"Active" FSCs (and IC-DISCs) may qualify for double tax benefits.

The post-NAFTA era has led to additional opportunities for U.S. companies to export products, particularly for entrepreneurial trading companies. Federal income tax law currently provides several tax reduction or deferral incentives for U.S. companies to make export sales, the most common of which is the foreign sales corporation (FSC). If a taxable U.S.-based export trading company currently organized as a C corporation (or as a limited liability company (LLC) taxable as a corporation) properly structures and actively operates as a qualified FSC, the company's qualifying export sales may obtain up to twice the normal Federal tax benefits available to most FSCs. This may mean a permanent Federal tax reduction of up to 30% on income from exporting.

The typical FSC operates as the commission agent of a related U.S. taxpayer that produces export goods. Every time the related U.S. taxpayer makes a qualifying export sale, the FSC earns a commission for having participated in the sale. The U.S. taxpayer can deduct the full commission, while the FSC only pays Federal tax on part of the commission. The safe haven rules to determine the maximum FSC commission generally yield a 15% permanent Federal tax exemption on export income otherwise earned by a C corporation.

Unlike the preceding situation, export trading companies purchase products directly from unrelated parties to sell to their customers. Because there is no related party supplying the export products, the regular rules do not apply. If the export trading company is operated as an active FSC, its maximum export profit is determined by its ability to "buy low and sell high," and not by the safe haven rules. Under Secs. 923(a)(2) and 291(a)(4)(A), an active FSC (whose only shareholders are C corporations) can qualify for a 30% permanent Federal tax exemption on qualifying export profits from the sales of products considered to have at least 50% U.S. content.

The table on page 541 illustrates how the double benefits are achieved. Obtaining these benefits depends on proving that the FSC is truly a separate operating entity. This means the FSC should directly execute contracts with suppliers and customers, have its own bank account, purchase inventory directly from unrelated suppliers, take legal title to inventory, have its own employees and bear administrative costs allocable to export activities. When related parties provide employees or services to the FSC, the Sec. 482 rules must be considered to be sure that the FSC is paying arm's-length prices.

Obtaining these benefits also depends on not being tripped up by other rules. For example, a qualifying active FSC should be incorporated in Guam or the Virgin Islands to avoid the Sec. 884 branch profits tax. An active FSC with corporate shareholders should have at least one U.S. location to allow its income to be effectively connected with the conduct of a U.S. trade or business, permitting the corporate shareholders to obtain a 100% dividends-received deduction for all FSC dividends.

Of course, care must be exercised not to get tripped up on regular FSC operating rules; e.g., all the management requirements of Sec. 924(c) regarding board of directors' or shareholders' meetings, existence of a principal bank account in a qualifying foreign location, and use of a principal (foreign) bank account to pay all cash dividends, legal and accounting fees, and salaries of the officers and directors. Only export activities qualifying for FSC benefits should be conducted by the FSC. Sales of ineligible property (either due to not meeting the U.S. content requirements, or because property is of a type prohibited from obtaining FSC benefits) or sales to ineligible customers should be conducted by a separate entity to avoid an additional layer of Federal corporate income tax.

Double Benefits

                        Commission FSC         Active FSC
                        Exporter   FSC    Exporter    FSC
Export taxable income    $100      $ 0      $0       $100
Commission payment        (23)      23     N/A       N/A
Exemption for FSC income
 (C corporation
 shareholders)              0      (15)      0        (30)
Taxable income           $ 77        8      $0         70
Total taxable income
 of exporter and FSC                85                 70
Permanent reduction
 of income                         $15               $ 30

Just as an active FSC can double the permanent exemption of export profits from Federal income tax, an active interestcharge domestic international sales corporation (IC-DISC) can double the deferral of export profits from Federal income tax from a maximum of 50% to a maximum of 100%. Therefore, individuals, S corporations, partnerships with individual partners, and LLCs taxable as partnerships with individual members currently conducting export trading activities, may also want to consider this technique in relation to IC-DISCs. With the proper overall income tax planning for closely held export trading companies and their owners, companies with export profits as low as $50,000 may save enough in Federal taxes to justify the additional administrative costs.

From Bill Major, CPA, Peoria, Ill.