a form of tax fraud or tax evasion (which is illegal) is a very important analysis.

them are not that disparate. Rather, oftentimes whether or not someone was acting legally or illegally would depend on the timing of the avoidance.

Legal Offshore Tax Avoidance

David decides he wants to launch his own foreign company. It is less expensive for him to form a company overseas (as a wholly-owned subsidiary) in order to operate overseas, than it would be to create a company in the United States to operate overseas — since he still has to register the company abroad (usually in each country it operates in) in order to conduct foreign business.

In addition, the tax liability would be different for let’s say an S Corp. or LLC that is formed in the United States and operating internationally versus a wholly-owned subsidiary of a particular country that might only operate in that one country (aka Foreign Tax Credit Limitations, R&D Credits, etc.).

David Forms a Sociedad Anonima

David’s goal is to own numerous rental properties throughout Costa Rica and Nicaragua. Through his work overseas, David has made numerous connections in these two different countries and believes it could be a moneymaker in the future.

As a result, David starts with Costa Rica. He forms a Sociedad Anonima. We have written numerous blogs about this type of corporation because it is a bit of an oddity; it is one of the primary types of entities that is formed in Latin American countries, and even though oftentimes it is used for estate planning and to hold real estate, United States identifies it as an IRC 301 per se corporation.

In other words, when David has to file his form 5471, he will not have the option to disregard the entity as is common with LLCs within the United States. Rather, the Corporation maintains default corporate status.

Is there anything illegal about David opening a Sociedad Anonima? No.

David Doesn’t Want  a Controlled Foreign Corporation (CFC)

David does not want the Corporation to be a Controlled Foreign Corporation, because then David will be subject to subpart F income. David is not really sure what that means, but after having a few consultations with different experienced International Tax Attorneys, the recurring theme is that subpart F income revolves around passive income and it may be taxed even if it is not distributed.

David hopes that owning rental properties and bed-and-breakfasts worldwide will become his only source of income. Therefore, David offers ownership in the company to three other individuals who are non-US persons, instead of just limiting it one non U.S. local Person (usually a Sociedad Anonima will require at least one local person to own 10% of the corporation).

What’s So Bad About a CFC

Briefly, a Controlled Foreign Corporation means the Corporation is owned more than 50% by U.S. persons, with each owning at least 10% share — with attribution rules applied (husband-and-wife would be considered owners of each other’s share).

If it is a Controlled Foreign Corporation and depending on if there is current year earning profits (E&P), there could be immediate tax liability with subpart F income —  even it has not ever been distributed to David.

If it is just a foreign corporation, then the same rules do not apply.

David Does Not Take any Distributions nor Salary

Since it is not a US corporation and does not operate in the United States, the Corporation is not subject to US tax law. Issues such as Mandated Salary, Earnings and Profit (E&P), Accumulated Earnings Tax (AET) and other very boring corporate tax laws are not applicable.

In addition, David is not taking any salary. As a result, during the early years, David is not earning any income.

Is this legal? Yes, under most situations it would be. Presuming the Corporation is acting properly under its own jurisdiction, the United States does not have authority over the Corporation. Therefore, reasonable salary and other related issues that oftentimes impact  S-corporations and C-Corporations in the United States may not impact the foreign corporations.

If the corporation begins to purchase US Situs or make US investments, the rules may change. But with its current status as a foreign corporation, in which David holds a minority interest, which does not operate in the United States, or own any US assets (and is not a controlled foreign corporation) it may mean that there is no tax liability to David unless he receives income.

**There are a number of different loopholes, exclusions, and exemptions to consider but from a tax avoidance standpoint, David is acting legally.

Illegal Offshore Tax Avoidance

Peter is not as astute as David. Peter is looking to earn money in the low tax jurisdiction and do his best to avoid any current income tax – but he still wants the money and he wants it now.

Therefore, Peter opens up the same type of corporation in Costa Rica. Peter has about $2 million of investment that he’s looking to invest outside of the United States.

Just as David did in the previous example, Peter opens up his own Sociedad Anonima. But, unlike David, Peter doesn’t trust anybody. Therefore, Peter will be the sole owner of the Sociedad Anonima — aside from the strawman that he uses as the 10% owner that is required by local law.

Is there anything illegal about this setup? No. But, since Peter is a US person who owns more than 50% of the business, it will be considered a controlled foreign corporation.

Peter Invests in Rentals and Mutual Funds

Peter decides to purchase different foreign mutual funds under the corporate name. The mutual funds and rental property immediately begin generating income. The income is distributed to Peter, but instead of Peter having it distributed to him, he has it distributed to a BVI he’s owned since 2004 and before the BVI shares need to be registered.

Peter’s BVI is receiving about $200,000 a year in income.

Must Peter report the income? Yes. Even though Peter hasn’t received the money personally, the money is most likely going to be considered subpart F income. Moreover, even though Peter owns the BVI 100% himself and it is technically an entity – it is also a controlled foreign corporation owned entirely by Peter.

Therefore, anything that was distributed to the BVI would have to be reported by Peter as income since it is passive income and distributed to the BVI – which Peter owns.

Peter Does Not Report the Income

Peter keeps the money in Hong Kong. Even though the money was issued to the BVI, the address of the BVI is in Hong Kong – which is very common. The money is accumulating in a bank account in Hong Kong of which Peter is the only owner and signatory.

Peter has done a lot of business with this particular bank over the years and therefore the bank does not ask Peter any questions about the source of the money.

Peter Files Tax Returns

Peter understands that he is a US citizen with a Social Security number, and he has been filing tax returns every year for his entire adult life. Therefore, it would be somewhat strange if Peter suddenly stopped filing taxes.

When it comes time to file his tax returns, all Peter reports is the consulting income he earns from a California LLC for consulting he does in California. Moreover, Peter uses a CPA and even though Peter has not told the CPA about these other investments, Peter has confirmed to the CPA when he was asked that he does not have any foreign or offshore investments or income.

What Reporting Errors has Peter made?

Peter has violated US tax law and may get himself in some serious trouble. Here are the main issues Peter will have to contend with and why his actions are illegal and considered tax avoidance:

Peter Did Not Report the Income

Since Peter is the primary owner of the foreign business, it is a controlled foreign corporation, and it earned passive income, Peter is required to report this information on his taxes and claim it as income. Without getting into too much detail, Peter’s company is a foreign personal holding company and earns all of its income at the current time from dividends and interest.

For purposes of this case, you can presume that there are no related entity exceptions to the dividend distributions or look through exceptions.

As such, Peter was required to report these earnings as income. Peter’s CPA is a well-versed CPA on international tax law. Peter knew this so the fact that he purposely did not tell his CPA about these earnings further alludes to his willfulness in the criminal aspect of his nondisclosure.

Peter Did Not Report the Accounts

In addition, Peter did not report his foreign accounts. Even though Peter is not the owner of the account, Peter is the only signature authority on the account and the main account holder is a corporation that Peter is the 100% owner of. As such, Peter is required to report these accounts on the annual FBAR and FATCA Form 8938.

Peter did Not File a Form 5471 or 8621

Since Peter did not want to report this information to either the CPA or the IRS, he did not complete the necessary forms 5471 or 8621. These are reporting forms that are required for individuals who have a certain percentage ownership of various foreign entities. Since Peter is the 90% owner and 100% owner respectively of these foreign corporations, Peter would be required to report the information to the IRS.

Peter Can Get in Real Trouble

If Peter is not careful – and even if he is – Peter could get into some serious trouble if the IRS finds him. He knowingly did not report foreign income nor disclose offshore accounts and file the forms necessary to report his foreign businesses.

He has hundred thousands of dollars per year in unreported income and it is clear that by using these types of foreign businesses he had the intent to evade tax.

What Can Peter Do – Offshore Disclosure

Since Peter’s income was earned legally, Peter may have the opportunity to enter OVDP. Under the traditional OVDP (offshore voluntary disclosure program), Peter may agree to pay a fine/penalty to avoid much larger fines and penalties as well as significantly reduce any chance of any criminal prosecution against him by the IRS.

The IRS finds Peter first and Peter is under examination or audit for any reason, he loses the right to enter the program.

OVDP – How Does it Work?

There is a lot of misinformation online regarding the pros and cons of OVDP, along with fallacies about how the process actually works.

At Golding & Golding, IRS Offshore Voluntary Disclosure is all we do. We have prepared hundreds of articles dealing with all different aspects of OVDP and Streamlined Offshore Procedures and have come to the conclusion there are four (4) main questions that we receive from clients.

OVDP Summary of the Basics

Understanding how the OVDP process works is important to effectively navigating the pitfalls and landmines of the submission process.

In fact, when it comes to OVDP, one of the hardest parts about moving forward is just understanding the process itself, and being able to distinguish fiction from reality.

As such, the four most important aspects of understanding OVDP for our clients are the following:

  • What is a preclearance letter?
  • What are the penalties associated with OVDP?
  • What is a closing letter?
  • What is opting out?

In this article, we will provide a summary about the different aspects of OVDP as they relate to these four main issues.

Preclearance Letter

The preclearance letter is the initial submission made on behalf of an applicant considering OVDP. While a person is not guaranteed entrance into OVDP, by submitting the preclearance letter, the IRS Criminal Investigation Department takes the opportunity to run a background check on the individual, estate or business.

What is the Purpose of the Background Check

The main purpose of the background check is to make sure that the individual is not already in tax trouble, or other trouble with the law. Even though the penalties associated with OVDP are high, relative to what could happen if a person was to get examined or indicted on criminal tax related issues involving offshore and foreign income, OVDP is a great deal.

A Preclearance Letter is not technically part of OVDP

This is a bit of a nuance. On the one hand, by submitting the preclearance letter you are opening yourself up to the IRS regarding your foreign accounts, assets, investments, etc. so that they can inspect, research and do their due diligence to determine whether you are authorized to apply.

On the other hand, technically, the preclearance letter is not part of the submission. In other words, feasibly you could submit an OVDP letter and then not move forward with submitting to the formal program, which is the the next step and involves submitting forms 14454 and 14457. Alternatively, if you were to submit the 14454 and 14457 and then discontinue the process, it would be considered a breach of the program and you can find yourself in some serious trouble.


OVDP penalties are broken down as follows:

Penalty on the Assets & Accounts

The penalties are relatively straightforward as follows:

– The applicant will categorize their submission down per year, within the 8-year compliance Period.

– For example, if a person is submitting for 2016 and already submitted their 2016 tax return incorrectly, they will need to amend for eight years-which would mean 2009 through 2016.

– Thereafter, the person will look at each year independently. For example, a person will look at year 2012 and assess which foreign accounts, specified foreign assets or income generating real estate they have for that year.

– Then, for that specific year only, and using the exchange rates for that particular year, the applicant will figure out the maximum balance of each account within that year. The applicant will then aggregate or add the maximum account balances together to calculate the annual aggregate total for that particular year.

– Next, the individual or other applicant will prepare the same analysis for each year within the compliance. Then, the applicant will take only the year that has the highest value and multiply it by one of two numbers:

Account and Asset (FBAR & FATCA) 27.5% Penalty

27.5% penalty is the general penalty amount. For example, as long as the individual was not associated, at all, with a “bad bank” or investor, the individual would multiply the highest balance by 27.5%. So David’s highest year had $500,000 of unreported accounts and assets, his penalty amount would be $137,500.

Account and Asset (FBAR & FATCA) 50% Penalty

The IRS publishes a list (updated periodically) of foreign financial facilitators, which includes individual investor “professionals” and foreign financial institutions. If any of the applicant’s money (even minimal) is invested with one of these “bad banks,” then the entire amount of unreported money (for all institutions, assets, etc.) is multiplied by 50% instead of 27.5%.

Therefore, continuing the example from above, if David had any money in one of these bad banks, and the penalty jumps to 50% for $250,000. It should be noted, that the IRS does not parse out the funds that are in that that bank and only expose those to the heightened penalties – rather, the full amount of unreported money is subject to the 50%.

Penalties on Taxes

Beyond the penalties associated with the undisclosed assets, accounts or investments — are the penalties on the taxes that are due. For example, let’s say David had $10,000 of unreported income in year 2012 and was subject to a nearly 40% tax rate.

In that year, in addition to the penalties identified above, David would also have to pay $4000 in taxes that are due, as well as a 20% penalty on the $4000, which is an $800 penalty. In addition, David also has to pay interest.

So if David has significant unreported income for each year and a compliance, David may have significant taxes, penalties, and interest amount due.

**In addition, if David did not file or pay his regular taxes (for example, David was required to but never filed a tax return for year 2012), David would also have to be subject to a possible failure to file and failure to pay penalty.

Closing Letter (906 Letter)

Typically, within one to three years from the beginning of the submission, this monstrosity comes to an end. As a result, the Internal Revenue Service will send the applicant a 906 closing letter.

By submitting a signed closing letter back to the Internal Revenue Service, the applicant has acknowledged the penalty, and agrees to everything the IRS has required from him or her in the submission.

Presumably, once the closing letter is signed, the IRS puts the matter to rest. This has many benefits for our clients who might’ve waffled between the streamlined program and OVDP, but had the following issues:

In other words, for all intents and purposes — the matter is over.


For some people, the chances of going streamlined and being taken to task on willful versus non-willful is too much to bear. At the same time, the thought of paying a 27.5% penalty or 50% penalty solely because they were risk-averse against submitting a streamlined application when the IRS still refuses to publish a clear-cut definition of the term willful is absurd.

As a result, instead of signing the closing letter the applicant agrees to opt-out. In an opt-out situation, the applicant still maintains the opportunity to stay “protected” under the program. At the same time, the taxpayer disagrees with the penalty amount and would rather allow the Internal Revenue Service to audit him or her in order to try to get the penalty reduced.

Oftentimes, the IRS may reduce the penalty depending on the facts and circumstances presented by the taxpayer. But, it has to be noted and considered that the IRS can also increase the penalty.

Nevertheless, the mere fact that the IRS may issue higher penalties (which is not common when the facts support the taxpayer’s opt out position) should not be enough to dissuade the taxpayer from an opt out when they firmly believe they can achieve a better result.

Even the IRS has published memoranda wherein the IRS provides that for some individuals the penalties are absolutely lopsided and and opt-out should not be held negatively against taxpayer.

OVDP and IRS Offshore Voluntary Disclosure

We hope this helped summarize the more pressing questions we get from new clients.

Please feel free to visit our International Tax Library to research other topics we have written about.

In addition, if you’d like to read a more comprehensive summary regarding the different programs you may find our IRS offshore voluntary disclosure program options summary helpful to you.

International Tax Lawyers - Golding & Golding, A PLC

International Tax Lawyers - Golding & Golding, A PLC

Golding & Golding: Our International Tax Lawyers practice exclusively in the area of IRS Offshore & Voluntary Disclosure. We represent clients in 70 different countries. Managing Partner, Sean M. Golding, JD, LL.M., EA and his team have represented thousands of clients in all aspects of IRS offshore disclosure and compliance during his 20-year career as an Attorney. Mr. Golding's articles have been referenced in such publications as the Washington Post, Forbes, Nolo and various Law Journals nationwide.

Sean holds a Master's in Tax Law from one of the top Tax LL.M. programs in the country at the University of Denver, and has also earned the prestigious Enrolled Agent credential. Mr. Golding is also a Board Certified Tax Law Specialist Attorney (A designation earned by Less than 1% of Attorneys nationwide.)
International Tax Lawyers - Golding & Golding, A PLC