Part 1 of a 2-part series
pageokImagine a scenario for cutting your federal income tax bill to 10% just by spending a couple of weeks per year on an exotic tropical island! What type of fool would fall for such a scheme? Evidently, hundreds of wealthy tax cheats have been convinced by the following pitch: Move to the U.S. Virgin Islands (VI), start a business there, and the government will reduce your taxes by 90% under a special Economic Development Program (EDP) designed to promote businesses within the VI. Leave it to conniving snake oil salesmen to exploit a law designed to promote economic development in a depressed economy by offering vacation home deals that virtually eliminate your taxes.
The tax benefits under the EDP stem from the VI government's authority under IRC Sec. 934(b) to provide that income from sources within the VI may be exempt from tax. Thus, in theory, if you take up residency there and build a business serving the VI, you'll receive a credit of 90% of your income tax liability under IRC Sec. 934 (enacted in 1960).
pageokIRC Sec 936(a)(1)(A) provides that a qualified possessions corporation electing the application of IRC Sec 936 is allowed a credit against its U.S. tax liability equal to that portion of such tax attributable to taxable income from the active conduct of a trade or business within a U.S. possession or the sale or exchange of substantially all of the assets used by the taxpayer in the active conduct of such trade or business. Eligible countries are Puerto Rico, Virgin Islands, and potentially the Marshall Islands and Micronesia.
To qualify under the EDP, taxpayers must be a Virgin Islands individual or business entity, such as a trust, partnership, corporation, or limited liability company and meet the rules relating to organization and operation of the business. Partnerships must have at least 80% of their income from VI source income and at least 50% of the income must be derived from the conduct of a trade or business operating in the VI. For businesses in operation longer than 3 years, the 50% income test applies with respect to the last three years.
pageokTax scam artists have devised and packaged a scheme to exploit the 90% tax credit provided by the VI whereby taxpayers residing in the continental U.S. feign residency in the VI and then, through a sham entity, claim business or salary income as emanating from the VI. These taxpayers then claim to meet the residency requirements of the VI tax credit, although, in substance, they remain living in the continental U.S. and their sources of income are based in the continental U.S. Thus, nothing of real substance has changed, except the "obligation" to acquire a residence and take a couple of weeks vacation in St. Croix.
pageokOf course, there are major problems with the tax shelter, but they will not arise until the promoter has made off with your money. First, the tax law looks at the substance of a transaction, not its form. If, after all the steps in a transaction and the real facts are considered, there is no meaningful change in the economic relationship, the transaction is considered a sham and tax law ignores it. It does not matter how many complicated steps and documents are produced. In the VI scam situation, if you want to avail yourself of the credit, you must actually move to the VI and become resident there. The law requires a "bona fide" residence. And, more importantly, your sources of income must emanate from the VI or must be effectively connected with a trade or business in the VI.
For Example: If you have a successful brokerage business, you can move to the VI, but if you continue to generate most of your income from clients located in the continental U.S., your income is not VI source and you are not entitled to the credit on that portion of your income. The legislative history of IRC Sec. 934 states that no credit is available for those with income generated in the continental U.S. or from sources of income outside the VI:
"in no case should this [goal] be attained by granting windfall gains to taxpayers with respect to income derived from investments in corporations in the continental United States, or with respect to income in any other manner derived from sources outside of the Virgin Islands."
S. Rep. No 1767, 86th Cong. 2nd Sess. 4 (1960)
pageokThe Sham Transaction Doctrine
pageokThe VI tax shelter, with minor variations, generally operates as follows: Taxpayers are advised to establish certain contacts within the VI that appear to support residency -- then terminate their existing employment relationship. Promoters then form a limited partnership (or similar entity) in the VI with the taxpayer as a partner and the entity elects to be taxed as a U.S. partnership. Promoters then qualify the entity under the EDP by completing the necessary paperwork. Note: merely complying with the technical requirements to form an entity does not determine how the entity will be taxed.
The partnership then contracts with taxpayer's current employer to provide the taxpayer's services through the partnership; thus, the taxpayer winds up providing the same services to the same employer, except a VI partnership is interposed between the taxpayer and the employer. Often, as part of the scheme, the employer treats the entity as an independent contractor and stops making payroll tax payments on the amounts paid to the entity.
The taxpayer then asserts receipt of partnership income from a VI partnership and claims the 90% credit on partnership income. Of course, nothing of substance has occurred: the taxpayer is providing the same services for the same employer and the VI partnership is nothing but a sham entity designed to take advantage of the 90% tax credit.
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|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.|