The Right Way to Use Offshore Business Entities

The Right Way to Use Offshore Business Entities

Could you benefit from an offshore business entity? Here are a few of the most common ways they're used:

To hold an investment portfolio.
For asset protection purposes.
To achieve greater privacy.
To operate an offshore business.
To own foreign real estate.
Foreign corporations, generally organized as international business companies (IBCs) are the most commonly used offshore business entity. Most countries with IBC legislation are in low or no-tax jurisdictions (e.g., the British Virgin Islands) and income from the IBC, particularly if earned outside the country of formation, isn't taxed there.

However, for U.S. persons investing overseas, foreign corporations usually aren't a good choice. This is due to the unfavorable tax treatment imposed on the foreign corporation 's U.S. shareholders. In virtually all cases in which U.S. shareholders use a foreign corporation to hold assets that generate passive income, they become entangled in a complex web of rules designed to prevent U.S.-based multinational corporations from diverting profits into foreign subsidiaries where tax can be deferred indefinitely.

These controlled foreign corporation (CFC) rules are among the most complex in the U.S. Tax Code. Here's a highly simplified summary:

If U.S. shareholders own more than 50% of the shares in a foreign corporation (e.g., an IBC), by vote or value, the foreign corporation is classified as a CFC. U.S. shareholders are defined as U.S. natural persons, partnerships, corporations, trusts, and estates that own, respectively, 10% or greater interests in the foreign corporation.

If you're a U.S. shareholder in a CFC, and it generates what the IRS calls "subpart F" income, you can't defer tax on that income. Subpart F income includes passive investment income, income from personal service contracts, income from transactions with related U.S. persons or entities, and income from certain industries such as insurance, banking, mining and others. Naturally, exceptions apply to many of these general rules.

If that's not enough, if your foreign corporation is classified as a CFC:

The 15% income tax rate on capital gains and dividends isn't available.
Losses on investments can't be allocated against gains until the IBC is liquidated.
Any investments in the United States may result in double taxation.
The basis of the stock does not step-up to its fair market value at the death of a shareholder for estate tax purposes. (For 2010 there is a step-up because of no estate tax).
Complex IRS reporting requirements also apply.
With a foreign corporation, you also won't receive much more asset protection with a corporation chartered in a U.S. state. While IBCs are less visible than domestic corporations, if you suffer a judgment, a creditor can simply obtain a court order to seize your shares. If you own more than 50% of the shares, the creditor can even liquidate the IBC.

Because of the tax traps in CFCs, offshore limited liability companies (OLLCs) are often a better choice for U.S. persons investing or doing business offshore. While you lose the opportunity for tax deferral on income and realized gains, by making the proper election with the IRS, you eliminate the potential tax problems of a CFC. However, you'll still need to pay tax on the OLLC's income or realized gain, and file an annual information return with the IRS.

OLLCs provide more asset protection than domestic LLCs. Attorney Christopher Riser explains why:

"A creditor of a member of a U.S. LLC with a U.S. manager may be able to obtain a court order forcing the manager to make distributions which, combined with a charging order, will satisfy the member's judgment debt. The creditor of a member of an offshore LLC with a non-U.S. manager in most cases will not be able to obtain jurisdiction over the non-U.S. manager. Even if an order were issued by a U.S. court, the non-U.S. manager could not be forced to comply unless and until a successful action was brought in the non-U.S. manager's jurisdiction."

OLLCs can also be used as estate planning tools in the same manner as domestic LLCs or domestic limited partnerships. If the OLLC is properly structured, minority membership interests should be discounted for estate and gift tax purposes for lack of marketability and lack of control. Proposals before Congress would eliminate these discounts for gifts of minority interests to family members.

Particularly if you're considering an offshore business entity to hold a portfolio of passive investments, an OLLC is one of the best ways to do it. Chapter 5 of my book THE LIFEBOAT STRATEGY contains an extensive discussion of offshore business entities, including OLLCs.
Offshore Pro Group