WSJ: The IRS Is Ramping Up Efforts to Flush Out Taxpayers Hiding Money Abroad

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The Wall Street Journal
TAX REPORT
Decembrer 10, 2011

What's Next for Offshore Accounts?
The IRS Is Ramping Up Efforts to Flush Out Taxpayers Hiding Money
Abroad, Even as New Opportunities Are Emerging to Move Money Offshore
Legally

Here's an irony: Even as the U.S. government is cracking down on
illegal foreign accounts, other new laws and proposals could present
big incentives for the wealthy to move more money offshore.

New rules affecting 2011 tax returns require taxpayers with assets
held offshore to make extensive disclosures to the Internal Revenue
Service or risk harsh penalties. The goal: to ferret out secret
accounts used to skirt U.S. taxes.


The tax code is encouraging people to exploit offshore investing
schemes to an unusual extent, even as the IRS intensifies its
crackdown on secret foreign accounts. Laura Saunders has details on
The News Hub. Photo: Reuters

This is only the latest turn in the U.S. government's three-year
crackdown on illegal offshore accounts, which already has resulted in
36 convictions since 2009, with four cases still awaiting trial and
many more expected to come.

Yet despite Uncle Sam's aggressive campaign, some advisers are seeing
new tax advantages—fully legal—in investments based offshore. That
edge could grow if Congress cuts tax deductions for upper-income
earners and the 3.8% tax on investment income takes effect in 2013 as
scheduled.

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So if a taxable investor faces a choice between an offshore investment
fund and an onshore version, "we find that many are better served by
the offshore version," says Robert Gordon, chief executive of Twenty-
First Securities in New York, an adviser to the wealthy.

The upshot: Both current and future owners of foreign-based assets
have much to consider as the new tax year approaches.

What's OK and What's Not
Many types of international investments aren't under scrutiny,
including foreign assets held in U.S.-based banks and brokerage firms.
The IRS already knows about income generated by these accounts.

What's more, there are legitimate reasons for holding offshore assets
ranging from vacation homes and business interests to accounts held
jointly with family living abroad. But income from foreign-based
accounts, and the accounts themselves, must often be disclosed under
the U.S. tax code.

The problem is that some people have long taken advantage of lax U.S.
enforcement and foreign tax haven secrecy to stash assets abroad to
evade taxes.

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Illustration by James Steinberg
In 2009, a scandal at the giant Swiss bank UBS offered a glimpse into
the extent of the problem. UBS admitted to helping people evade U.S.
taxes, paid $780 million and disclosed the names of more than 4,500
U.S. taxpayers with secret accounts at the bank. A UBS spokesman said
the cross-border matter was fully resolved as of the end of 2010, and
UBS commitments to U.S. agencies were fulfilled.

The repercussions from the UBS case continue today. Swiss and U.S.
officials are negotiating a sweeping agreement to name U.S. account
holders from at least 11 more Swiss banks—including Credit Suisse
Group, says Bryan Skarlatos, an attorney with Kostelanetz & Fink in
New York who has handled nearly 1,000 confessions of U.S. taxpayers
with secret foreign accounts. A spokesman for Credit Suisse declined
to comment.

Mr. Skarlatos says he also has seen evidence of U.S. investigations
into banks in Israel, and believes investigations are ongoing into
Hong Kong and Singapore banks.

The message for U.S. investors: Anyone with an undeclared foreign
account should be on high alert.

The IRS has held two limited amnesties for offshore account holders in
recent years, and more than 30,000 U.S. taxpayers have stepped forward
to pay back taxes and stiff penalties in hopes of avoiding criminal
prosecution. Now the IRS is mining data from those confessions and
from foreign banks to find others who haven't come clean.

"Agents are conducting what seem to be routine audits and asking about
foreign accounts only at the end, before telling taxpayers they have
foreign bank records in hand," says David Gannaway, a principal at
Citrin Cooperman CPAs in New York.

Some say the IRS has been too heavy handed.

"In its limited amnesties, the IRS hasn't distinguished between an 84-
year-old grandmother who is a Holocaust survivor or a U.S. taxpayer of
Indian descent whose father put an account in his name without telling
him—which is common—and the crooked businessman who skims cash in the
U.S. and hides it abroad," says Kevin Packman, a attorney at Holland &
Knight who has had handled more than 200 confessions.

In Canada, many generally law-abiding citizens with dual U.S.
citizenship are in technical violation of the rules, from small
farmers to David Alward, the premier of the province of New Brunswick,
who was born in Beverly, Mass.

"I'm not different from thousands of dual citizens in New Brunswick,
which has strong ties to the U.S.," he says. "The threat of losing
significant assets has been a real concern." To avoid criminal
prosecution, some confessors have had to agree to a 25% penalty on the
highest value of a wide range of foreign assets since 2003, not just
bank accounts—even if those values have since fallen.

On Dec. 7, the IRS posted comments reminding dual citizens that
penalties won't be imposed in all cases. Mr. Alward said he is
"encouraged by the IRS's latest stance," but "remains concerned."

New Rules
Congress responded to the UBS scandal by passing the Foreign Account
Tax Compliance Act of 2010. Known as Fatca, it is a multifaceted
effort to rein in offshore tax evasion that applies both to
individuals and a broad range of financial institutions.

Phase One of Fatca applies to individuals and takes effect in 2011 for
the 2012 filing season, according to an IRS spokesman. U.S. taxpayers
will have to file a new form disclosing offshore assets when the total
exceeds as little as $50,000.

Among other assets, the form covers offshore financial accounts held
directly and indirectly, such as bank and brokerage accounts; direct
ownership of foreign stock; direct or indirect ownership of
partnership interests such as offshore hedge and private-equity funds;
foreign retirement accounts; and offshore pensions and annuities.

The new IRS form is due with the tax return, and it is different from
the Foreign Bank Account Report that many U.S. taxpayers also have to
file separately with the Treasury Department. But as with the bank
account report, the penalties for nonfilers are harsh: up to $10,000
for each 30 days of nonfiling. For extreme evaders there are criminal
penalties as well.

Surprise Tax Benefits Overseas?
Even as the IRS cracks down on illegal offshore accounts, financial
advisers to the wealthy are spotting new opportunities for generous—
and legal—tax breaks offshore.

David Miller, a partner at Cadwalader, Wickersham & Taft in New York,
says the U.S. tax code is encouraging Americans to move money
offshore, and has counted a dozen legal ways to minimize taxes by
doing so.

For example, say John has a choice of putting money in a domestic
hedge fund or an offshore mirror version. If he chooses the offshore
fund, he can deduct his hefty investment fees, which often are 2% of
assets. In an onshore fund, he generally can't.

There aren't any statistics that track the practice, but Michael
Oates, a CPA with Rothstein Kass in New York who advises alternative
investment funds, says many hedge funds are allowing U.S. individual
investors to come in through foreign feeder funds or are considering
it.

"We often advise our funds, especially those with swaps or high
leverage, to organize as an offshore vehicle for U.S. investors
because of the tax advantages," he says.

Alex Gelinas, an attorney with Sadis & Goldberg who advises hedge
funds, confirms the trend: "More funds are putting language in their
offering documents telling U.S. investors there may be substantial tax
advantages to investing through the foreign feeder."

Often the tax savings come from putting an investment into an offshore
corporation in order to preserve deductions that would disappear if
the same investment were made through a U.S.-based entity. The result:
The investor owes U.S. tax on net income, not gross income.

Among the other benefits of such offshore funds: Holders can take
state-tax and other deductions curtailed by the alternative minimum
tax; avoid some or all of the 3.8% Medicare tax on investment income
taking effect in 2013 for most couples with adjusted gross income
above $250,000 ($200,000, single); and avoid limitations on itemized
deductions for upper-bracket taxpayers, which have been proposed by
the Obama administration.

Moving assets abroad may bring extra savings for those living in high-
tax states like New York, Massachusetts and New Jersey.

Mr. Miller offers an example based on a New York City resident and
current tax rates. It includes the 3.8% tax coming in 2013, but not
the proposed limit on itemized deductions. Say the New York resident
receives a distribution of $100,000 of investment income but pays a
$20,000 fee, so he receives $80,000 net.

All told, an investment in a domestic fund would result in a tax bill
of $52,485 of federal, state and local taxes. The same investment in
the fund's offshore mirror would result in a tax bill of just $41,988—
a 13 percentage point improvement in after-tax return.

There are drawbacks. A big one is that investors in offshore funds
have to take specific steps to avoid turning capital-gains into
ordinary income, which is taxed at a much higher rate.

Offshore tax benefits also could provide a potent selling point for
otherwise lackluster, high-fee investments. "Hedge-fund managers are
always looking for a way to justify their enormous fees," says
Christopher Van Slyke, an adviser in Austin, Texas.

Still, Twenty-First's Mr. Gordon, who has long specialized in high-end
tax planning, says the drawbacks usually don't outweigh the potential
tax benefits of offshore vehicles. Depending on the taxpayer's
circumstances, he says, there can be a difference of one to five
percentage points, or more, in after-tax returns.

"Taxable investors, especially in hedge funds, owe it to themselves to
look offshore," he says.

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