It's Tax Time

~~~ BLOG HAS MOVED ~~~

Click here to see where my blogg has moved   My Blog Has Moved

INTEREST CHARGE – DOMESTIC INTERNATIONAL SALES CORPORATION

What is an Interest Charge – Domestic International Sales Corporation?  Better known as IC-DISC, was originally created as a Domestic International Sales Corporation in 1971 to stimulate U.S. exports, IC-DISC is a variation of the original creation. It allows U.S. owners of a qualified business tax savings on a calculated percent of qualified export sales.

What are the tax savings?  Instead of the exporting company paying up to a 35 percent federal corporate tax on 100 percent of export NET income, a tax deductible commission is paid to the IC-DISC Corporation.  When the commission received by the IC-DISC Corporation is distributed to its shareholders, they pay an individual tax rate based on the qualified dividend tax rate.  Depending on the shareholder’s ordinary income tax rate that could be between ZERO to 20 percent in 2013.  For example if the Corporation is in the 35 percent Federal tax rate and a shareholder has a 15 percent dividend tax rate, the shareholder realizes a 20 percent federal tax savings.  This is a permanent tax savings and not reversed in later years. 

Depending on how the IC-DISC is set up, IC-DISC income may or may not be considered income that is subject to the additional 3.8% Medicare Tax.  There is alot of ambiguity and no tax court cases to rely on.  In general the 3.8% Medicare Tax is a tax on investment or passive income.  If the IC-Disc is set up as a Commission DISC [see the discussion on how a Commission DISC works on page 2], the dividends will be considered coming from a passive activity, then the Medicare Tax applies.  However if the IC-DISC is set up as a Buy/Sell DISC where the export activities occur in the DISC corporation [see the discussion on how a Buy/Sell DISC works on page 2], then the income is not from a passive activity and Medicare Tax on Investment Income does not apply. However this has not been tested in court and it is my opinion the IRS will take the position that the Medicare Tax still applies because the word dividend is used in the code.  But I believe the IRS would be incorrect and tax should not apply because the Buy/Sell DISC is not a passive activity and the distributions out of the DISC are not true dividends, just taxed as a dividend.  As in many other cases the IRS could lose in court.  But like I said before this has not been tested in court and taking this position is aggressive and even though, in my opinion, has merit the Taxpayer could lose in court

Unfortunately not all states recognize the IC-DISC, California is one of them.  Some tax consultants take the position that if the IC-DISC is organized in a state outside of California, like Nevada, California tax can be avoided.  However I believe this is incorrect due to California Nexus rules.  Because the DISC and the California export company are related and the economic activity that creates income in the DISC occurs in California, a combined return will be required and tax paid. 

Additional tax savings

There are a number of related planning opportunities associated with this technique. An IC-DISC can be used as a succession planning tool to accumulate cash on a tax-advantaged basis to facilitate a buyout of the Exporter itself. Exporters have also used these entities to provide equity incentives to key management personnel without the drawbacks of granting an equity interest in the Exporter itself. Care must be taken in structuring these types of arrangements if the shareholders of the IC-DISC are not the same as the shareholders of the Exporter, although such arrangement is permitted.

Because the IC-DISC does not pay income tax, and its shareholders are only taxed when distributions are made, other planning opportunities exist if these shareholder distributions are deferred. For instance, the IC-DISC can loan the commission payments back to the Exporter.

Interest paid on this indebtedness generates another deduction for the Exporter, and the interest income is treated as a dividend to the shareholders. The same tax savings described above are effectively realized on the financing transaction. If distributions of commission income are deferred, there is an interest change (which is deductible for corporation shareholders). This interest change is based on the deferred tax liability of the shareholder and the base period Treasury bill rate.

Who should consider forming an IC-DISC?  An IC-DISC may be established at any time during the year by any non-publicly traded corporation that earns significant income from exporting goods, including software, or from engineering or architectural services on foreign construction projects.  The corporation must be organized under the laws of a state or the District of Columbia and meet the following tests:

(1)   At least 95% of its gross receipts in the DISC during the tax year are qualified export receipts.  The 95% rule does not apply to all gross receipts of the export company, just the gross receipts in the DISC.

(2)   At the end of the tax year, the adjusted basis of its qualified export assets is at least 95% of the sum of the adjusted basis of all of its assets in the DISC.

(3)   The DISC has only one class of stock, and its outstanding stock has a par or stated value of at least $2,500 on each day of the tax year (or, for a new corporation, on the last day.

(4)   The DISC maintains separate books and records.

(5)   The DISC is not a member of any controlled group of which a foreign sales corporation (FSC) is a member.

(6)   Its tax year of the DISC must conform to the tax year of the principal shareholder(s) who has the highest percentage of voting power.

How does an IC-DISC work? 

  Commission DISC

(1)   The exporting company forms an IC-DISC corporation, which generally mirrors the ownership structure of the exporting company.

(2)   The IC-DISC charges the exporting company a commission on NET income related to export sales using one of the two following methods, whichever is greater:

·        The ‘Four-Percent’ Gross Receipt Method

·        50% of NET income

(3)    The exporting company fully deducts the commission expense.

(4)   The IC-DISC distributes profits to its shareholders via dividends

(5)   U.S. income tax is imposed on the IC-DISC shareholder’s dividends on the shareholder’s personal tax return.

(6)   No employees are required within the Commission DISC and the entity has no effect on exporting operations.

   Buy/Sell DISC

(1)   The exporting company forms an IC-DISC corporation, which generally mirrors the ownership structure of the exporting company.

(2)   The DISC takes title to the goods it exports and operates as an export subsidiary with employee(s) who handles the export functions such as purchasing, invoicing.

(3)   A commission rate, using the arm's length transfer pricing rules of the IRS regulations (IRC Section 482), is established to pay the related supplier for the goods it takes title of.

(4)   100% of the profits related to export sales are captured at the lower tax rate rather than only the commission element as in (2) above.

(5)   The IC-DISC distributes profits to its shareholders via dividends

(6)   U.S. income tax is imposed on the IC-DISC shareholder’s dividends on the shareholder’s personal tax return.

Other Forms

      There are other forms to be considered. They are as follows:

(a)   Safe Harbor Buy/Sell IC-DISC. The IC-DISC purchases and sells export property. The parent company reimburses the IC-DISC-paid export promotion expenses plus 10 percent. Does not require an IRC Section 482 transfer pricing study.

(b)   Export Invoice Factoring. The IC-DISC purchases invoices (connected to the commissions paid) from the parent company on a non-recourse, discounted basis (e.g., at a 3% or 4% discount rate). Requires an IRC Section 482 transfer pricing study.

(c)   IC-DISC with Foreign International Sales Corporation (FISC).  The IC-DISC owns 100 percent of a FISC that buys and on-sells inventory at a mark-up to foreign customers. The FISC must be located in a jurisdiction outside the 50 states and Puerto Rico. The parent company pays a commission to the IC-DISC for the FISC sales and requires an IRC Section 482 transfer pricing study.

Cautions

The IC-DISC is considered a Tier 1 audit issue by the IRS and requires additional due diligence to ensure compliance and substantiation of company practices.  Tier I audit issues are of “high strategic importance” to the IRS and have a significant impact on one or more industries. Tier I issues may involve a large number of taxpayers, a significant dollar amount, a substantial compliance risk or high visibility. Issues will be placed in this category if the IRS has an established legal position or directive out on the issue.  In other words, if you form an IC-DISC, it could be a “red flag” for audit.  Normally if a taxpayer is honest and follows the rules, with transparency, an audit should not deter them from taking appropriate tax positions.  The IC-DISC rules are complex and time consuming, if the IC-DISC is set up improperly, calculated incorrectly or lacks substantiation, your business could face additional taxes, penalties, and interest.  Thus it is imperative that you seek proper tax advice from a CPA or tax attorney.

Applicable tax codes 

(1)   Internal Revenue Code § 995(f)

(2)   Treasury Regulation § 1.995(f)-1(d).

(3)   IRS Instructions for Form 1120-IC-DISC

(4)   IC-DISC Audit Guide [LB&I-04-0212-003]

Summary 

The Interest Charge – Domestic International Sales Corporation, also known as IC-DISC, allows qualified US exports a tax deductible commission from business net income equal to 50 percent of NET export income.  That commission is then distributed to the shareholder of the IC-DISC Corporation as a dividend and the shareholder pays an individual tax rate based on the qualified dividend tax rate when the dividend is distributed

 

Domestic Production Activities Deduction

 

What is Domestic Production Activities Deduction? 

The Domestic Manufacturing Deduction also referred to as DPAD or the Section 199 deduction is a tax deduction for businesses that perform manufacturing and other qualified production activities in the United States and Puerto Rico [US-based].  It was established in 2004 by the American Jobs Creation Act of 2004 to increase the investment in domestic manufacturing facilities. 

What lines of business qualify for the dedication?

The following lines of business qualify for the Domestic Production Activities Deduction. They MUST be US-based:

• Manufacturing and production
• Selling, leasing, or licensing items that have been manufactured
• Producing or growing agricultural or horticultural products
• Marketing US-based agricultural or horticultural products
• Mineral extraction
• Oil-related production activities.  This includes production, refining, processing, transportation, or distribution of oil or gas, or any primary product from oil or gas
• Production of electricity or water
• Qualified film production
• Selling, leasing, or licensing motion pictures that have been produced in the United States,
• Construction services including building and renovation of residential and commercial properties
• Engineering and architectural services
• Software development, including the development of video games.

The following activities do not qualify

·        Sale of food and beverages prepared by the taxpayer at a retail establishmen

·        Transmission or distribution of electricity, natural gas, or potable water

·        The lease, rental, license, sale, exchange, or other disposition of land.

·        Construction services those are cosmetic in nature, such as painting

·        Leasing or licensing items to a related part

What entities qualify for the dedication?

·        Corporations, both “C” and “S” corporation

·        Partnerships and Limited Liability companies

·        Sole Proprietorships

·        Agricultural Cooperatives

What are the tax savings? 

The tax savings is a tax deduction equaling to the lesser of

·        Nine percent of NET Qualified Production Income

·        Nine percent of taxable income, without regard the DPAD

Also, the deduction cannot exceed fifty percent of W-2 wages and reportable commission paid to employees that contribute to the qualified activities.

Qualified Production income is the net of gross income from the qualified production activities less all expenses directly related to the qualified production activities.  For a business with only one line of business, the expensed deducted will be the same as total expenses. For businesses with multiple lines of business, income and expenses will need to be allocated.

General Rules and Safe Harbor

The Domestic Production Activities Deduction is limited to income arising from qualified production actives in whole or significant part US-based. Under a "safe harbor" rule, businesses can take the deduction if at least twenty percent of the total costs are the result of direct labor and overhead costs from US-based operations.

If any part of manufacturing or production activities is outside the United States and Puerto Rico, then businesses must use either the safe harbor rule or allocate costs using the facts and circumstances of their business.

Cautions

The DPAD is considered a Tier 1 audit issue by the IRS and requires additional due diligence to ensure compliance and substantiation of company practices.  Tier I audit issues are of “high strategic importance” to the IRS and have a significant impact on one or more industries. Tier I issues may involve a large number of taxpayers, a significant dollar amount, a substantial compliance risk or high visibility. Issues will be placed in this category if the IRS has an established legal position or directive out on the issue.  In other words, if you take the DPAD, it could be a “red flag” for audit.  Normally if a taxpayer is honest and follows the rules, with transparency, an audit should not deter them from taking appropriate tax deductions.  The DPAD rules are complex and time consuming, if the deduction is calculated incorrectly or lacks substantiation, your business could face additional taxes, penalties, and interest.  Thus it is imperative that you seek proper tax advice from a CPA or tax attorney.

Applicable tax codes 

(1)   Internal Revenue Code § 199

(2)   Internal Revenue Code § 927(a)(2)(C)

(3)   Internal Revenue Code § 1382(b)(c)

(4)   IRS Regulation § 1.199

(5)   IRS Proposed Regulation § 1.199(3)(f)(3)

(6)   IRS Instructions for Form 8903

Summary 

Many small business’s has traditionally over looked a potential this very important tax deduction.  Even though there are a set of complex rules, at nine percent of NET income from qualified production activities, businesses are unnecessary leaving money on the table by not taking advantage this tax deduction.  According to Paul Schlather, a senior tax partner with PricewaterhouseCoopers' Private Company Services practice, “while Section 199 comes with a very complex set of rules, chances are small businesses will qualify for the deduction much easier than the rules depict".

 

Are You Required To File A Gift Tax Return?

Article Highlights:
A gift tax return must be filed if you give gifts in excess of $14,000 per recipient during the year.

• Directly paid medical and educational gifts are excluded
• Married individuals can increase the annual $14,000 exclusion to $28,000 by splitting gifts.
• The estate tax exemption can be used to offset gifts in excess of the annual exclusion.

Frequently, taxpayers think that gifts of cash, securities, or other assets that they give to other individuals are tax-deductible and, in turn, the gift recipient sometimes thinks that income tax must be paid on the gift received. Nothing is further from the truth. To fully understand the ramifications of gifting, one needs to realize that gift tax laws are related to estate tax laws.

When a taxpayer dies, the value of his or her gross estate (to the extent that it exceeds the excludable amount for the year) is subject to estate taxes. Naturally, individuals want to do whatever they can to maximize their beneficiaries’ inheritances, and limit the amount of tax the estate may owe. Because giving away one’s assets before death reduces the individual’s gross estate, the government has placed limits on gifts, and if those gifts exceed the limit, they are subject to a gift tax that must be paid by the giver.

Gift Tax Exclusions – Certain gifts are excluded from the gift tax.

• Annual Exclusion – This is the annual amount that an individual can give to any number of recipients. This amount is adjusted for inflation, and for 2013, it is $14,000, and can be in the form of cash, property, or a combination thereof. For example, a taxpayer with five children can give $14,000 to each child in 2013 without any gift tax consequences. The taxpayer cannot deduct the gifts, and the gifts are not taxable to the recipients. Generally, for a gift to qualify for the annual exclusion, it must be a gift of a “present interest.” That is, the recipient’s enjoyment of the gift can’t be postponed to the future. For gifts to minor children, there is an exception to the “present interest” rule, where a properly worded trust is established. If the total of all of your gifts to each individual is not over $14,000, then there is no gift tax return filing requirement.
  
• Lifetime Limit – In addition to the annual amounts, taxpayers can use a portion of the federal estate tax exemption (it is actually in the form of a credit) to offset an additional amount during their lifetime without gift tax consequences. However, to the extent that this credit is used against a gift tax liability, it reduces the credit available for use against the federal estate tax at the time of the taxpayer’s death. For 2013, the credit-equivalent lifetime gift tax exemption is $5.25 million. If you made a gift to any individual in excess of $14,000 during the year, a gift tax return filing for the year is required even if there is no tax due. The filing allows the IRS to track your federal estate tax exemption reduction as a result of gifts, and includes the tax if you exceed the current lifetime limit.
  
• Education and Medical Exclusion – In addition to the amounts listed above, there are two additional types of gifts that can be excluded from the gift tax:
  
  (1) Amounts paid by one individual, and on behalf of another individual, directly to a qualifying educational organization as tuition for that other individual.
  
  (2) Amounts paid by one individual, and on behalf of another individual, directly to a provider of medical care as payment for that medical care. Payments for medical insurance qualify for this exclusion.

Caution: Watch out for unintended gifts such as when an elderly parent places a child on title of the home or other assets.

Gift-Splitting by Married Taxpayers – If the gift-giver is married and both spouses are in agreement, gifts to recipients made during a year can be treated as split between the husband and wife, even if the cash or property gift was made by only one of them. Thus, by using this technique, a married couple can only give $28,000 a year to each recipient under the annual limitation previously discussed.

If you believe that you have a gift tax filing requirement, have additional questions, or would like this office to assist you in planning an appropriate gifting strategy, please call.

Brazil is threatening to launch a full-blown trade war against the U.S. over Cotton

Brazil is threatening to launch a full-blown trade war against the U.S. for ignoring an order by the World Trade Organization to stop subsidizing its domestic cotton growers.  In June 2004 the WTO ordered the US to stop the more than $3 billion in subsidies to cotton farmers because the subsidy distorts global prices and violates international trade rules.   However the Brazilian threat comes after the US stopped subsidizing Brazilian cotton farmers.  So the question is -- is Brazil involved in bribery?  Read the attached and you decide.

Reed http://www.thestate.com/2014/01/23/3222085/us-brazil-cotton-dispute-may-fuel.html

Trade with China is good, but what about Mexico?

Despite the drug violence in Mexico that killed more than 15,000 people last year, and the negative attention that has all but destroyed border tourism, trade between that country and the U.S. has recovered and surpassed prerecession levels. Last year, trade was at an all-time high.

See http://www.foreignaffairs.com/articles/140334/shannon-k-oneil/six-markets-to-watch-mexico