Originally published on Forbes.com.
The Panama Papers, a leaked set of 11.5 million confidential documents from the Panamanian law firm Mossack Fonesca, has generated a lot of interest in the subject of off-shore corporations. There is a general sense that someone who owns off-shore corporations must be up to no good, engaging in tax evasion at the least. It is just not true. There are many valid, innocent reasons to own foreign corporations. I spoke with Lief Simon, once a typical American boy from Arizona, who, still a US citizen, lives with his family in Panama. He owns several foreign corporations – ten or so. He has a spreadsheet, but it was not handy. Taking him at his word, and there is no reason to doubt him, there is nothing nefarious going on.
Why Have A Foreign Corp If You Are Not Getting Away With Anything?
Lief is a cofounder of Live and Invest Overseas. He pointed out at least five legitimate reasons to have an offshore corporation.
Real Estate
If you want to own real estate in a foreign country it might be prudent to use an entity in the target country to achieve limited liability. Sometimes it is the only way you can own real estate in some countries. Lief indicated that in Mexico a foreigner cannot have title to real estate in his own name if it is within 50 kilometers of the ocean.
Then There Is Probate
Even if you are allowed to own real estate directly, on your death, your heirs might be subject to the probate process, which can be grueling, whereas a corporation, an intangible asset, may not be subject to probate in the country where the real estate is located.
Asset Protection
You might be getting into a gray area here, but positioning assets so they cannot be reached by creditors can be legitimate.
Provide For Investment Diversification
Thanks to the way that our Securities and Exchange Commission protects us, offshore brokers and mutual funds that may have attractive investment will often not accept Americans as clients or investors. They will, however, accept foreign entities owned by Americans.
Operate An Active Business
This is kind of an obvious no-brainer, but there it is. This is where I have run into off-shore entities a few times in my career. I am incredibly parochial so I struggled to think of a foreign business that I would like to own. All I could come up with is a pub in Ireland or a bookstore in London. Either one of those would be way cool. Maybe a dive shop in the British Virgins.
Just Plain Folks – Just Not Parochial
So a lot of foreign entities owned by Americans are owned by people who are not trying to get away with anything. They own businesses or real estate in other countries, sometimes by inheritance and a corporate form of some type is the most logical way to own those assets or at least they or their advisors think so.
Can Be A Sweet Deal
If you do own a foreign corporation, given the right circumstances, it can be a sweet tax deal. Suppose you formed your corporation to run a business in a foreign country with a more favorable tax regime than the US has. (The pub in Ireland and the bookstore in England maybe not so much) How about a bed and breakfast in Macedonia where you will have a flat 10% rate according to Wikipedia? This is probably a ridiculously impractical suggestion, but I needed to come up with something.
If you use an entity that is considered a corporation for US tax purposes any income you accumulate in the corporation is tax deferred. You can take out $100,800 in salary and have no US income tax thanks to the foreign earned income exclusion. That also might mean you don’t have to make payments on your student loans if you are in Income Based Repayment, since IBR is based on federal adjusted gross income
Show And Tell
Even though you may end up owing little or no tax, you still will have to spend a bit either in your own time or money to professionals or some combination to be in compliance. Lief told me that one expert who lectures on these issues cautions people that doing things overseas should not be a game of “Hide and Seek” rather it is “Show and Tell”. The penalties for failing to disclose foreign transactions and holdings are extremely nasty.
The nastiest penalties are probably for not disclosing ownership or authority over foreign bank accounts. That is really not that hard to do. It is now handled on-line. If you have an interest in a foreign corporation there is a good chance that you have to file Form 5471 and attach it to your return. Form 5471 can be pretty hard to do for a variety of reasons, but it is very unwise to neglect it.
Some Big Penalties Coming?
One of the outcomes of the Panama Paper drama may well be that people who were really not doing anything illegitimate will end up getting hit pretty hard for lack of compliance out of ignorance or because it seemed too hard. If the IRS is handed the names of Americans who own foreign corporations and has the resources, to some extent the investigation will be like shooting fish in a barrel. You owned this corporation. You did not file Form 5471. You are busted. The corporation had bank accounts and you did not file FBARs – double busted. Substantial civil penalties even though you weren’t really getting away with anything.
Why It Is Hard
Form 5471 requires a lot of information about the foreign corporation. In my experience, the challenging part for American accountants is getting the information. Much gets lost in translation. Sometimes it is difficult to determine what kind of an entity it is that your client owns. Sometimes the people overseas controlling the books and records are less than cooperative.
If you are getting involved in overseas transactions of any sort, try to get your advisors on both sides of the border to coordinate things. This is one area where the national accounting firms really shine, but you may find that they are too expensive if you are involved in relatively modest transactions.
If your reasons for being involved in foreign corporations are entirely benign, you may want to check if your disclosures are in order especially if you used Mossack Fonesca. It is critical that you work with people who understand both how things are done in your target country and how that translates into US taxation and disclosure. It is really marvellous if you can get them to communicate with one another, although I have to tell you, I have never seen it go really smoothly.