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IC-DISCs as a Tax Arbitrage and Wealth Transfer Strategy

By: Christine Ballard August 23, 2016

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WHAT IS AN IC-DISC?

Interest Charge Domestic International Sales Corporation (“IC-DISC”)

oAllows IC-DISC shareholders to defer tax on export related income

oNo federal taxation at the IC-DISC level oTaxes deferred until the income is distributed o IC-DISC shareholders are required to pay interest

on the deferral of income

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WHY SHOULD YOU CARE?

IC-DISC reduces shareholder’s tax liability oOrdinary income is converted into qualified

dividend taxed at preferential tax rates when distributed to IC-DISC shareholders

Exporting company can pay IC-DISC a tax deductible

commission o The IC-DISC can distribute the commission to its

shareholders in the form of qualified dividend o Exporting company must have taxable income

Tax rate reduction usually about 16%

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COMMON USED BY

US-based manufacturers and value added assembly operations

Distributors of US-manufactured products Food and agriculture exporting nuts, apples, wine, etc. Recyclers US-based architects and civil engineers with foreign

projects

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IC-DISC BASICS

IC-DISC Shareholder

Commission

Flow of Funds

Exporter IC-DISC (Tax Exempt)

Dividend

Tax deduction at

ordinary rates

35% or 39.6%

Tax Exempt

* Watch States*

Qualified

Dividend

23.8%

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COMMON STRUCTURES

Related Supplier

IC-DISC

Shareholder Shareholder

Commission Qualified Dividend

Example 1 - Passthrough

Taxed at

preferential

rate to

shareholders

Deductible

to supplier

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COMMON STRUCTURES

IC-DISC Related Supplier (C Corporation)

Shareholder Shareholder

Commission

Qualified Dividend

Example 2 - Corporation

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USES IN FAMILY WEALTH TRANSFER

To recap – benefits for everyone o Tax rate arbitrage opportunity o Converts ordinary income to qualified

dividend, taxed at capital gain rates

Uses in family wealth transfer o Ability to push income and cash to another

generation o Set-up of an IC-DISC usually not considered a

gift

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COMMON STRUCTURES

LLC

IC-DISC

Shareholder (Patriarch) Heirs

Commission

Qualified Dividend

Example 3 – Wealth Transfer

Related Supplier

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WHO CAN BENEFIT?

Manufacturers, producers and resellers of “qualified export property”

Qualified export property include goods:

oThat are produced in the US; oWith ultimate destination outside the US (sales to

unrelated party); and oWhere the cost of foreign content does not exceed

50% of the sales price

IC-DISCs are widely used by owner-managed and family-owned businesses

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SETTING UP AN IC-DISC

IC-DISC must be set up as a separate entity

o Incorporated as C corporation o Election has to be made to treat entity as IC-DISC

(Form 4876) o Election must be filed within 90 days of the

beginning of tax year in which the election will take effect

o Single class of stock o Minimum capital $2,500 o Commission agreement between IC-DISC and

exporter

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DETERMINING THE COMMISSION AMOUNT Commission DISCs: Two primary methods may be used to

determine the commission paid to IC-DISC o 4% of the “qualified export receipts” (simple

method); o 50% of the combined taxable income of the related

supplier & IC-DISC from the sale of qualified export property (i.e. foreign source income)

o The former is generally used when related supplier is selling a high volume with low profit margins

Buy-Sell DISCs: Use Section 482 intercompany pricing

methods. The DISC will have employees

Commission (or reasonable estimate) should be paid within 60 days after the close of tax year

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EXAMPLE – TAX SAVINGS IC-DISC Creates Tax Savings: Combined Almonds Walnuts

Export sales gross receipts $105,000,000 50,000,000 55,000,000 Cost of goods sold (94,500,000) (45,000,000) (49,500,000) Gross margin 10,500,000 5,000,000 5,500,000 Selling, general and administrative expenses (7,350,000) (3,500,000) (3,850,000) Combined taxable income 3,150,000 1,500,000 1,650,000

% Foreign 90% 80%

IC-DISC commission, greater of: 50% of export sales net income $ 1,335,000 $ 675,000 $ 660,000 4% of export sales gross receipts $ 3,560,000 1,800,000 1,760,000

IC-DISC commission (limited to taxable income) $ 2,670,000 $ 1,350,000 $ 1,320,000

Federal tax savings to exporter 39.60% 1,057,320

IC-DISC dividend $ 2,670,000 Federal tax on dividends paid by IC-DISC shareholder 23.80% (635,460)

IC-DISC Federal net tax savings $ 421,860

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MAINTAINING IC-DISC STATUS

The IC-DISC must meet the following requirements annually

o 95% or more of the gross receipts are “qualified export receipts”

o The adjusted basis of the qualified export assets meets or exceeds 95% of the total adjusted basis of all assets held by the IC-DISC

o The IC-DISC maintains only one class of stock o The par value of the stock is at least $2,500 for each

day of the tax year o The IC-DISC maintains separate books and records o The election to be an IC-DISC is in effect for the tax

year

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MAINTAINING IC-DISC STATUS

export assets under §993(b) include: oExport property oAssets used primarily in connection with the

sale, lease, or other specified activities relating to qualified export property, and in connection with performing certain services

oSufficient cash required to meet the working capital requirements

oSubject to limitations, amounts on deposit in the US to acquire other qualified export assets

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CALIFORNIA CONSEQUENCES

FTB Ruling 2015-02 “Unwinds” IC-DISC transactions IC-DISC files its own California return IC-DISC pays only $800 minimum tax

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THANK YOU

Christine Ballard CPA, MST Partner, National Tax International Tax Services

MOSS ADAMS LLP 635 Campbell Technology Parkway Campbell, CA 95008 D (408) 558-4338 T (408) 558-7500 C (703) 328-4180 christine.ballard@mossadams.com