partnerships

IC-DISC Still Providing Big Tax Benefits

January 22, 2022 by Frank Vari, JD. MTax, CPA

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.

Summary
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 frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

Payroll Tax Credits Provide Cash Flow Benefits For Technology Start-Ups With Research Activities

January 14, 2020 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

Our practice serves a number of early and mid-stage technology clients and many have significant research and development (“R&D”) activities and expenses but have not generated taxable income either due to tax planning or net operating losses. Conventional wisdom has been that these companies cannot claim any tax benefits related to their R&D related expenses because they have no taxable income. However, these same clients often pay significant payroll taxes and they are often unaware that they can reduce their annual payroll taxes, and improve cash flow, by as much as $250,000 per year by taking advantage of the United States (“US”) R&D payroll tax credit.

Let us explain here how we help our qualifying clients claim these important benefits.

As noted, US businesses historically have not been able to use the traditional US R&D income tax credit in tax years where there was no regular US income tax liability. However, the Protecting Americans from Tax Hikes (“PATH”) Act of 2015 made very favorable changes to the research credit that help mitigate the impact of this limitation. In particular, PATH allows certain small businesses to offset their alternative minimum tax (“AMT”) or payroll tax liability with a research credit. As a result, small businesses in an AMT or net operating loss (“NOL”) position that cannot claim the traditional R&D credit can now claim tax and cash flow benefits.

The R&D Credit

The R&D credit was enacted back in 1981 to stimulate US R&D activities by helping businesses offset some of the costs associated with their qualified R&D activities. Quite basically, a qualified R&D activity expense qualifying for the credit is one where:

The expense is incurred in a trade or business which represent R&D costs in the experimental or laboratory sense;
The research is technical in nature including bioscience engineering, computer science including software, chemical/polymer design, manufacturing processes, and other similar activities;
The research contains aspects of experimentation related to a new or improved design, function, or performance; and
The research is intended to result in a new or improved product or business element for the taxpayer.

Today, there is a regular R&D credit and an alternative R&D simplified credit (“ASC”) option to calculate the benefits. Qualifying businesses can compare the two methods and choose the more favorable one by making an annual election on a timely filed federal return. Businesses that have not claimed a regular credit in a prior year may make the election on an amended return for that year.

PATH significantly expanded the R&D credit by allowing certain businesses to claim R&D tax benefits in years when they had no regular US income tax liability. In other words, before 2015, if a business didn’t have US taxable income, there was no way to claim an R&D credit. Now, the R&D credit can be used to reduce AMT or payroll tax liabilities.

Although AMT liabilities may also be reduced, our discussion here will focus on the payroll tax R&D credit.

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Which Businesses Qualify For Payroll Tax R&D Credits

In order for a business to offset its payroll tax liability with the R&D credit, the taxpayer must be a Qualified Small Business (“QSB”). A QSB may be a corporation, partnership, or even an individual with gross receipts of less than $5 million for the current tax year and no gross receipts for any tax year preceding the five tax year period ending with the current tax year.

Example: For the first five years of its existence, Corporation A had gross receipts of $1,000,000, $7,000,000, $4,000,000, $3,000,000, and $4,000,000. Corporation A is a QSB for year 5 because its gross receipts are less than $5,000,000, even though its gross receipts exceeded the limitation for a prior year. However, Corporation A is not a QSB in year 6 due to having gross receipts in year 1.

Gross receipts here are reduced by returns and allowances but also include non-sales related items such as interest, dividends, rents, royalties. These receipts must also be adjusted to account for predecessor entities meaning that past mergers and acquisitions are relevant to this calculation. One must also adjust for any entities or individuals treated as a single taxpayer meaning that gross receipts must be aggregated for a controlled group of corporations or for trades or businesses under common control.

Claiming Benefits

A QSB may elect to claim the R&D credit against the Old Age, Survivors, and Disability Insurance (“OASDI”) portion of the employer’s Federal Insurance Contributions Act (“FICA”) payroll tax liability for up to five tax years. The election to claim the payroll R&D credit must be made on a timely filed US tax return including extensions (please note this differs from the regular R&D credit which can be claimed on an amended return). The election is reported in Section D of Form 6765 as part of the aforementioned return. Special rules apply for partnerships and S corporations.

The election must indicate the amount of the research credit that the QSB intends to apply to the expected payroll tax liability. This amount is the smaller of:

A $250,000 cap;
The amount of the research credit for the tax year (without regard to the election); or
The amount of any business credit carryforward under IRC §39 carried from the tax year of the election, without regard to the election, but only for QSBs that are not partnerships or S corporations.

A QSB that files quarterly payroll tax returns may apply the credit on its payroll tax return for the first quarter beginning after it files the federal return appropriately reflecting the election. For these quarterly payroll taxpayers, a QSB seeking benefits related to 2019 R&D activities that files that timely files their US income tax return by April 15, 2020 will be able to claim these benefits beginning in the second quarter of 2020 but not before. If the return is extended, then the timing of the benefits extends as well. Accordingly, a QSB that files annual payroll tax returns may apply the credit on the first quarter beginning after the date on which the business files its US income tax return containing the election.

When filing the payroll tax return, Form 8974, Qualified Small Business Payroll Tax Credit for Increasing Research Activities, must be completed and attached to the payroll tax return to ensure that the amount of the previously elected credit is limited to the employer portion of the Social Security tax for the period. Any excess may be carried forward pursuant to future periods. The credit does not reduce the QSB’s deduction for payroll taxes which provides an additional benefit.

Next Steps

The best next steps for any start-up with R&D activities is to take the following steps along with a qualified tax adviser:

Determine qualification as a QSB;
Identify qualifying research activities;
Calculate the amount of the R&D credit and the corresponding payroll tax offset;
Make the appropriate elections and file the requisite income tax and payroll tax forms using the most beneficial methodologies; and
Organize supporting documentation in case of a tax authority examination.

In summary, any tech start-up not claiming these cash flow benefits should be paying attention.

Please let us know how we can help you plan for your tax planning and compliance needs. Learn more about our business tax practice or our firm by contacting us at FJVTAX.com.

Can a Partnership With Some Service Activities Claim Section 199A Benefits?

November 16, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

We recently went on the Massachusetts Society of CPAs (“MSCPA”) tax practitioner website, aka the “HUB”, to answer a question regarding the ability of a partnership that has some service type activities to claim Section 199A benefits. We do get a number of questions on this so we felt it would be great to share on our blog.

The basic question presented was whether a partnership that manufactures and sells goods but has some consulting or service type activities may claim Section 199A benefits?

This is a very good Section 199A question that, as noted above, we’re seeing quite a bit in our business practice. It highlights the fact that Section 199A is actually a very complicated piece of legislation lacking solid administrative guidance and detailed understanding among many professionals. Many clients have assumed they qualify for Section 199A benefits when they actually do not.

When Section 199A was enacted and reviewed by the tax community there were more questions than answers to many specific fact situations. In particular, the statute itself left unclear to us the treatment of trades or businesses with both a Qualified Trade or Business (“QTB”) component which is benefit eligible and a Specified Service Trade or Business (“SSTB”) component which is not benefit eligible.

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Section 199A only applies to pass-through businesses. C Corporations received their tax break separately by reduced tax rates. The Proposed Regulations issued in August created the term “relevant pass-through entity” (“RPE”). An RPE is generally a partnership, other than a Publicly Traded Partnership, or an S corporation that is owned, directly or indirectly, by at least one individual, estate or trust. In most states, including Massachusetts, partnerships are mostly multi-member LLCs.

Section 199A defines a QTB rather simply as any trade or business except a SSTB or services performed as an employee. A SSTB includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. For practitioners familiar with former Section 199 and the former Extraterritorial Income Exclusion (“EIE”) rules, one could foresee how services besides architecture and engineering were going to be excluded from benefits – and they were but in a complicated fashion.

The Proposed Regulations provide us with our only guidance on our issue of a partnership, i.e., an RPE, with both QBI and SSTB activities. Prop. Reg. 1.199A-5(c)(1) provides a de minimis rule based on trade or business gross receipts and the percentage of gross receipts attributable to a SSTB under which a trade or business will not be considered a SSTB merely because it performs a small amount of services in a SSTB. The Preamble to the Proposed Regulations explains that this rule was created because the Treasury Department and the IRS believe that requiring all taxpayers to evaluate and quantify any amount of specified service activity would create administrative complexity and undue burdens for both taxpayers and the IRS. It is simply an administrative safe harbor.

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Under this rule, a trade or business, determined before application of the aggregation rules, which I’m not addressing here, would not be a SSTB if in a specific tax year it has: (1) gross receipts of $25 million or less, and (2) less than 10% of the gross receipts are attributable to the performance of services in a SSTB. Take note that this includes the performance of activities incidental to the actual performance of services. For a trade or business with gross receipts greater than $25 million, the trade or business qualifies for the de minimis rule if less than 5% of the gross receipts are attributable to the performance of services in a SSTB.

The bottom line is that if the SSTB activities rise above these safe harbor amounts within a single RPE, the entire trade or business is tainted and is considered to be a SSTB. The law does not allow you to otherwise create allocations within a single RPE. It is either a QBI or a SSTB depending upon the results of the test outlined above.

We are assisting many of our clients with both QBI and SSTB activities with restructuring options to qualify for Section 199A benefits. However, any restructuring alternatives are fact dependent. There is no one option that applies to all businesses but restructuring options do exist that allow many taxpayers to claim these important new benefits.