IRS has focused its arguments in two areas: (1) Lack of bona fide residence; and (2) lack of VI-source income. To qualify for the IRC Sec 934 tax break, taxpayers need to comply with both requirements. Under the tax schemes promoted to U.S. residents, taxpayers qualify under neither.
Bona Fide Residency
Residency is a facts and circumstances test: Have you really and truly moved to the VI, or are you faking it? Where you live and how long you live there are the predominant factors. Promoters provide a checklist of residency factors -- such as change in location for bank accounts, voter registration, vehicle registration, and driver's license; joining clubs and purchasing a residence in the VI -- and invariably reassure the taxpayer that maintaining their actual residency in the U.S. for most of the year is permissible.
Unfortunately, taxpayers cannot have one residence for tax purposes and another residence for everyday life. Unless the taxpayer actually moves to the VI along with their family for a period of years and lives there a majority of the time, those attempting to establish a bona fide residency in the VI for federal income tax purposes will inevitably fail.
The Tax Prophet
VI-source income involves an analysis of where the business income is generated. First, personal services are sourced where they are performed, so a taxpayer working in the U.S. but funneling income through a VI entity fails the VI-source rule (as well as the residency rule). Second, even if the taxpayer manages to establish a bona fide residency in the VI, if the sources of income are from the continental U.S., the income is not VI-source and will not qualify for the tax credit under the EDP.
For example: A successful insurance broker in Ohio establishes a bona fide residence in the VI, but continues to solicit business from his contacts in Ohio and continues to generate income from his existing Ohio clientele; the sources of income are not VI-source and will not qualify for the tax credit. Any new business derived from residents or companies of the VI, however, should qualify for the tax credit (provided the taxpayer is a bona fide resident of the VI. Thus, moving to the VI and "tele-commuting" to the U.S. will not work.
Note: Those contemplating the sale of their company's highly appreciated securities or their business located in the U.S. will not meet the VI-source income test, so moving to the VI in anticipation of the sale will not reduce your taxes under IRC Sec. 934. Also, expect taxpayers to reincorporate the businesses in the VI, then sell the "VI-based" business and claim the 90% credit. Although this manuver adds a layer of complexity, it should fail under the sham transaction doctrine.
The Tax Prophet
Gary J. Payne was a successful insurance executive, earning close to $675,000 income per year during 2000 and 2001. He owed approximately $500,000 in federal income taxes for both years. Not to worry, Mr. Payne hooked up with Kapok Management, a VI company, which promoted the 90% tax credit scam. He then formed a VI entity and claimed his income now belonged to the VI entity. Kapok Management formed the VI entity and assisted with the money flow, receiving a portion of the income as compensation for its services.
Payne purchased an apartment and a condominium in the VI, registered to vote there and obtained a driver's license, but he continued to live in the continental U.S. and run his insurance business through the same office. He visited his VI apartment a couple of weeks per year. He then filed tax returns in the VI and claimed the 90% credit.
Unfortunately for Mr. Payne, he got caught and now faces up to 5 years in prison, as well as the revocation of his insurance license. The Department of Justice believes there are at least 65 others in Mr. Payne's position and they should expect criminal indictments in the near future.
The Tax Prophet
Expect the VI scam to be replicated among other U.S. possessions with similar laws. Those who have participated in these schemes must be losing sleep, as IRS has identified the program as bogus and is actively investigating promoters in the hope of securing their client lists. As with every other outlandish tax scam, if is sounds too good to be true, it probably is. Taxpayers should be aware of schemes that rely on false facts, such as a feigned residence, or when tax breaks are offered without any real change in economic circumstances. However, as long as there are rich and greedy taxpayers, there will be snake oil salesmen to take them to the cleaners.
The Tax Prophet
All contents copyright ? 2008 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet(TM) is a trademark of Robert L. Sommers.