What’s the big deal about offshore banks?

Dear Cecil:

What's the rant with offshore banking? It's a big thing in every John Grisham novel, but what's the real story? Forget ethics and morals. If I put in my paltry hundred bucks a week, will it make more than at my local bank? Will they even talk to me about starting an account with a hundred bucks? Most important, if I don't pay taxes on it here, do I have to pay taxes in the Cayman Islands or the Bahamas, etc.?

Cecil replies:

OK, we’ll forget about ethics and morals. These aren’t essential to survival in the modern world. However, a big bankroll is. Therefore I’ll ignore the part about the hundred bucks and pretend you’re a person of means. Those island bankers are laid-back and friendly, but they don’t want to deal with insignificant crumbs.

All right, then. This being the age of specialization, I turned to Sam, pillar of the Straight Dope Science Advisory Board and international business consultant. His report:

“I’ll assume we’re talking an honest bank located in a tax haven — that is, a country that has no (or very, very low) tax rates, such as Bermuda, the Bahamas, the Cayman Islands, Liechtenstein, the Channel Islands (Jersey and Guernsey), and a few others. The banks provide services that let you invest in almost anything, anywhere. So you can think of your account as an investment account rather than just a bank savings account.

“Let’s say that you, a U.S. citizen and resident and therefore a taxpayer, put some money into the Bank of Bermuda. How can you make that work to your advantage?

“(1) You put the money in a regular investment account in your name. The money earns interest. If you had put that money in a U.S. bank, the bank would send you a 1099-INT statement at the end of the calendar/tax year, indicating the amount of interest the account earned. That amount is taxable income. The 1099 also goes to the IRS, so you’d better report it on your income tax forms.

“The Bank of Bermuda has no obligation to report investment earnings to the U.S. government. Thus, if your money is in the Bank of Bermuda (or any offshore bank), you would know how much taxable income it earned, but nothing would have been reported to the IRS.

“So, the first way people profit from an offshore bank is by cheating on their income tax. They omit the earnings from their tax forms and hope the IRS won’t notice or track it down. However, if the IRS does go after you, it’s going to get you for tax evasion, you chiseler.

“(2) You use the account for money laundering, parking ill-gotten millions in the account to conceal their origin. At $100 per deposit, we’ll assume this is not your main concern.

“(3) You set up an investment trust fund at the offshore bank. Broadly speaking, if you set up a trust fund in the U.S., the fund is a taxable entity, so it pays tax on earnings each year. (There are exceptions, like 401(k) retirement trust funds.) If a U.S. trust fund earns an investment return of $100, around $35 goes to the government. The trust fund pays you the remaining $65, which is taxable income to you.

“However, for a trust fund in a tax haven, the fund itself is not taxed. The investment earnings accumulate and compound tax-free — obviously a huge advantage. When the money is paid out to you, it becomes taxable, but you’re back in situation (1), in which the government might not know you failed to report the income. Since we know what a law-abiding guy you are, Mr. Forget-the-ethics, we won’t dwell on that. The major advantage of an offshore trust, assuming you want to follow U.S. law and report all income as you should, is that the money can accumulate tax-free. This is the same advantage offered by a 401(k) plan or similar retirement fund such as an IRA, except that the 401(k) plan or IRA is more heavily regulated and there are maximum allowable contributions. Offshore trusts have no such maximums, so they’re very attractive to those wealthy enough to take advantage of them.

“As for you, with your $100, these are legitimate banks that accept small deposits. But when you factor in postage and bank fees, the tax savings may not do much more than buy you two six-packs instead of one.”

Send questions to Cecil via cecil@straightdope.com.

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