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".

 

Year-End Tax Tips and Reporting Checklist - Tips vs. Service Charges

Businesses with tipped employees need to be aware of the IRS’ intent to enforce the taxability of tips and service charges. A tip is subject to special withholding rules, while a service charge is treated as any other taxable wage. Service charges should be characterized as wages and not included with tips when calculating the FICA tip credit.

Year-End Tax Planning Moves for Businesses

As the end of the year approaches, many are looking for ways to reduce their business profits before year's end. Here are some possible moves that might apply to your situation.

Self-employed Retirement Plans - If you are self-employed and haven't done so yet, you may wish to establish a self-employed retirement plan. Certain types of plans must be established before the end of the year to make you eligible to deduct contributions made to the plan for 2012, even if the contributions aren't made until 2013. You may also qualify for the pension start-up credit.

Increase Basis - If you own an interest in a partnership or S corporation that is going to show a loss in 2012, you may need to increase your basis in the entity so you can deduct the loss, which is limited to your basis in the entity.

Hire Veterans - If you are considering hiring some new employees between now and the end of the year, you might consider hiring a qualifying veteran so that you can qualify for the work opportunity tax credit (WOTC). The WOTC for hiring veterans in 2012 ranges from $2,400 to $9,600, depending on a variety of factors (such as the veteran's period of unemployment and whether he or she has a service-connected disability).

Purchase Equipment - If you are in the market for new business equipment and machinery and you place them in service before year-end, you will qualify for the 50% bonus first-year depreciation allowance. Or, you can elect to expense up to $139,000 of the newly acquired items using the Sec 179 expensing allowance. The $139,000 expense limit is reduced by one dollar for every dollar in excess of the $560,000 annual investment limit.

Purchase an SUV for Business - If you are in the market for a business car, and your taste runs to large, heavy SUVs (those built on a truck chassis and rated at more than 6,000 pounds gross [loaded] vehicle weight), consider buying in 2012. Due to a combination of favorable depreciation and expensing rules, and depending on the percentage of business use, you may be able to write off most of the cost of the heavy SUV this year.

These are just some of the year-end steps that can be taken to save taxes. Please contact this office so we can tailor a plan to your particular needs.

OCTOBER 2010 TAX BRIEFING

Informal Claim for Refund:
Informal claims for refund typically arise when the period of time for filing a claim on the appropriate form has expired, but to obtain a refund the taxpayer contends that a letter or some other communication sent or provided to the IRS meets the minimum requirements set forth in Reg. 301.6402-2 . Here, taxpayer and the IRS narrowed their dispute to whether taxpayer's 2004 tax year claim for refund was barred by limitations. In finding for the taxpayer, a New York District Court noted that taxpayer's January 2007 letter, although brief, "put the IRS on notice that he believed his disability pension had been improperly taxed as earned income since 1983. Although [taxpayer] did not use the word refund , the only reasonable construction of his letter is as a request for refunds for tax years since 1983 and an assurance that his pension would not be improperly taxed in the future." McMillan v. IRS , 106 AFTR 2d 2010-XXXX (DC E.D. N.Y.).

SIFL Rates for Employer-provided Aircraft:
Under Reg. 1.61-21(g) , employers can use a special computation rule to value employees' flights on an employer-piloted aircraft. The employer multiplies the Standard Industry Fare Level (SIFL) cents-per-mile rate in effect at the time of the flight by the appropriate aircraft multiple provided in Reg. 1.61-21(g)(7) , then adds the applicable terminal charge. For flights taken from 7/1/10–12/31/10, the SIFL rate will be $.2243 per mile for trips up to 500 miles, $.1710 per mile for trips from 501 to 1,500 miles, and $.1644 per mile for trips over 1,500 miles. The terminal charge will be $41.00. Rev. Rul. 2010-22, 2010-39 IRB .

Changes in 2010 Reporting of Uncertain Tax Positions:
The IRS announced significant changes to its original proposals for the reporting of Uncertain Tax Positions (UTPs) on 2010 corporate returns. The changes include: (1) a five-year phase-in of the reporting requirement based on a corporation's asset size, (2) no reporting of maximum tax adjustment, (3) no reporting of the rationale and nature of uncertainty in the description of the position, and (4) no reporting of administrative practice tax positions. Corporations with assets of $100 million (increased from $10 million for 2010) or more must file Schedule UTP starting with 2010 tax years. Instead of reporting the maximum tax adjustment for each UTP, the corporation will rank all reported positions based on U.S. federal tax reserve. The final schedule and instructions are available at www.irs.gov/businesses/corporations/article/0,,id=221533,00.html . IRS Ann. 2010-75, 2010-41 IRB .

IRS Policy of Restraint for Uncertain Tax Positions:
The IRS announced an expanded policy of restraint in seeking documents related to Uncertain Tax Positions (UTPs) coinciding with the release of newly modified Schedule UTP. Taxpayers may remove the following information from tax reconciliation workpapers provided to the IRS: (1) drafts, revisions or comments concerning the description of tax positions reported on Schedule UTP, (2) the amount of any reserves for tax positions reported on the schedule, and (3) computations determining the ranking of tax positions reported on the schedule. IRS Ann. 2010-76, 2010-41 IRB .

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