All United States citizens must pay income tax for all income received. This includes income received overseas. Nevertheless, many taxpayers are frequently tempted to use off shore means of evading income taxes. Some of these methods are legal. For example, there is nothing illegal about creating a foreign corporation or partnership that does business in the United States. Likewise, a foreign trust that manages an asset for a domestic citizen is generally permissible and legal.
However, not every off shore arrangement that reduces tax liability is legal. Many countries have strict secrecy laws that individuals use to conceal assets and income. But even if assets are secret or concealed, they are still subject to taxation. Income is taxable regardless of the government’s knowledge of it.
When a foreign entity is created in one of these countries for the purpose of concealing the ownership of a domestic asset or income stream, this is viewed as an abusive tax avoidance scheme. For instance, diverting skimmed income to an off shore entity to evade taxation is considered an abusive method of evading taxation. If a taxpayer makes payments to an off shore entity that he controls entirely and meanwhile deducts those expenses from his tax filings, this is also viewed as abusive.
Some businesses don’t even go so far as to create fake deductions. They merely hide the income through an off shore account. A business owner sets up an account in the same name as the business in a foreign bank with favorable secrecy laws. Customer checks are then deposited in the foreign account and the income is never reported to the IRS.
A more sophisticated scheme involves fictitious sales of property to a foreign entity that the taxpayer controls for either less than its true value or for a note that will never be repaid. With ownership of the property located off shore, the tax payer can attempt to evade payment of taxes. Some taxpayers have attempted to do the reverse and purchase equipment from an off shore entity that they control and then deduct payments as expenses, thus reducing taxable income.
Once funds are moved off shore, taxpayers will attempt to access those funds while evading detection through a variety of methods including: credit cards that draw on the off shore account, loans from their offshore entities, use of offshore property below market rental rates, bogus transactions, gifts, etc. These methods all allow taxpayers to receive the benefits of income while assisting in evading the reporting of that income. Taxpayers caught doing any of these things are likely to face an IRS determined to make them pay for their transgressions, with both civil penalties and criminal punishment.
It’s important though to remember that there is nothing inherently illegal about using foreign accounts for their tax advantages as long as the income is not concealed from the government. One important way to avoid being accused of concealing is to complete a Report of Foreign Bank Accounts. Foreign tax advantages are not illegal when the taxpayer is not attempting to conceal income.