Historically, FSCs have been considered feasible only in a C corporation environment; only C corporations can claim a DRD for dividends from an FSC. Likewise, FSCs are normally created under the ownership of a related supplier. There are, however, alternatives for the ownership of FSCs that might increase their effectiveness. In addition, the use of an interest-charge domestic international sales corporation might also be considered under certain circumstances.
Individual retirement account (IRA)-owned FSCs can provide significant tax benefits, particularly in an S environment. Because S corporations are not allowed a DRD, an FSC owned by a related S corporation supplier provides no benefit; in fact, the result is a slightly higher effective tax rate. An FSC owned directly by the shareholders will yield no tax benefit, for the same reason. However, an IRA-owned FSC can be used to receive tax-free distributions from the FSC. A second benefit is that the dividends from the FSC can be reinvested tax-free and remain tax-free until distributed from the IRA. Exhibit 1 illustrates the potential tax benefit of an IRA-owned FSC in an S environment.
Exhibit 1: FSC Potential Tax Benefits No FSC FSC owned by S corporation and/or shareholders Tax on S shareholders: 1. Export profits $100.00 $100.00 2. FSC commission (23.00) 3. Taxable income 100.00 77.00 4. Tax at 39.5% 39.50 30.42 Tax on FSC: 1. Income 23.00 23.00 2. Exemption (16/23) (16.00) 3. Taxable income 7.00 7.00 4. Tax at 34% 2.38 2.38 Tax on FSC dividends: 1. After-tax FSC income 20.62 2. Tax at 39.5% 8.14 Total tax liability 39.50 40.94 Tax on reinvested profits 39.5% 39.5% FSC owned by IRA or plan Tax on S shareholders: 1. Export profits $100.00 2. FSC commission (23.00) 3. Taxable income 77.00 4. Tax at 39.5% 30.42 Tax on FSC: 1. Income 2. Exemption (16/23) (16.00) 3. Taxable income 4. Tax at 34% Tax on FSC dividends: 1. After-tax FSC income 20.62 2. Tax at 39.5% 0 Total tax liability 32.80 Tax on reinvested profits 0%
The use of an IRA-owned FSC requires that the prohibited transaction rules be considered; certain activities that the FSC normally engages in should be avoided. Careful drafting of FSC documents should reduce any exposure.
An additional benefit derived from using an IRA-owned FSC is having key employees, who are not owners of the related supplier, own FSC stock through their own IRAs. As long as the employees own less than 50% of the FSC's stock, the administrative pricing rules can be used to compute the FSC's commissions. This allows key employees to participate in profits generated from export sales without ownership of the company There is also a significant benefit to the employee, not only to the extent of the dividends received from the FSC, but also as a result of the ability to reinvest those dividends tax-flee in the IRA.
Similarly, children and grandchildren of the owners of the related supplier can own FSC stock through IRAs. This can be an effective tool to transfer wealth from the owners of the related supplier to their descendents, with a deductible expense to the related supplier. There may be gift tax implications for FSC ownership by the children, grandchildren and other relatives of the owners of the related supplier, however. In Rev. Rul. 81-54, commissions paid for no significant services to a DISC owned by persons related to the owner of the related supplier were gifts subject to gift tax. There is some question, however, whether this ruling applies to FSCs or even whether it is valid for DISCs. Regardless of the gift tax implications, the advantages of moving assets from the related supplier owner's estate, combined with the tax-free investment of those assets, may be beneficial even if gift tax is imposed.
Consideration should also be given to using Roth IRAs, if the income level is met. Although the owners of the exporter will typically not be eligible to create a Roth IRA, it may be a viable option for the owners' descendents or the exporter's employees. A Roth IRA provides an additional tax benefit; distributions are not taxable if certain requirements are met.
Although an IRA or other qualified plan-owned FSC may be the only option considered when the related supplier is an S corporation, consideration should also be given to this arrangement when the related supplier is a closely held C corporation. The benefits of IRA-owned FSCs are equally applicable, regardless of whether the related supplier is an S or a C corporation.
The first step in setting up an IRA-owned FSC is to create and fund the IRA. Care should be taken in choosing the IRA custodian, as some custodians are not familiar with (and, therefore, are not comfortable with) an IRA investing in a FSC. Some custodians have affiliates that operate as management companies in the more popular FSC locations. While this can provide obvious benefits, it is not required.
Once the IRA is established and funded, the FSC should be set up. The custodian should be provided with written authority to make the payments necessary to set up the FSC. Required payments might include incorporation fees, annual business licenses, set-up fees to the management company and professional fees. Once the FSC is established, the owner of the IRA should instruct the custodian in writing to buy the FSC stock. If there will be multiple owners of a FSC, the instructions should state the percentage each IRA will own.
FROM MICHAEL W. GRANBERG, CPA, OAK BROOK, IL3
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|Title Annotation:||foreign sales corporations; taxation|
|Author:||Granberg, Michael W.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 1999|
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