Offshore Tax Savings Ideas

Around this time of year, many people may be a little depressed when they have to think about the big check they had to send to the IRS. Well, they should do something about it! And while they're at it, why don't they add an offshore flavor to their tax savings?

The following ideas should be considered which can help you cut next year's tax bill a minimum of 10% and, if they're willing to live outside the U.S., by 90% or more:

A person should begin by doing all those things he knows he "should" do, such as loading up his IRA, pension plan or 401(k) to whatever contribution limits apply. If he contributed only $10,000 for 2006, he could easily save $4,000 or more next April 15. (Incidentally, an IRA is a great way to fund foreign investments, and is one of the only ways U.S. taxpayers can safely invest in offshore mutual funds.)

Life insurance, variable annuities and other tax-deferred investments could be considered. An individual won't get a tax deduction when he buys them, but the income from them grows free of U.S. tax. Once again, insurance contracts, if they are bought them from a foreign insurance company, offer convenient and potentially tax-deferred access to foreign investments. These are the easy savings. While they won't save additional taxes by using these techniques than a person would if he invested only in the U.S., he'll have access to a world of investments that are difficult or impossible to buy in the U.S.

If a person wants to save even more in taxes, then he should think about starting an offshore business.

Hypothetically, let's say someone forms a U.S. company that owns and operates a website selling handmade rugs in Guatemala. His marketing is successful and, within two years, he's making $500,000/year after all costs. From those profits, he pays himself an annual salary of $250,000.

The most tax-efficient way to operate a small business like this in the U.S. is with an LLC or an S-corporation where all income is attributed to the business owners, and none to the business itself. But even then, assuming this business is a person's only source of income, he'll pay over $172,000 in federal taxes.

Let's say that, instead of forming this business in the U.S., he forms it in low-tax Panama and operates it through a Panama international business company (IBC). However, to save taxes in the U.S., it must be a genuine Panamanian business. So, he pays someone in Panama, such as a secretary or accountant, an annual salary of $25,000 to operate the business. The owner pays himself a $250,000 dividend (upon which he will pay tax). The remaining $225,000 in profits, he will keep offshore as retained earnings. If the business meets some stringent requirements, the most important of which is that the owner doesn't manage the enterprise himself, the entire $225,000 can be tax-deferred. Assuming it does, then the owner's total savings in federal tax is $79,281.

Of course, most start-up businesses need hands-on management. So if someone really wants to make this strategy pay off, he'll need to move offshore to a country like Panama that doesn't impose income tax on foreign income. In that case, he can manage the business and legally defer U.S. taxation on the profits, provided that his company:

Is engaged in an active trade or business
Operates entirely outside the U.S.
Doesn't buy products or services from U.S. persons or companies related to him
Doesn't generate U.S. source income, or, if it does, that income is not "effectively connected" to a U.S. trade or business.

These requirements aren't difficult to meet for anyone living offshore and the business income is mostly from non-U.S. sources. The tax picture gets even more favorable when he considers U.S. citizens living offshore can receive a salary of up to $80,000 free of U.S. tax, plus an additional $80,000 for their spouse.

For an offshore business generating $500,000 in annual profits, living and managing it offshore gives him a total tax savings of more than $160,000! (That's if, instead of paying himself a $250,000 salary, he pays himself $125,000 annually and his spouse another $125,000. The balance of $250,000 remains tax-deferred in the corporation.)

Of course, the IRS is aware of these strategies, both for tax savings in offshore investments and offshore businesses. To begin with, there are complex reporting requirements with which the owner must comply, and hiring offshore tax experts to do the required accounting can be expensive. And, over the years, the IRS has persuaded Congress to erect a series of obstacles to these offshore tax savings. For instance, as deferred income accumulates within a person's IBC, he'll need to invest those profits in the business or pay dividends to himself that are taxable at ordinary U.S. rates. If he doesn't pay dividends, he may lose the opportunity to defer tax on the IBC's earnings.

So, the bottom line is to go offshore. However, those who choose to do so should be careful, and get professional advice before they do