In a time when business taxpayers have few ways to save tax dollars, the good news is that I-C DISC continues to provide big tax benefits to closely held businesses. When compared with high – and likely rising – corporate and individual tax rates these benefits are especially attractive and worth pursuing.
Those that have followed the journey of the Interest Charge Domestic International Sales Corporation (IC-DISC) through the winding legislative process behind the Tax Cuts and Jobs Act of 2017 (TCJA) as well as proposed changes to US tax laws know that it has survived intact. Those that have followed these export tax benefits from the 1970’s DISC, whose enactment was somewhat contemporaneous with the unrelated peak of disco music, to FSC to EIE and now back to IC-DISC know that it has really been quite a legislative and judicial journey for these important export tax benefits. Now that we can be sure that IC-DISC benefits have survived, where exactly do we stand post-tax reform and what can we do to maximize IC-DISC benefits?
IC-DISC one of the last remaining export incentives provided to U.S. based taxpayers. It’s been an important part of tax planning for closely held companies since the Jobs and Growth Tax Relief Reconciliation Act of 2003 cemented into law reduced capital gains tax rates making IC-DISC a profitable tax strategy. As an added bonus, it is not currently on the World Trade Organization’s radar unlike some other current U.S tax incentives, i.e., the Foreign Derived Intangible Income (FDII) regime, so IC-DISC beneficiaries can rest assured that they are playing nice with our trade partners which is comforting. Also, don’t forget that IC-DISC is probably the last remaining tax planning technique where the IRS is willing to look past substance over form, at least a little bit – more on that later, which is not something seen too often.
Everyone probably knows the bad news by now that the reduction in U.S. individual tax rates has also reduced the IC-DISC benefits. However, it still provides a hefty 13.2% tax rate benefit to individuals which is only a slight reduction from the pre-TCJA rate of 15.8%. The difference is the 2.6% top individual tax rate drop from 39.6% to 37%. If the business is a pass-through, and assuming newly enacted §199A is available to the taxpayer, it still provides a 6% rate benefit. Thus, even post TCJA, IC-DISC remains an important planning tool for businesses of all types.
What many taxpayers are missing is that there are planning tools out there that can make IC-DISC an even better tax planning vehicle without increasing shareholder risk. Some are more complex than others but here are some that we’re using with our IC-DISC clients:
Ensuring IC-DISC Compliance
If an IC-DISC is not properly qualified there are no benefits and there are likely penalties. This is pretty simple to understand but it is very often a problem. IC-DISC is an attractive planning tool but it is often adopted by taxpayers who don’t want to deal with the complexities of IC-DISC qualification or by an inexperienced practitioner who fails to properly implement or advise their client on the importance of these rules. I have been part of many acquisitions of middle market companies where the seller’s IC-DISC was determined to be defective during due diligence as a result of taxpayer error. Similarly, the IRS understands this very well and disqualifies many IC-DISC benefits on this basis. It is never good when an IC-DISC fails this way but in practice many do. Please don’t be the advisor that has to tell your client their IC-DISC has been disqualified.
Utilize IRC §482 Transfer Pricing
IC-DISC is one of the few areas where the IRS cannot force a taxpayer to use IRC §482 arm’s length principles to determine the profit allocation between related parties. However, IRC §482 is best used here proactively by the taxpayer. Most IC-DISC taxpayers that I work with use the 4% of export gross receipts methodology. For many taxpayers that’s a mistake. Most often, their IC-DISC advisor doesn’t fully understand how IRC §482 works and is unable to even model what the answer would be so the taxpayer doesn’t get to see what the options truly are. By addressing the IRC §482 options, or consulting with an IRC §482 expert, an IC-DISC may see greatly enhanced profits. It is certainly fact dependent, but I’ve seen it deliver enough benefits that is part of every IC-DISC analysis we perform.
Grouping Transactions vs. Transaction by Transaction (TxT)
For those of us that practiced in the FSC days, TxT was one of the most popular tax planning tools out there and was used by FSCs with literally millions of individual transactions. We all know that FSC is long gone but the TxT method is alive and well but is a little of a lost art since the very large companies had to stop doing it. Most of the IC-DISCs out there utilize grouping(s) of transactions. Grouping is a proper methodology and it can be the best and is certainly the easiest to apply. However, like transfer pricing above, TxT often produces significantly better benefits. It requires that each individual transaction be treated separately which is beyond the capabilities of many IC-DISC practitioners. At a minimum, grouping vs. TxT must be modeled to ensure that the taxpayer is obtaining, or maintaining, maximum benefits.
Appropriate Expense Allocations
In order to properly determine the profitability of foreign sales, the taxpayer must utilize the principles of IRC Treas. Reg. §1.861-8 and its relations. These rules can certainly be complex and they are not often applied properly. For example, many U.S. based exporters spend large amounts on things like interest and selling expenses which are, in practice, mostly directed toward U.S. activities. By improperly overallocating these expenses to foreign sales they are artificially dampening IC-DISC profits. The IRC §861 expense allocation rules are not optional and it is imperative that the practitioner fully understand them.
IC-DISC for the Foreign Owned U.S. Company
There are many closely held U.S. companies with foreign shareholders that export. Please keep in mind here that sales to Canada and Mexico are also exports. Many of these corporations do not utilize IC-DISC but many should. Especially those that reside in treaty countries with low dividend tax withholding rates. This can be difficult because to properly model the results you need to understand the shareholder’s resident country tax laws as well as the shareholder’s tax posture. That said, I’ve seen this benefit work for foreign shareholders often enough that I always consider it when I see these facts.
Utilizing a Roth IRA
This has been a somewhat popular planning tool utilizing a Roth IRA to avoid annual contribution limits. The Roth IRA value grows while the IC-DISC profits are not taxed. Simple enough but it is not a risk free strategy. The IRS feels that this is a violation of substance over form and argued that, albeit unsuccessfully, in Summa Holdings, Inc., No. 16-1712 (6th Cir. 2/16/17). My view is that the IRS argued this case wrong but that’s another article. If you live in the 6th Circuit, good for you. The primary risks here are that the IRS does not like this and Summa Holdings predated the enactment of IRS §7701(o) which codified the economic substance doctrine. Until the IRS makes another run at this you certainly have substantial authority for this position where it makes sense.
IC-DISC as Non-Qualified Executive Retirement Tool
You don’t see this one too often but it makes sense. We have advised a client who was retiring from a leadership position in a successful family business. IC-DISC itself made sense as a planning tool but it also played a neat part in the transition of the business by placing the IC-DISC ownership in the hands of the retiring executives. Keep in mand that the IC-DISC does not have to be held by the same shareholders as the related supplier. This planning, in essence, permits the related supplier a full tax deduction and the retired executives enjoy reduced qualified dividend tax rates.
The bottom line here is that IC-DISC remains alive and well for the foreseeable future courtesy of the TCJA. Thus, it is time to start considering using IC-DISC again and, more importantly, maximizing IC-DISC benefits with proven and reliable strategies.
Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at firstname.lastname@example.org or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.