IC-DISC – THE LAST REMAINING EXPORT INCENTIVE FOR US MANUFACTURERS AND EXPORTERS
An IC-DISC can provide a permanent 20% tax savings (or even more) for qualifying U.S. manufactures and exporters.
Background
For U.S. exporters operating their business via a sole proprietorship or pass-through entity (e.g., limited liability company (LLC), S corporation, limited partnership (LP)), the IC-DISC benefit is essentially tied to the differential between the qualified dividend rates and the ordinary income tax rates. This differential was originally set to expire on December 31, 2010 but Congress extended it in late December of 2010 to December 31, 2012.
Many practitioners strongly believe that this differential will be extended past 2012 even if tax rates on ordinary income increase. In addition to benefiting sole proprietorships and pass-through entities, exporters operating their business via a C corporation can benefit by using the IC-DISC to eliminate double taxation on a majority of their export income, as well as to reduce the need to incur additional payroll taxes on income paid to their shareholders/officers. The IC-DISC is not a tax shelter.
To qualify as an IC-DISC, a domestic corporation must pass two main tests known as the qualified export receipts test and the qualified export assets test. The qualified export receipts test requires that 95% of the gross receipts of the IC-DISC constitute qualified export receipts. The qualified export assets test requires that 95% of the assets of the IC-DISC be qualified export assets. Qualified export assets include accounts receivable, temporary investments, export property, and loans to producers.
Because most of the qualified export receipts categories focus on export property, it is critical that the exporter substantiate that its exports satisfy the definition of export property. Three requirements must be met in order for the IC-DISC to receive income from an export sale. The export property must:
(1) Be manufactured, produced, grown, or extracted in the U.S. by a person other than the IC-DISC.
(2) Be held primarily for sale, lease, or rental for use, consumption, or disposition outside the United States
(3) Have a maximum of 50% foreign content.
Although exporters often think of newly produced property as export property, used equipment and even scrap also qualify.
In its most recent form, the IC-DISC can provide a permanent 20% tax savings (or even more) for qualifying U.S. exporters. In certain cases, it eliminates U.S. tax entirely on the majority of export income. In addition, distributions to individual shareholders are currently taxed at a maximum rate of 15% – providing a way to convert 35% ordinary income to 15% qualified dividend income. Of course, this assumes that the U.S. exporter generates operating profits and is creating taxable income in the U.S.
IC-DISC Structure
The IC-DISC is a “paper” entity used as a tax-savings vehicle. It does not require corporate substance or form, office space, employees, or tangible assets. It simply serves as a conduit for export tax savings. An important feature of the IC-DISC is that shareholders can be corporations, individuals, or a combination of these.
This is how an IC-DISC works:
- Owner-managed exporting company forms a special U.S. corporation that elects to be an IC-DISC. The election is made on IRS Form 4876-A, which must be filed within 90 days after the beginning of the tax year.
- Exporting company pays IC-DISC a commission.
- Exporting company deducts commission from ordinary income taxed at up to 35%.
- IC-DISC pays no tax on the commission as long as certain qualification standards are met such as the 95% qualified export assets and the 95% qualified export receipts requirements of Section 992(a)(1).
- Shareholders of an IC-DISC are not taxed until the earnings are distributed as dividends. However, the shareholders must pay annual interest on the tax deferred.
- Shareholders that are individuals pay income tax on qualified dividends at the capital gains rate of 15%. C Corporation shareholders are automatically considered to have received 1/17th of the IC-DISC’s taxable income even if no distributions are made.
- The result may be a 20% or more tax savings on commission.
Permanent Tax Savings on Global Sales
Permanent tax savings begin with the exporting company deducting the commission it pays to the IC-DISC from its ordinary income, which is taxed at up to 35%. Tax law sets the commission rate, which is based on export sales revenue, as the greater of either 50% of net export income or 4% of export sale revenue. Because the IC-DISC is tax exempt, tax is paid only on distributions to shareholders. Individual and pass-through company shareholders pay income tax on qualified dividends at the long-term capital gains rate of 15%.
Ability to Leverage Cost of Capital
An IC-DISC is more than a tax-savings vehicle. It can also be used as a deferral tool to leverage a company’s cost of capital. IC-DISC earnings need not be distributed to shareholders; they can instead be used to perpetuate and grow the deductible dividend tax rate savings. Tax rate savings are perpetuated by lending accumulated IC-DISC earnings back to the exporting company in return for a note and interest. The exporting company can deduct the interest expense, and interest income is considered a dividend to the IC-DISC shareholders. Reinvesting IC-DISC earnings back into the exporting business results in additional tax rate savings and diminishes the group’s cost of capital.
Opportunities to Create Management Incentives
Businesses can also use ownership in the IC-DISC to provide incentives. Exporting company management and other personnel can be named as shareholders, which allows them to benefit from additional cash flow created by increasing global sales.
Means to Facilitate Succession Planning
An IC-DISC offers a number of ways to execute a succession plan. Among these, ownership in the IC-DISC can be used as a means of generating cash, which can be distributed to shareholders in a tax-advantaged manner. IC-DISC shareholders participating in a buyout of current or previous shareholders can leverage these tax-advantaged IC-DISC earnings to pursue the buyout plan.
Conclusion
For U.S. exporters, the IC-DISC is the only remaining tax-saving opportunity. If you are unsure about whether or not an IC-DISC will work, ask the following questions:
- Do you have any transactions outside of the U.S.?
- Do you use overseas distribution?
- Does your product cross any borders?
- Are you generating operating income?
If the answer to any of these questions is yes, an IC-DISC could be a valuable tax-savings vehicle for your business.
On the surface, the rules covering the IC-DISC may seem simple. However, to maximize the tax benefit, a qualified IC-DISC advisor should be engaged. Many times an IC-DISC expert can double if not triple the tax benefit the IC-DISC provides by applying their in-depth understanding of how to structure the IC-DISC and using the complex advance pricing rules that the Internal Revenue Code allows for determining the tax benefit. A firm that has proven IC-DISC expertise, offers fixed fees, and optimizes the IC-DISC on a transactional basis (which almost always provides the best result) should be chosen.
SEC “Seeking Small Business Input”
In line with President Obama’s recent Executive Order relating to regulation and the regulatory environment the SEC is seeking input on topics that specifically impact smaller reporting companies.
In the request for comments they state “We are particularly interested to hear your views on rules that affect smaller reporting companies, as well as smaller companies that are not subject to the Commission’s reporting requirements but seek to raise capital in the exempt markets.”
The SEC request is looking for comments within the following 3 areas where you can post and read comments posted by others:
- Regulations and Exemptions Relating to the Offer and Sale of Securities
- Disclosure and Reporting Requirements
- Updating Commission Rules to Promote Economic Growth
As of today there are very few comments posted and most of them relate to exempting smaller reporting companies from the XBRL requirements citing cost constraints.
I urge everyone in the smaller reporting company arena to take advantage of the opportunity to make suggestions.
The Hire Act of 2010 Extends The Statute of Limitations for Failure to Report Certain Foreign Activities
Overview
Among the provisions of the Hiring Incentives to Restore Employment (“HIRE”) Act, enacted into law March 18, 2010, is Section 513(c) that provides that the three-year period of limitations during which the Service may assess additional tax does not begin to run until all of the information required under Internal Revenue Code (“IRC”) sections 6038, 6038A, 6038B, 6046, 6046A, and 6048 is filed (e.g., Forms 5471 or 8865), and that the limitations period extension is not limited to adjustments related to the information required to be reported by these sections, but will apply to all items for the taxable period. Section 513(c) of the HIRE Act also authorizes a new six-year period of limitations for the assessment of tax related to an income omission in excess of $5,000 attributable to foreign financial assets required to be reported under new IRC section 6038D.
Background
Taxes generally are required to be assessed within three years of the filing of the return, regardless of whether the return was timely filed. There are several exceptions to the general three-year rule. These exceptions include, for example, instances where a return is false or fraudulent (unlimited limitations period), there is a substantial omission of gross income (six-year limitations period), or a taxpayer fails to include on any return a Form 8886, Reportable Transaction Disclosure Statement, with respect to a listed transaction (limitations period does not expire before the date which is one year after the earlier of (a) the date Service is furnished with such information or (b) the date a material advisor furnishes the taxpayer’s name under the list-maintenance rules).
Prior to enactment of the HIRE Act, IRC section 6051(c)(8) provided that the three-year limitations period did not expire until three years after the date on which the Secretary of the Treasury was provided with information required, for example, on Forms 5471, 5471, or 926. The suspended limitations period generally has been applied only to the issues or items related to the foreign information reporting – not the entire tax return.
Section 513(c) of the HIRE Act provides that the three-year period of limitations does not begin until the foreign reporting information has been furnished to the Service. The provision clarifies that the period of limitations is suspended for all items on the return, not just items related to the omitted information reporting required under IRC sections 1295(b), 1298(f), 6038, 6038A, 6038B, 6046, 6046A, and 6048. Thus, it applies to any reporting required under the authority of these sections and the regulations there under (including Forms 926, 3520-A, 5471, 5472, 8621, 8858, and 8865). Section 513(c) of the HIRE Act further provides a new six-year limitations period for the assessment of tax on understatements of income attributable to foreign financial assets.
For this purpose, an understatement of income attributable to foreign financial assets is an omission from income in excess of $5,000 and the omitted income is attributable to an asset with respect to which information reporting is required under new IRC section 6038D. New IRC section 6038D requires individual taxpayers with an interest in a “specified foreign financial asset” during the taxable year to attach a disclosure statement to their income tax return for any year in which the aggregate value of all such assets exceeds $50,000.
Impact on Financial Statement Reporting
The period of limitations may also affect accounting for income taxes under ASC 740 (formerly known as FAS 109), such as tax liabilities that a taxpayer may have recorded with respect to uncertain tax positions. For example, in the case of a failure to comply with the foreign information reporting provisions referred to in IRC section 6051(c)(8), a previously recorded uncertain tax position liability that may have been released due to the expiration of the statute of limitations may be required to be recorded again as a result of the suspension of the limitations period under IRC section 6051(c)(8).
Implications
Taxpayers must be diligent in ascertaining the extent to which foreign operations and information is gathered and reported as required. The failure to identify and properly include such information as required may suspend the start of the limitations period, such that the Service may assess additional tax.
For a complete technical explanation of the Hire Act prepared by the Joint Committee on Taxation, click here
Form 5471 – A Harsh New Reality for US Shareholders of Foreign Corporations
Who is required to File Form 5471?
Certain US persons who are shareholders (both corporate and individual shareholders), officers or directors of a foreign corporation may be required to file Form 5471 on an annual basis. Here, is a link to the IRS Website on filing requirements l.
There are four categories (including corporate shareholders) that may be required to file the form, as follows:
1. A US person who is an officer or director of a foreign corporation in which any US person owns or acquires 10% or more of the stock of the foreign corporation.
2. A person who becomes a US person while owning 10% or more of the stock of the foreign corporation.
3. A US person who had control of a foreign corporation for at least 30 days.
4. A US shareholder who owns stock in a foreign corporation that is a controlled foreign corporation for an uninterrupted period of at least 30 days and who owned that stock on the last day of the that year.
What Information is Required?
The required information may be as minimal as the identification of the US shareholder and the name and address of the foreign corporation – or it may be as extensive as a comprehensive balance sheet and income statement converted from multiple foreign currencies into US dollars, including computations of cumulative earnings & profits and disclosure of related party transactions.
When is Form 5471 Due?
Form 5471 is due with the income tax return of the affected shareholder. For most corporations, that would March 15th or the extended due date. For most individuals, that would be April 15th or the extended due date.
How Long does it take to Prepare?
The IRS estimates the average time to prepare Form 5471 is approximately 38 hours, exclusive of record keeping time and the time required to learn about the relevant law and the instructions. The learning time could be much longer for someone who is not familiar with the pertinent sections of the tax law.
Harsh Penalties – A New Reality
For many years, it was extremely rare to get any IRS reply regarding a filing, even if the form was very late. The IRS has been warning in public statements that the Form 5471 penalties were coming and would be automatically assessed by the IRS computer. The penalty under IRC Section 6038(b)(1) is $10,000 for each late or incomplete Form 5471.
Remember, very often, the information on this form does not result in any taxable income or tax due for the taxpayer. So, the $10,000 penalty is a “disclosure” penalty, unrelated to the actual tax consequences of the information provided on the Form 5471. The $10,000 penalty is real and is now being automatically assessed.
If the failure continues for more than 90 days after the date the IRS mails notice of the failure, an additional $10,000 penalty will apply for each 30-day period or fraction thereof during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000.
Why should a US Corporation with NOLs still be Concerned?
With the economic downturn, many US corporations have build-up significant net operating losses (NOLs). Thus, management may not be overly concerned about filing Form 5471, based on its belief that the company’s NOLS will shelter any potential exposure. However, because the failure to file Form 5471 results in a penalty (not a tax), NOLs do not any shelter this exposure.
Thus, the often unforeseen result is a FIN 48 liability and hit to the P&L for $10,000 for each unfiled Form 5471. For example, a US corporation with four foreign subsidiaries for which Forms 5471 have not been filed in the three most recent tax years would be required to accrue a $120,000 (a $10,000 penalty for each unfiled Form 5471 x 4 subsidiaries x 3 tax years) FIN 48 liability and current year P&L expense, which can be a huge P&L hit for company with no US taxable income.
Additionally, the three year statute of limitations with respect to the underlying tax income tax return (Form 1120, 1040, etc.) does not start running until Form 5471 is properly filed, as the return was not complete at the time it was originally submitted.