Tax Avoidance vs Tax Evasion
Tax Evasion vs Tax Avoidance: When it comes to taxes and the IRS, sometimes there is a fine-line between planning to minimize taxes (aka legal Tax Avoidance) — and committing criminal tax fraud, especially in the realm of international and offshore tax (aka Tax Evasion). How a U.S. person determines whether the tax planning activities they are performing 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. Oftentimes whether or not someone was acting legally or illegally will depend on the timing of the avoidance. We will summarize the Difference Between Tax Evasion vs Tax Avoidance with a case study example:
Case Study Example of Tax Evasion vs 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, which is a is a bit of an oddity from a U.S. tax perspective. A Sociedad Anonima 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 a 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?
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 the recurring theme in his research is that subpart F income usually involves passive income and it may be taxed even if it is not distributed. He 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
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 and GILTI — 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 and not the U.S., the United States does not have authority over the corporation.
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
In the next example, the Tax Evasion vs Tax Avoidance conundrum becomes more evident.
Peter is not as astute as David. Peter is looking to earn money in a 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 local accountant 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 and in uneven amounts, 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 (which began in 2009).
Peter’s BVI receives 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 may also have GILTI and IRC 965 issues.
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. For purposes of this case, you can presume that there are no related entity exceptions to the dividend distributions or look through exceptions. Therefore, 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 hundreds of 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 New 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.
That concludes the summary of Tax Evasion vs Tax Avoidance.
Golding & Golding: About Our International Tax Law Firm
Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure.
Contact our firm for assistance with getting compliant.