Exporter benefits: exploring the tax benefits of IC-DISCs.
An IC-DISC is the least talked about but most potent all tax shelters. if Vu happen to be an export, VI IC-DISC is a U.S. corporation that exists and [Unctions entirely on paper. ICs either a subsidiary or a sister company of a U.S. exporter, to which the exporter either pays a commission or sells its products (which are then exported by the IC-DISC). The U.S. exporter's business partners need not be aware of the IC-DISC's existence. K.:-DISC rules allow an exporter to either convert ordinary income into a qualifying dividend, or indefinitely defer U.S. income taxation on 50 percent of its net income Erna] the first SIO million in foreig-n sales. It's a significant tax benefit available to any business that exports: movie producers, software developers, architects. engineers and manufacturers.
To qualify as an 1C-DISC a U.S. corporation must mi 'et the following:
* Be organized in a U.S. state;
* Have at least 95 percent If its gross receipts consist of qualified export receipts;
* The adjusted basis of its qualified export assets at the eh Ise of the taxable yrar must equal or exceed 95 percent of the sum of the adjush
* cl basis of all assets of the corporation at the close of the I axable year;
* It does not have more than one class If stock. and the par or stated value of its outstanding stock is at least S2,500 on each day of the taxable year;
* It must make an election within 90 clays of the first tax year in be treated as a DISC by filing IRS Form ,18711-A and receiving consent of all shareholders an existing corporation must elect within 90 clays prior to the start of the new tax wart;
* Nlaintain separate books and records:
* Is an eligible corporation tax exempts. S corps and certain other corporations cannot lx DISCs: and Is not ii the same control group as a foreign sales corporatii in. IRC Sec. 992 and Treas. Reg. Sections 1.992-1 and 2. Al! Code references are to the Internal Revenue Code of 1984 as set forth in Title 26 of the United States Code).
Qualilied export receipts are defined in IRC: Sec. 993(a) I to include receipts and services related to such receipts from the sale. exchange. lease or rent of export property. Services telated to the sale. exchange, lease or rent of export property may include warranty. maintenance, repair and transportation. Qualified export receipts do not include receipts and related services from the sale. exchange, lease or rent for ultimate use in the United States [WC See. 993ax21.
Expi in property is: N lannfactured, produced, grown or extracted in the U.S. b someone other than the IC-DISC: dd, leased, rented in the ordinary ciiiirse of business outside the United States will be deemed satisfied if delivered to a carrier or freight forwarded lbr shipment outside the t 'nited Stat. s : and
* Having at leasi preent foreign content.
FRC.: Sec. 99:;.c. With the exception of copyrights used in the motion picture or recording industries, export property does not include intellectual pmperty of' any kind I IRC Sec. 993iciiiii.
Qualdied export assets must be documented in the IC-DISC application and include assets used primarily in connection with the sale. leases rentals rental, handling, transportation, packaging. assetil thy or servicing of export property, as well as certain accounts receivable, bank accounts, producer's loans Joan by the DISC if its ;it accumulated tax deferred profits to its parent manufacturint company) and obligations.[IRC Sec.993(b)].
If a corporation fails to qualify as a DISC because it does not meet the 95 percent gross receipt or 93 percent export assets tests, it can qualify by distributing to shareholders its gross receipts, which are 1101 qualified. or all of the assets that are not qualified Sec. 992(c)].
IC-DISC Structure and Tax Benefits
IC-DISC is exempt from federal income Lax IRC Sc('. 991). State taxation is less certain, with approximately hall Of the states following the federal tax treatment and the remainder taxing IC-DISCs. As a practical matter, an IC-DISC is often organized in Delaware or another state that does not tax income.
Following organizatim. the corporation:
* Files IRS Form 4876-A;
* Enters into a commission agreement with the U.S. exporti I he agreement will outline the sem its to be performed by the IC-DISC for the sale or export property);
* Opens a bank account;
* Maintains its own books and records to track commission payments; and
* Annually riles IRS Form 1120-IC DISC and any required state income -tax returns.
Thc IC-DISC: is effectively a transfi*r-pricing regime: income is transferred In ent I he LS. exporter to the IC-DISC: by allowing the exporter to deduct the commission paid I1RC Sec. 994 and Treas. Reg. Section 1.994-1 a The income is transferred either b paving the IC-DISC a commission _for its services or by selling products to IC-DISC which it then exports. Even though all transactions with IC-DISCs have no substance, the distitution between the payment of commission and tile resale of' products is not purely semantic.
A commission DISC is protected by the safe-harbor rules of IRC Sec. 994 tsec belt a buy/sell DISC must satisfy the transfer pricing rules or IRC Sec. 482.
To qualify lor the sale-harbor of IRC Sec. 994. the commission cannot be greater than 4 percent of IC-DISC's qualified export receipts on reselling the property; plus 10 percent of' export promotion expenses, or 50 percent of the combined taxable income from export sales of the exporter and the IC - DISC. plus 10 percent of IC-DISC's export promotion expenses [IRC Sec. 994(a)].
Note: It's 4 percent of up to $10 million in export sales or 50 percent of taxable income generated on the first $10 million in export sales this varies based on prifitability.. which.tre two very differenteea in's.
Ownership of an IC-DlSC is not restricted. and there is no limitation on the number of IC-DIS's Orme It may be a subsidiary of the exporter. have common shareholders or have one of the more advanced ownership structures discussed below.
The exporter itself may be a ClflS coil), an 1.1k: taxed at any form or an individual. S corps, partitersliips and disregarded entities are oficn used as shareholders of 1C-1)ISCs to allow for flowthrough income tax treatment of dividend distributions by IC-DISCs.
The tax on IC-DISC.'S income is deferred to the extent not distributed to the shareholders. The tax may be deterred only it the first Si() million of qualified export receipts I I RC See. 995t bit 1)(E)]. When qualified export receipts exceed $10 million, shareholders are taxed in a deemed dividend From the IC-DISC at the preferential dividend rate [TRC Sec. I 'The sharehoders, pay an annual interset charge lat one-year Treasury constant maturity yield which is currently 0.11 percent] on the lax deferred [IRC Sec. 995(f) (1)]. The interest charge is computed on IRS Form 8.1.0,1.
II the IC-DISC distributes its income currently, shareholders are taxed at the preferential 20 percent qualilYing dividend tax rate [Treas. Re. Section 1.995-1(1)(2)]. Thus, even without a delerral, the use of an IC-DISC structure allows the exporter to deduct commission paid to an IC-DISC at its ordinary income tax rate, and then tax the same commission amount to the shareholders at the 20 percent tax rate.
The IC-DISC Planning Example
Jerry manufactures and distributes breaklasi cereal. In 201-1 his sales wcrc SI 1 million. of which S 1 0 million were attribitted to sales in Europe and the remainder in the United States. Net income was $3.5 million, with $2.4 million attributable to Europe.
Jerry forms a Delaware corporation, transfers ownership to an irrevocable trust and names his child. Cosmo, as the trust beneficiary.
The trust makes an IC-DISC election for the Delaware corporation and has the corporation enter into a commission agreement with Jerry.
The commission that- Jerry can pay to the IC-D1SC is the greater of $400.000 (4. percent of lOreign sales), or $1.2 million i.50 percent of net income attributable to loreign sales. Each yearierry deducts S1.2 million and transfers the same amount out or his estate. lithe IC-DISC retains the S1.2 million, a nominal interest charge is paid. lithe IC-DISC: dividends out the S1.2 million, Cosmo pays a 20 percent Lax on dividends received. Even with a current dividend and no deliTral, Jerry achieves an income tax arbitrage of 5235.200 per year at a 39.6 percent tax rate an admirable result.
le-DISCs are a true tax shelter for a small or mid-size exporter, and have been quickly gaining popularity over the past Few years. However, the rules are complex and the tax benefit can vary widely based on We structure of the 1C-DISC. Expert counsel is strongly advised.
Jacob Stein, Esq. is a partner at Klueger and Stein, LLP. You can reach him at Jacob@lataxlawyers.com.
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|Date:||Dec 1, 2014|
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