In my first article of this series, I gave a scenario of a business that had a $400,000 profit. The business owner played some accounting magic to reduce his taxes from $145,000 to $115,000. That is tax avoidance, where taxes are reduced by following the tax laws.
At this point, I’m going to put some names to help this story along. The business owner is named Fred. His business is incorporated and called “ABC Ltd.” Fred owns all the shares of ABC Ltd.
Fred is the voice and face of the business. But the customers and vendors to this business are, legally speaking, doing business with ABC Ltd., not Fred.
Fred anticipates more years of $400,000 profit. Even with his legal tax manipulations, he still has to pay $115,000 in taxes. Fred wants to reduce taxes even more.
So Fred hops a plane to Bermuda. He hires tax lawyers and accountants in Bermuda to set up a corporation on this island off the US Coast. This corporation is called 123456 Bermuda Inc. And this corporation opens a bank account in Bermuda. Fred deposits $25,000 into this account. Remember that he just had a profitable year, so this deposit is not difficult for Fred to make.
Fred returns to the USA. He instructs his American lawyer and accountant to sell his shares of ABC Ltd. to 123456 Bermuda Inc. The two parties, Fred and 123456 Bermuda Inc., negotiate a sale price of $20,000. I think most readers realize that Fred was negotiating with Fred in this deal. The lawyers and accountants wrote up the deal to withstand a legal audit of the IRS.
So $20,000 move from 123456 Bermuda Inc. to Fred’s personal account in the USA.
But Fred has proof that he invested $150,000 into ABC Ltd. five years ago. So he can now claim a business loss of $130,000. Hold on to this number!
The ownership of ABC Ltd. has changed from Fred to 123456 Bermuda Inc. But for all visual appearances, the business is the same. Fred is still in charge, making deals and instructing employees. All the employees, customers, suppliers, banks, and governments are still dealing with ABC Ltd. They likely don’t know an ownership change has occurred. Fred continues managing ABC Ltd. the same way he managed ABC Ltd. before he took a little vacation to Bermuda.
But Fred’s accountant knows of the ownership change and is working the numbers so Fred pays even less tax than before. He tells Fred: “Fred, have ABC Ltd. pay you a salary of $8,000 a month.” Fred puts himself on the payroll for that amount.
The year goes by. ABC Ltd. has earned another profit of $400,000. ABC Ltd. has already paid Fred $96,000 in salary, so it has a surplus of $304,000 that needs to be managed for tax avoidance.
Then, just by magic, an invoice appears on Linda’s desk. Linda is ABC Ltd.’s bookkeeper. She looks at the invoice: 123456 Bermuda Inc. is billing ABC Ltd. $304,000 for “management fees.” Somehow 123456 Bermuda Inc. sold ABC Ltd. some excellent management advice. Linda sets up this payable in the next round of payables to ABC’s vendors. The money moves to Bermuda.
With this invoice, ABC Ltd. is, legally speaking, an American company that is breaking even. With no profit to show, it is no longer obligated to pay any corporate taxes in the USA.
But some of you are saying that most of this $304,000 would show up as profit for 123456 Bermuda Inc., so it would pay corporate taxes there. This is true, but the corporate tax rate in Bermuda is 1%, compared to 20% in the USA. By setting up this offshore company, Fred has reduced his corporate tax rate by 95%. Bermuda sets up these low rates to attract profitable American businesses to set up such profitable offshore companies.
In essence, Bermuda gets the benefit of ABC profits without having to put up any of the infrastructure needed to make those profits. In other words, the United States gets the shaft.
And this story ain’t over
Fred moved $304,000 to Bermuda. Maybe $3,000 went to the Bermudan government in corporate taxes. Maybe another $3,000 went to Bermuda lawyers and tax accountants. But paying this $6,000 is much less than paying $115,000. In essence, Fred is keeping more of that profit for himself.
But he did draw $96,000 from ABC Ltd. Surely he is paying taxes on that, right?
Well, not really. Remember that $130,000 loss he took when he sold the shares of ABC Ltd. to 123456 Bermuda Inc. He can now take that loss and apply that against that salary. I estimate it will take two years before Fred has to pay any American taxes on his American salary.
And this story still ain’t over
If Fred transfers money from the bank account of 123456 Bermuda Inc. into Fred’s personal account, he would be legally required to report that transfer as income and pay appropriate taxes on it. So it seems that Fred’s tax reduction scheme is really not that profitable — unless he leaves all his money in Bermuda.
Here’s how Fred can move money back to the USA, untaxed.
1. Bermuda is a nice place to vacation. When vacationing Bermuda, he can use the money in this Bermuda bank account to pay for restaurants, hotels, golf courses, and sailboats. Remember, this money comes from profits earned in the USA, which has not paid any American taxes. If we vacation in Bermuda, we have to pay our taxes first.
2. Bermuda is a colony of the United Kingdom. I suspect Fred can vacation in the UK to the same effect.
3. Fred can withdraw American cash from 123456 Bermuda Inc.’s bank account and bring it back to the USA. I believe the limit is about $10,000. Fred can make a trip every month. He can take a family member to bring back another $10,000.
4. The Bermuda bank account probably has a credit card attached to it. Fred can use this card to buy things in the USA: groceries, restaurants, event tickets, plane tickets, gasoline, car repairs, etc. Remember, the rest of us have to pay our taxes first before buying these things. Fred does not have to pay taxes before he buys these things.
5. Fred wants to buy a ski chalet in Colorado for recreational purposes. Even with a salary of $96,000, it would be hard to make this purchase. So Fred gets 123456 Bermuda Inc. to buy the chalet — because it is holding lots of untaxed American profits. But more likely, 123456 Bermuda Inc. would set up and own an American holding company. That holding company would own the chalet. That holding company turns this chalet into an Air BNB and have a Colorado company manage it. Then Fred’s accountants in Bermuda can send an “management fee” invoice to that holding company, which is, only coincidentally, almost the same as the profit. So this holding company does not pay much American tax. Yet the profits still move into 123456 Bermuda Inc.
6. And Fred uses the chalet four weeks a year at no charge.
Tax avoidance and tax evasion
There is a difference between these two terms. Tax avoidance is using legal means to reduce taxes. With the laws as they currently stand, I would say that 123456 Bermuda Inc. is mostly tax avoidance.
Fred could move $100,000 from 123456 Bermuda Inc. to his personal account, pay the American taxes, then use the rest at this pleasure. He would still be within the law.
But when Fred uses items 1 to 6 in the above list, he is evading taxes. He is essentially using untaxed American profits to buy American things. Evading taxes is illegal. By going through items 1 to 6 (or other “move money” actions), Fred could face tax bills and fines that bankrupt him. Or he could go to prison.
But it is difficult for the tax auditors to find these infractions and later prove them in a court of law. If Fred is taken to court, there are tax lawyers who specialize in tax cases — and will hold the tax auditors to a high standard to prove their case to a judge. These lawyers know their way around the tax laws better than the auditors. The lawyers are great for getting their clients off the hook. Hence the auditors are reluctant to take businesspeople like Fred, their holding companies, and their offshore companies to court.
And this story still ain’t over
In the future, Fred will want to sell his business. The buyer will buy the shares of ABC Ltd. from 123456 Bermuda Inc. The money will be sent to Bermuda. It will be exempt from any capital gains tax in the USA. Any capital gain tax the Bermudan government might impose would be a lot less than the American capital gain tax.
Fred may move the business sale money back to the USA as salary or dividends. These payments will be taxed, but still not the capital gains. Or Fred might find ways to evade those taxes — and get away with it. Having an offshore company gives Fred more options to play with his money.
Ethics and morals
I may have given the impression that moderately successful businesses would immediately follow the path of Fred: i.e. move their profits offshore. I really can’t say for sure whether 5% or 50% of successful businesses take this path. But it is easier for businesses to take this path than it was 30 years ago. And competitive pressures may be a big reason to force some of them into this path.
I should say that many businesspeople do understand the relationship between paying taxes and having a strong civil society that allows them to earn and enjoy profits. They may grumble at paying taxes. They may prefer a political party that promises to cut taxes. But they do not set up offshore companies — because it is the right thing to do.
Besides, adding an offshore company is another headache and worry. Sometimes it is easier to pay the tax.
Published on Medium 2024
