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After Panama Papers, rich will still want tax shelter

Money in an envelope behind the back
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Tax avoidance is like a game of musical chairs — wealthy people are going to keep playing even if fewer seats are available.

The explosive Panama Papers leak this week that revealed many hidden offshore accounts held by rich and powerful people worldwide has heightened calls for authorities to crack down on such tax-ducking shenanigans.

At the same time, the Obama administration has introduced new rules that would make it harder for companies to shield income from U.S. taxes by relocating their corporate headquarters overseas through so-called inversions.

But experts say that even before those events, it was already getting more difficult — and riskier — in recent years for wealthy Americans to hide their incomes.

However, they also said they expect many rich people to continue pushing the envelope as they seek to keep more of their money from the tax man.

"Let me tell you something, the rich are they worst ones, they're the ones who don't want to pay it," said Henry Obadiah, founder of Rock & Hammer Tax Service in New York.

"The ones who can afford it the most hate paying taxes the most," said Obadiah. "They'll do anything to avoid paying taxes."

Obadiah noted that a common tax avoidance tactic by wealthy people has been "to set up offshore corporations in the Cayman Islands or these other tax havens, where there is no corporate tax, and they'd funnel all of their incomes over there, and they'd pay nothing in taxes."

But recently "it's gotten a lot harder to shield their income," Obadiah said.

One major reason is that the federal government has become more aggressive at pursuing civil and criminal penalties against people who fail to file disclosures of overseas accounts.

Obadiah said the civil penalties for failing to file the disclosure, known by the acronym FBARs (the IRS' abbreviation for foreign bank and financial accounts), can be significant.

And "people would panic thinking they were going to jail" when they received a notification about a possible FBAR violation, he said.

Because of such fear, the number of FBARs filed increased considerably in recent years.

Last year, the number of foreign-account filings topped 1 million — an all-time high, and an 8 percent increase over 2014's filings, according to the IRS. And the agency noted that FBAR filings have grown on average by 17 percent per year during the last five years.

"Taxpayers here and abroad need to take their offshore tax and filing obligations seriously," said IRS Commissioner John Koskinen. "Improving offshore compliance has been a top priority of the IRS for several years, and we are seeing very positive results."

Joseph Gulant, an attorney and tax expert at the firm Blank Rome, said, "the noose is really tightening on these off-shore structures."

As a result, "the field of play is much more constrained than it used to be" for rich people looking to reduce their tax exposure.

The pressure is not only on rich people who use such accounts or off-shore corporations, but also on the overseas banks and countries that historically had accommodated efforts by the wealthy to dodge taxes, Gulant said. The banks and countries have increasingly submitted to such pressure.

In 2014, a U.S. law went into effect to require foreign financial entities to disclose information about American clients or face financial penalties themselves.

Gulant's firm has had clients come into the office and reveal they held overseas accounts or had other structures set up to shield their money from taxes, and asked "what should we do now?"

Some of those clients, he said, are children or grandchildren of people who had escaped the Holocaust, and who only became aware of the existence of overseas accounts in their inheritance after the death of a parent or grandparent.

Gulant's recommendation is to disclose everything to the U.S. government, even if the accounts or structure were not set up to duck taxes.

"You're not going to be able to hide this stuff forever," he said.

He also recommends that clients don't set up overseas accounts as mechanisms to reduce their tax exposure, even if the structure would arguably be legal.

"It's just not worth the headache, in my view, that comes with this stuff," Gulant said. "It's being carefully watched, it's being systematically shut down."

Getting some people to reveal their overseas accounts or shell corporations isn't always easy.

"From my experience, the people that are involved with these things, they're not bad people," Gulant said. "But the old paradigm is this is what wealthy people did, this is what you do to hide your taxes."

"We've had people who have shown up at the office and go through their portfolio of assets, and we'll advise them what the penalty is going to be" if they don't disclose the accounts to the government, or pay taxes on them, Gulant said. "And then we never hear from them again," he said with a laugh.

In other cases,he said, "we've had people who have continued to engage in a series of schemes, if you will, against our advice or judgment, and some of them have actually paid the price ... civil and criminal."

Gulant said that post-Panama Papers he expects some wealthy people to continue tax reduction strategies, which can include "strategies with off-shore trusts."

"There are some legitimate trust structures that can be utilized," he said. "But you have to be very careful, because if you don't do it right, you could put yourself in a situation where the tax situation is worse."

Sometimes, he said, the rich throw that kind of caution to the winds and set up an offshore asset protection trust in a place such as the Marshall Islands or the Cook Islands, which offer both a tax-free environment and privacy about who actually is controlling the trust.

Those people think "I'm going to transfer all these assets to an island somewhere in the Pacific and my creditors, including the IRS are not going to be able to get it," Gulant said. But that belief won't necessarily withstand the legal power of the U.S. government.

Another potential legal strategy — even in the face of tightened rules about such inversions — is to move an existing company overseas to a country that has a lower corporate tax rate than the United States, he said.

And Americans can renounce their citizenship to avoid U.S. taxes. In 2015, nearly 4,300 Americans gave up their citizenship, an increase of more than 20 percent, the third year in a row for the record to be broken.

Individuals who are willing to do so can also move within the United States to reduce, often greatly, their annual tax hit.

David Tepper, the hedge fund billionaire who founded Appaloosa Management, filed to move his personal tax residency in December from New Jersey to Florida. He also officially moved Appaloosa out of New Jersey to Miami in January.

Both moves could save Tepper hundreds of millions of dollars in taxes, since Florida has no income taxes, unlike New Jersey, where the top income tax rate is 8.97 percent. People close to Tepper told CNBC he made the move to be closer to his mother and sister, who live in Florida.

Obadiah said other legal means of reducing tax exposure for the wealthy include contributing to defined benefit plans. Self-employed people can sock much more money into such retirement plans by contributing both as an employee and employer than people who are hourly or salaried employees of a company.

Another strategy, Obadiah said, is to make contributions to a "captive insurance" plan, a means of self-insurance "where you can legally put in a significant amount money."

"It's good for people who have high need for insurance, like doctors or construction companies," he said.

And although it skirts the line legally, Obadiah has seen cases of wealthy "people deferring cashing checks [they receive] to avoid claiming the income in that year." He noted that under the law, income is supposed to be booked in the year that it is received, even if they actual check isn't cashed until the following year.

"Rich people are definitely the most aggressive" in trying to reduce their annual taxable income, he said. "They're in the higher tax bracket, they get the most benefit from reducing their income."