Dispelling The Myths: The Truth About Offshore Tax Havens
Want To Keep Your Best Employees? Get Creative!
Did you know that if you have a salesperson who spends just 2 days in Michigan making sales calls, you might have to file a tax return in that state? As businesses continue to expand their geographical territories, the cost and administrative burden of complying with various state laws is becoming enormous.
To make matters worse, state governments are becoming increasingly aggressive in their compliance initiatives - especially towards out-of-state business.
States are always looking for new and creative ways to tax the "other guy" while providing favorable treatment for companies in their home state. Plus, pressure to generate revenue among states has become intense, due to federal cutbacks in state funding. Thus, taxing out-of-state companies has become a way for states to broaden their tax base, boost revenue, and provide relief for in-state companies.
Nexus remains a controversial topic. States have repeatedly tried to expand the definition of nexus to reach additional taxpayers and out-of-state dollars.
Nexus describes the degree of business activity that must be present before a taxing jurisdiction has the right to impose a tax on an entity's income. Normally, sufficient nexus is established when a company owns or leases property, employs personnel, or has capital in the state. However, in 1993 the South Carolina Supreme Court held that physical presence was no longer a requirement to establish nexus. Many out-of-state companies became susceptible to South Carolina's taxing jurisdiction. This decision created the precedent that states and other taxing jurisdictions needed to gain a fresh revenue stream.
While many states have agreed to some uniform standards to determine nexus, they still can interpret these standards a little differently. Meanwhile, some states ignore the standards altogether and follow their own set of rules.
Companies that are liable for taxes in a number of states know the division of income among states can be a complex process. In the last 10 years, many states have adopted apportionment formulas that weight the sales factor more heavily than the property and payroll factors. Use of the double-weighted sales factor tends to pull a larger percentage of an out-of-state company's income into the taxing jurisdiction. This occurs when the company's major activity within the state is the sale of goods.
Double-weighting the sales factor also provides tax breaks to companies domiciled in the state, because they generally have significantly more property and payroll costs than do out-of-state companies. A single factor sales formula, currently enacted in a few states, places a greater tax burden on out-of-state companies. Because of these inconsistencies in the apportionment provisions, interstate companies are at risk for paying tax on more than 100% of their income.
State tax laws often discriminate against out-of-state companies by taxing them at higher rates or on different tax bases than in-state companies. Although the US Supreme Court has determined that such discrimination is unconstitutional, states have been slow to enact legislation putting in-state and out-of-state companies on an equal basis. So, these discriminatory taxes continue to be used to generate revenue.
Protesting discriminatory state taxes and the legal appeal process can be very time-consuming and expensive. Often the dollars at stake are not worth the efforts. But, allowing such taxes to remain provides a heavy burden on out-of-state companies and puts them at a competitive disadvantage with in-state companies.
So far, this discussion has centered on income taxes. Multi-state companies must also contend with sales and use tax, franchise tax, and property tax issues. Each state has different sales tax and property tax exemptions; and city and county jurisdictions may have their own rules as well!
Not only are states expanding the reach of their taxes, they're becoming more and more aggressive towards out-of-state businesses that aren't in compliance. If your company isn't filing the necessary state tax returns, it faces significant exposure for back taxes, interest, and penalties for as many years as it has been out of compliance.
As the tax consequences of doing business in a number of states grow in complexity and significance, it's imperative to give this issue the attention it deserves. We can help you assess your exposure and take the necessary corrective action.
Visit your favorite search engine on the Internet and search for "tax haven," and you're likely to end up with over 1,600 hits. A number of theses Web pages are from promoters with a can't miss strategy to never pay taxes again.
While there are a few legitimate offshore planning techniques, many of these vehicles are merely scams, based on half-truths or outright lies.
In every major country, you can pack up your belongings, move to another country, and never pay taxes in your homeland again, However, the US taxes citizens on their worldwide income, regardless of where it is earned or where they are living. You can live for the next 30 years in the Cayman Islands and you will still be taxed in the US on all or your earned and investment income.
Any promoter who says you can simply move your money, or your body, offshore and avoid US federal income tax doesn't know or understand US tax law.
Promoters often say that income can be hidden from the Internal Revenue Service by putting it in a secret offshore bank account. Unlike domestic banks, which must report interest income to the the IRS on Form 1099, foreign banks aren't subject to these requirements. It's up to us, as taxpayers, to report such income on our tax returns.
Moral issues of whether or not to evade taxes aside, the fact is that it is illegal to fail to report income. Because there is no statute of limitations on unreported income, if the IRS audits someone 30 years from now and discovers a foreign bank account, they can assess taxes, interest, and penalties for all of those years, and prosecute the person for criminal actions.
Another common scheme is a secret foreign trust known as a "Pure" Trust (also "Equity," "Constitutional," and "Common Law" trusts). Promoters claim these trusts are exempt from income tax. Someone always has to pay the tax. Either the grantor of the trust, the trust beneficiaries, or the trust itself is liable for the tax. The IRS generally treats these types of trusts as grantor trusts, meaning that whoever set up and funded the trust will be liable for the tax on its income.
Promoters often argue that these trusts are not subject to US laws. However, the IRS is going after these fraudulent trusts by going after the promoters. Once indicted, the promoters will surrender their customer lists to the IRS, giving the Service the basis for taxpayer audits.
While many of these tax haven schemes are outright scams, the Internal Revenue Code does provide a way to avoid tax on foreign income - the foreign earned income exclusion.
For 2000, up to $76,000 of earned income from a foreign source can be excluded if certain requirements are met. To qualify, your tax home must be in a foreign country, and you must either by a bona fide resident of a foreign country for an uninterrupted period including an entire year, or you must be present in a foreign country for at least 330 days during a 12-month period.
If the tax benefits from moving assets offshore are so limited, why would such a move ever be considered? Some taxpayers want the legitimate asset protection benefits of moving assets offshore. Many foreign countries have much better privacy laws than the US, and moving assets offshore can often protect them from creditors.
When done properly an in advance, asset protection planning is perfectly ethical and legal. And in today's lawsuit happy society, it may not be a bad idea in some circumstances.
While we've exposed some of the scams and dispelled some of the myths, there are many more out there. The important thing to realize is that if it sounds too good to be true, it probably is. And, never enter into a transaction with any of these promoters without discussing it with a trusted adviser first.
In today's labor market, it's becoming more and more difficult to retain key employees. Consequently, it's time to get creative when devising compensation packages for your best employees. Besides the typical salary, retirement plan, and fringe benefits, there are a number of less traditional means of compensation that can give your employees the incentive to stay with your company and improve their performance.
Traditional retirement plans are subject to strict compensation limits, contribution limits, and nondiscrimination requirements that severely limit the amount of benefit you can provide your top brass. When traditional plans aren't enough, consider a nonqualified deferred compensation plan. As a nonqualified plan, it isn't subject to most of the aforementioned limitations. And, a nonqualified plan can discriminated in favor of your key employees.
Unlike a qualified plan, a nonqualified plan cannot be funded in advance. The benefits must be paid out of the general assets of the employer. Also, the employer doesn't receive a tax deduction until the benefits are paid to the employee. While much more flexible than qualified plans, nonqualified plans are subject to some restrictions, and there may be some FICA tax implications to address. So, be sure to consult with us before establishing one of these plans.
Stock options aren't just for publicly-traded companies anymore. More and more closely held, private companies are using stock options to reward employees. Operating on the principle that employees will accumulate more wealth if the value of the company increase, options provide employees an incentive to work harder. Options can even increase company loyalty as employees develop a sense of ownership in the company and are more inclined to stay with the company as it grows.
Stock options are particularly appealing if a company is trying to position itself to go public or be sold in a few years. Stock options are also useful with S corporations where the shareholders can generally distribute cash to the extent of its earnings. However, special consideration must be given to S corporations since a deemed second class of stock could taint a company's "S" election.
As with any form of compensation, the tax effects of the transaction must be considered. Stock options are treated differently depending on their type. The timing as to when the options become taxable must be considered, as well as how the employee is to pay for both the exercise of the options and the tax due when the transaction does become taxable.
If you want to avoid some of the cash outlay issues encountered with stock options, consider a phantom stock appreciation plan. Under such a plan, the company awards bonuses to its employees in the form of hypothetical shares of stock. The company can then pay cash or phantom stock dividends on the stock or just let it appreciate.
At some point in the future (such as retirement), employees can cash in their shares and receive the excess of the fair market value of the phantom stock over their value when the shares were issued. Employees don't pay tax on their shares until that time.
Using either stock options or phantom stock will require a determination of the value of the company at various intervals in time. Since the company's value can't be determined by simply checking the stock ticker, using these types of plans may require a little more legwork. We can help you objectively determine the fair market value of your company.
In this increasingly competitive market, traditional compensation packages simply may not be enough. If you'd like to get creative and learn whether these forms of compensation will work for you, please give us a call.
If you have any questions or comments contact us
at Shonsey & Associates
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