5. Offshore entities offer some potential for tax savings, but have many potential pitfalls. Many blockchain startups use an offshore entity to conduct the ICO in order to avoid U.S. income taxes. This is easier said than done. The rules applicable to offshore entities are exceedingly complex and definitely require professional tax advice to navigate. Here are a few takeaways:
- Foreign corporations engaged in a US trade or business are subject to tax on their income that is “effectively connected.” Income is effectively connected if it is derived from assets which are used in or held for use in the US, and the activities of the US business were a material factor in the realization of the income. Long story short, if you set up a foreign corporation but otherwise conduct your ICO from the U.S., the income from that ICO will still be subject to US income tax.
- Foreign corporations owned more than 50% by U.S. Shareholders are called Controlled Foreign Corporations (“CFC”) for federal income tax purposes. CFCs are subject to a complex set of rules under “Subpart F” meant to prevent tax avoidance. The U.S. shareholders of the CFC must pay income tax on certain types of income, which might include the proceeds of an ICO depending on the circumstances.
- If you have signatory authority on a bank account belonging to the foreign corporation, you will have to disclose that account to the IRS by filing an FBAR if the account balance exceeds $10,000 at any time during the year. Failure to file an FBAR can result in penalties as high as $250,000 and five years in prison.
- In addition to the FBAR, you may have additional filing requirements if your foreign corporation is a CFC. These include Form 5471 and possibly Form 8621, which will add considerably complexity and cost to your annual tax return filings. There are also civil and criminal penalties for failure to file these forms.
At the end of the day, establishing a foreign corporation is relatively easy, but laying the proper groundwork and making sure your foreign corporation accomplishes its purpose takes very careful planning and legal advice.
6. Don’t forget about state or local taxes. While tax conversations tend to focus on just federal income taxes, don’t forget about taxes at the state or local level. Most states piggy-back off of the IRS, so if your ICO income is taxable at the federal level, it is probably taxable at the state level as well. Some states have tax rates of over 10%, like California and New York, that will need to be factored into your startup’s budget.[/vc_column_text][/vc_column][/vc_row]