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IC-DISC Strategies: Mastering the Complex Operational Challenges Anticipating IRS Audit Risks, Calculating Commissions, and Tackling Computational Intricacies

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IC-DISC Strategies: Mastering the Complex Operational Challenges

Neal Block, Baker & McKenzie

[email protected]

May 6, 2014

Jerry Jonckheere, Plante Moran

[email protected]

Jerry Ogle, Ogle International Tax Advisors

[email protected]

Today’s Program

Fundamental Concepts Of IC-DISCs

[Jerry Jonckheere]

Implementing Various Ownership Structures For IC-DISCs

[Neal Block]

Compliance And Reporting By IC-DISCs

[Jerry Ogle]

Slide 6 – Slide 24



FUNDAMENTAL CONCEPTS OF IC-DISCs

Jerry Jonckheere, Plante Moran

7

Domestic International Sales

Corporations (DISCs)

Background and tax benefits of DISCs

General review of tax benefits of DISCs

How the DISC came to be

Requirements of a DISC

Initial requirements

Annual requirements

Export property

Other considerations

8

Domestic International Sales

Corporations (DISCs)

DISC benefit arises as follows:

Commissions paid to a DISC reduce taxable profit of related supplier

corporation deductions at ordinary rates)

DISC is tax-exempt entity – Sect. 991 income can be deferred

DISC dividends received by individual shareholders are qualified

dividends taxed at the capital gains rate Income can be taxed at lower capital gain tax rates

9

Commission reduces taxable profit

passed through to S corporation

shareholder (up to 39.6% tax

savings).

DISC is not subject to tax.

S corporation shareholders pay

20% tax on DISC dividends.

Shareholders may be subject to an

interest charge for the tax deferral

on DISC earnings not distributed

General Review Of DISCs:

Pass-Through Structure

Shareholders

S Corporation

DISC

Commission Dividend

10

General Review Of DISCs:

C Corporation Structure

Commission reduces taxable

profit of C corporation (up to

35% tax savings)

DISC is not subject to tax

C corporation shareholders pay

tax at 20% on DISC dividend

Shareholders are subject to an

interest charge for the tax

deferral on DISC earnings not

distributed

Shareholders

DISC

Commission

Dividend

C Corporation

11

How DISCs Came To Be

1971: Congress enacted DISC provisions

U.S. tax on DISC income was deferred until it was repatriated

1970s – 1980s: European Union (EU) challenged DISCs as allegedly violating

General Agreement on Tariffs and Trade (GATT)

1984: Congress enacted foreign sales corporation (FSC) provisions

FSCs exempted a percentage of export income from income tax

DISC was modified to allow deferral of DISC income from annual

maximum of $10 million of export receipts but interest charges on

deferral (the DISC became the IC-DISC)

12

How DISCs Came To Be (Cont.)

Late 1990s: European Union (EU) members complain to World Trade

Organization (WTO) that FSC represents an illegal export subsidy, but DISC

was not challenged

2000: Congress repeals FSC tax scheme and enacts extraterritorial income

exclusion (ETI or EIE); EU immediately lodged complaints

2003: Congress enacts favorable dividend tax rates for individuals

Tax rate on qualified dividends drop from 35% to 15%, creating an

opportunity for permanent savings

13

How DISCs Came To Be (Cont.)

2004: Congress repealed ETI

2006: IRS becomes aware of DISC planning and is looking for revenue

raising provisions and proposes legislation to treat DISC dividends as not

qualified but the legislation is not passed

2007: Repeal of capital gain rate for DISC dividends is proposed but not

passed.

Dec 31, 2012: Favorable dividend tax rates were to sunset but legislation

extends favorable qualified dividend rate

Rate increased from 15% to 20%

14

DISC Initial Set-Up

Commission DISC vs. buy/sell DISC

Domestic corporation (C corporation)

Must be a domestic corporation incorporated under the laws of any

state or the District of Colombia

Determine state tax implications

Single class of stock

$2,500 capital

Required by last day to elect IC-DISC status

15

DISC Initial Set-Up (Cont.)

Form 4876-A election

File within 90 days from the beginning of tax year or inception of entity

Establish books and records by the end of first year of operation

16

DISC Annual Maintenance

95% qualified gross receipts test

95% qualified export assets test

$2,500 capital on each day of tax year

Timely payment of commission to IC-DISC

File IC-DISC income tax return

Maintain IC-DISC books

International boycott reporting

17

DISC Annual Maintenance (Cont.)

95% qualified gross receipts test

Qualified gross receipts are at least 95% of IC-DISC gross receipts for the

year.

Qualified gross receipts:

Sale, exchange or other disposition of export property

Lease or rental of export property used outside of U.S.

Related and subsidiary services

Dividends from related foreign export corporation

Interest on obligations that are qualified export assets

E.g., producer’s loans

Engineering and architectural services

18


95% qualified gross receipts test (Cont.)

Other receipts to consider

Sales made to U.S. distributors

Sales made to foreign disregarded entities

Excluded receipts

Export property is for ultimate use in the U.S.

The sale, lease, etc. is accomplished by a subsidy of the U.S. government.

The export property is for the use by the US government, where the use

is required by law or regulation.

19


95% qualified export asset test

At least 95% qualified export assets at year-end are qualified.

Categories of export assets

Export property

Working capital

Only amount necessary for required working capital

Commission receivable

Stock or securities of related foreign export corporation

Producer’s loans

20


Commission payment

Payment of initial commission estimate within 60 days of DISC’s year-

end (March 2, calendar year).

Any unpaid commission must be paid within 90 days of finalization.

Unpaid amount cannot be more than original estimate – i.e., estimate

must be at least 50% of final.

File IC-DISC return (Form 1120-IC-DISC)

Due within 8 ½ months of year-end

Maintain IC-DISC books and records

21

Export Property For DISC (1.993-3)

Manufactured, produced, grown or extracted in the U.S. by a person

other than a DISC

Held primarily for sale, lease or rental for direct use, consumption or

disposition outside the U.S.

Not more than 50% of fair market value of the export property can be

attributable to foreign content.

Consider qualified export property sold to U.S. distributors

22

Other Considerations

DISC commission reduces QPAI deduction.

Relates to the deduction for domestic production activities

DISC commission reduces profit on foreign title transfer sales. [Sect.

863(b)]

May reduce foreign tax credit limitation

Provide for deferred tax on accumulated DISC income (FAS 109/APB 23)

State income tax considerations

23

Problems?

Failure to file Form 4876-A timely

9100 relief

Distribution needed to meet qualification requirements

Deficiency distribution

Failure to meet 95% qualified export asset test and 95%

qualified gross receipts test, as well as timely paying

commission

Equal to amount of taxable income attributed to the non-

qualified portion

Deemed reasonable cause if paid on or before 15th day of ninth

month after year or within 90 days of an IRS request

If paid after, interest in the amount equal to 4.5% of distribution

[§992(c)(2)(b)]

Slide Intentionally Left Blank

UPDATED IC-DISC OWNERSHIP STRUCTURES AND SAVING THE DISQUALIFIED DISC

Neal Block, Baker & McKenzie

©2014 Baker & McKenzie LLP - 26

Overview of this Section

Structuring

– Privately-held company: C Corp, S Corp, partnership, LLC taxed as a partnership

– Closely Held and Publicly-traded “C” corporation deferral

– Individual Retirement Account (IRA) and Roth IRA

– Estate planning, executive compensation

– Treaty benefits

– Sourcing benefits Saving The Disqualified DISC

– 9100 Relief

– Additional Qualified Assets and Additional Liabilities

– Deficiency Distribution


C Corporation

– Dividends to “C” Corp Shareholders subject to corporate tax at approximately

35%

– Recommended that IC-DISC be owned directly by the individual shareholders

of the C corporation so they can avoid double taxation and receive dividends

at 23.8% capital gains rate

Where Exporter Shareholder include C Corporations, or Tax Exempt Entities, alternative structures may

be used for their ownership.

IC-DISC Ownership Structures

Privately-Held Company

U.S. – C Corp

Exporter

(Related Supplier)

IC-DISC

Commission

35%

IC-DISC

Individual Shareholders

IC-DISC Dividend 23.8%



S Corporation and LLC

– Dividends pass through the corporation to the shareholders and are

deferred from taxes and receive dividends taxed at the 23.8% capital

gains rate

IC-DISC Commission

39.6%

IC-DISC

U.S. Exporter

(S Corp.)

Capital Gains Dividend – 23.8%

Individual Shareholders


Partnership Owned by LLC or S Corporation

– Dividends pass through the partnership to the partners

and shareholders of the S corporations and taxed at the

15% capital gains rate

IC-DISC

23.8% Div.

Partnerships

and/or S Corps


Individuals

39.6% Commission

Deduction Exporting

Partnership

Deemed Exporter

C Corp DPAD

Public Shareholders


Putting Supply Chain Activity

in One Exporting Partnership

BEFORE

A sells to B ($10 profit) B sells to C (10 Profit) C exports and pays rent to D

Only C’s Export Profit Less D Payment qualifies

for DISC benefits.

Manufacturing

A

B

C

D

Exports and pays

DISC a commission

Further

Manufacturing

Pays

Rent

Sale

Sale

Leases Space to C

DISC

AFTER

A

B

C

D


ABCD

Partnership

DISC

DISC

Commission

on Total Profit

of ABCD


Closely Held and Publicly-Traded

Corporation - Deferral

IC-DISC Receivables &

Commission

IC-DISC

Up to $10 Million

Deferred

C CORP

Up To $10 Million Deduction


Publicly-Traded Corporation

– IC-DISC may defer from taxation 16/17 of best $10

million of gross receipts. The balance is deemed

distributed to its shareholders.

– Large exporters who generate substantial export

receivables can sell the receivables to the IC-DISC at a

discount. The discount income qualifies as qualified export

receipts.



– Deferred income becomes a low-cost, pre-tax source of

funds for export working capital and financing

international sales

– As much as $10 million may be generated from discount

income and 16/17 deferred from tax (i.e. $1 of discount

income = $1 of gross receipts)

– Additional deferral is available by use of non-qualified

assets up to 5% of total DISC assets and non-qualified

gross receipts up to 5% of gross receipts


Example I Assume: An IC-DISC owned by a “C” Corp. in 2012 receives

commissions for export sales and earns discount income from factoring export receivables of $8 million. It earns a 20% or $.4 million commission on the best $2 million of sales. The IC-DISC is tax exempt and is allowed to retain income attributable to the best $10 million of gross receipts. The balance of gross receipts over $10 million is deemed distributed to the IC-DISC’s shareholders as a dividend. Use of the IC-DISC results in a $2.77 million tax savings as follows:



Example I (cont.)

Discount income $ 8.00 million

Commission on best $2 million of sales .40 million

Total IC-DISC income before deemed

distribution $ 8.40 million

Less 1/17 deemed distribution .50 million

Total income to be retained $ 7.90 million

Tax Savings @ 35% $ 2.77 million



Example I (cont.)

Interest charge imposed on IC-DISC shareholder on tax

savings (based upon One Year Treasury Bill rate)

Assume tax savings in 2013 $ 2.77 million

Interest rate on One Year Treasury Bill

in Sept. 2013 1%*

Interest charge payable when IC-DISC

shareholder’s 2013 return due (2014) $ 27,700 Tax benefit from interest deduction -

$27,700 @ 35% 9,695

Net cost of interest charge $ 18,005

*Assumed Rate



Example II

MAXIMUM BENEFIT FROM DISCOUNT INCOME

Assume:

$10 million of discount income $10.00 million

Less 1/17 deemed distribution .85 million

Net $ 9.15 million

[Can be increased by non-qualifying receipts up to 5% of total receipts]



Example II (cont.)

Tax benefit $10 million @ 35% $ 3.20 million

Interest Charge:

$3.2 million saved at 1%* $ 32,000

Tax benefit from interest

deduction – $32,000 @ 35% 11,200

Net cost of interest charge $ 20,800

*Assumed



Beneficiary Roth IRA – 0 Tax

Regular IRA – Regular Tax

IRA

C CORP

C Corporate

Tax Rates on

IC-DISC Dividends

IC-DISC

Corporate Tax Rates

on IC-DISC Dividends

0 Tax

on C Dividends


IRA IC-DISC Benefits

Use of C Corp To Own IC-DISC Stock

– Allows dividends from IC-DISC to be taxed to C corporation at corporate rates of 15% - 35%

– Dividends from C corporation to IRA tax-free

– Assets invested by IRA tax-free

– Distributions taxed when distributed by regular IRA distributions tax free when distributed by Roth IRA

– May be combined with IRS direct ownership of IC-DISC stock


IRA IC-DISC Benefits

IRA Ownership of IC-DISC

– Accumulated IC-DISC income taxed at corporate rates 15-35% when distributed

– Assets in IRA invested tax-free

– Multiple IRA structure could reduce total tax on IC-DISC dividends

– Use of LLC owned by IRA to avoid custodian involvement

– Roth IRA distributions not taxed to beneficiaries

– Cases pending on whether DISC commissions can be disallowed using substance v. form and if Excise tax on DISC commissions is applicable: Hellweg, T.C. Memo. 1211-58 and Ohsman, T.C. Memo. 1211-98 upheld no excise tax on Roth IRA/DISC structure and appeals dismissed. Two cases pending, one DISC and one FSC, cross motions for summary judgment expected to be filed in DISC case soon.



Estate Planning and Executive

Compensation

– Estate Planning: Ownership of IC-DISC stock in different proportions

than exporting company stock can remove IC-DISC dividends from

estate. Rev. Rul. 81-54 may result in gift tax exposure, but Hellweg

decision effectively held Rev. Rul. 81-54 inapplicable. All gift tax cases

have been dismissed, but could be resurrected if the Service is

successful in pending cases.

– Executive Compensation and Succession: IC-DISC dividends can

be paid to designated employees who own IC-DISC stock but do not

have to be the same shareholders of the parent company. May avoid

safe harbor pricing requirements. Can be used as a type of employee

stock purchase plan.


Foreign International Sales Corporation

(FISC)

– FISC: Owned more than 50% by IC-DISC

– FISC Dividends: Qualified IC-DISC export receipts [count towards best $10 million of gross receipts]

– Generally same activities qualify as IC-DISC regarding export property and related and subsidiary services

– 95% qualified export assets and gross receipts tests

– No safe harbor pricing

– Recommend when qualifying activities subject to low tax and otherwise would be subpart F income

IC-DISC

FISC


Foreign Individual, Partnership, or

Trust* Structure [Must be disclosed on 1120 IC-DISC Returns]

Foreign Individual,

Partnership, or Trust

DISC Related Supplier

23.8% Capital Gains

Rate**

Commission

35% deduction

*Trust not taxed as a corporation.

**Possible treaty rate.


Treaty Country Corporation Structure

Treaty Country

C Corp.

DISC Related Supplier

Div. @ Treaty

W/H Rate

(5% or less)

Commission

35% deduction


Treaty Benefits (Ownership of a DISC by a Treaty Country Corporation)

– Section 996(g) classifies IC-DISC dividends as effectively connected with the conduct of a trade or business in the U.S. through a permanent establishment. This would likely result in foreign corp. shareholder of a DISC being subject to tax on DISC dividends at up to 35% tax.

– Section 996(g) is in conflict with most treaties which prevent taxation of a treaty country corporation in the absence of an actual permanent establishment (i.e., the mere existence of a U.S. subsidiary is not sufficient for U.S. taxation of dividends to parent as effectively connected income through a permanent establishment).


Treaty Benefits (Ownership of a DISC by a Treaty Country Corporation)

(Continued)

– Under the later-in-time theory, treaties executed after June 1984, therefore, may prevent 996(g) from applying

– IC-DISC dividends may thus be taxed at treaty rate on dividends

– If foreign owner of DISC is an individual, the 23.8% tax rate on DISC dividends should apply even if no treaty benefit

– Treaty Country taxation of DISC dividends must also be taken into account


Sourcing Benefits

– Section 861(a)(1)(D) treats IC-DISC dividends attributable to qualified export receipts as foreign source income to U.S. shareholders.

– IC-DISC dividends are presently in a separate basket (Section 904(d) Passive Basket).

– Opportunity exists to put foreign taxes into IC-DISC to create and increase foreign source income limitations:

(a) From U.S. title passage

(b) From FISCs.

Saving the Disqualified DISC

1. A DISC will not qualify as a DISC if its election [form 4876-A] is not

filed timely, generally within 90 days of incorporation date. Also

capital stock of $2500 par stated value must be validly issued by

the date the election is due.

2. 95% of the DISC’s assets on the last day of the taxable year must

be qualified export assets or the DISC will be disqualified.

3. 95% of the gross receipts for the year must be qualified export

receipts or the DISC will be disqualified. In the case of a

Commission DISC the qualified export receipts are those of its

related supplier’s sales. Generally this test is commonly met since

the DISC commissions are virtually always based on qualified

export receipts. In addition, Treas. Reg. § 1.993-6(e)(2)

51

provides that if the DISC commission agreement excludes

non-qualified gross receipts, they will not be taken into

account. The Tax Court in a split decision has held that this

provision may not be relied upon where an actual commission

has been paid on non-qualifying gross receipts. See Hughes

International Sales Corporation v. Commissioner, 100 T.C.

293 (1993). The Internal Revenue Service, however, has

informally held that the intent of the regulation was that the

provision not allow for non-qualified gross receipts to be

taken into account and has allowed them to be excluded.

52

CONSEQUENCES

– If election is not timely filed, no DISC benefit in the year of

incorporation and until a valid election is timely filed.

– So-called section 9100 relief may allow for a late election if

granted by the Service for reasonable cause.

– 9100 Relief commonly granted, but filing fee can be

expensive (around $8,000).


If a DISC is disqualified, the accumulated DISC income

(deferred income) is deemed distributed over 2 times the

number of years the DISC has been in existence up to 10

years. See Section 995(b)(2). The first deemed distribution

is the year following the year of disqualification.

54

The DISC income for the year of disqualification, except as

discussed later, does not qualify for DISC benefits. It can

be either reallocated to the related supplier under section

482 or left in the DISC at the discretion of the Internal

Revenue Service. If left in the DISC the income is taxed as

ordinary corporate income at corporate rates. See Addison

Int’l., Inc. v. Commissioner, 90 T.C. 1207 (1988); aff’d 887

F.2d 660 (6th Cir. 1989); Jet Research, Inc. v.

Commissioner, T.C. Memo. 1990-463.

55

If the qualified export assets are not substantially below the

95% amount, it may be possible to examine the underlying

transactions to find additional qualifying gross receipts or

additional DISC income in an amount which would make the

95% test met. This could be done by a redetermination of the

DISC income before the filing of the DISC’s return. Under

Treas. Reg. § 1.994-1(e)(5), the resulting additional

receivable generally would be a qualified export asset at the

end of the prior taxable year if paid within 90 days of the

redetermination.

56

Deficiency Distribution May Be Available

1. The rules for a deficiency distribution may be found at Treas.

Reg. § 1.992-3 and provide that (1) an otherwise disqualified

DISC under the 95% qualified gross receipts test may

distribute an amount equal to the income attributable to the

non-qualified gross receipts and (2) that a DISC that is not

qualified under the 95% qualified export assets test may

distribute an amount equal to the total amount of the non-

qualified assets for the taxable year. If a deficiency

distribution is made for a taxable year, the DISC is qualified

for that year. Deficiency distributions may be made for more

than one taxable year.

57

2. The distribution is taxed as a current year’s distribution, but if

made, will qualify the DISC year as a qualified DISC for the

year in which it missed either the 95% qualified export assets

test or the 95% gross receipts test.

3. The deficiency distribution and the year for which it is made

must be labelled as such at the time it is made and

notification made to the Internal Revenue Service and DISC

shareholders that the distribution is a deficiency distribution.

4. It may be made in cash or other property.

58

5. There must be reasonable cause for the failure to meet the

95% test, but the similar standard for failure to make the

DISC election timely has been lax. Generally, it appears that

lack of sufficient knowledge of the DISC rules and regulations

or simple negligence will be considered as reasonable cause.

Our experience has been that if a deficiency distribution is

made before an audit has commenced, the deficiency

distribution will not be challenged.

Prior agreement of the Service for a deficiency distribution is

not required.

59

a. So long as a deficiency distribution is made by the time

the DISC’s return for the year of disqualification is due,

there is no penalty attached to the deficiency distribution.

Rather, the distribution is taxed either as dividend income,

return of capital or capital gains depending on the DISC’s

earnings and profits for the year of the distribution.

b. After the first DISC return is due subsequent to the year of

disqualification, a 4-1/2% interest charge per year is

imposed upon the DISC making a deficiency distribution

for each year or partial year that the non-qualified assets

are retained in the DISC’s possession or the assets

attributable to non-qualified gross receipts are not

considered to be distributed.

60

c. Since the DISC is a tax exempt entity, the interest charge will

not reduce DISC taxes, but will reduce its accumulated DISC

income.

d. If the same asset remains on the DISC’s books for more than

one taxable year, only that amount will be required to be

distributed in qualifying the initial year and future years.

Further, only one 4-1/2% of the amount which remains on

hand in future years is required for each year the DISC

remains disqualified, i.e., if an amount is paid out, for

example, after the second consecutive year of

disqualification, the deficiency interest for the first year of

disqualification would be the three years of deficiency interest

for the original amount. The 4-1/2% amount will not be again

imposed on the same amount to qualify the second year.

61

For example, if the only disqualified asset is $100 in years one and two, a $100 deficiency distribution and an interest charge of 4-1/2% on the $100 for three years can qualify the DISC for both the first and second year.

e. There is no tracing of assets required for the deficiency distribution. All that is required is an amount equal to the disqualified amount being distributed. This should allow for capital contributions to be made to the DISC for the purposes of allowing it to make the deficiency distribution. (Since the deficiency distribution is designed to remove non-qualified assets from the DISC’s balance sheet, allowing for the contribution of capital for the purpose of making a deficiency distribution is consistent with that result.)

62

f. If the statute of limitations has run for a year in which a

DISC has not been qualified, it may be desirable not to

make a deficiency distribution for that year.

i. A DISC does not lose its election to be treated as a

DISC unless it is not qualified as a DISC for five

consecutive years. A deficiency distribution in one

of those years should allow the DISC election to

remain in effect for all five years in that period. See

Treas. Reg. § 1.992-2(e)(3).

63

ii. Under section 992(a)(2), a DISC which is

disqualified which has not timely received a

statutory notice of deficiency is not allowed to take

the position that it was not a qualified DISC.

Further, if the Service does not attempt to disqualify

the DISC, it will remain as a qualified DISC for all

purposes of the Code. See Treas. Reg. § 1.992-

1(g). Unfortunately, the claims court and the

Federal Court of Appeals has held that the failure to

qualify can only be used by the Service against a

taxpayer, not by a taxpayer in its favor. See

Stokely-Van Camp, Inc. v. Commissioner, 974 F.2d

1319 (Fed. Cir. 1992).

64

Clean DISC/Dirty DISC

There are no limitations on the number of related DISCs.

If a DISC may have qualification problems, a new DISC

may be incorporated for future years. This may lessen

the audit risk for the prior years.

65


COMPLIANCE AND REPORTING BY IC-DISCs

Jerry Ogle, Ogle International Tax Advisors

Ogle International Tax Advisors

offers IC DISC consulting services.

In addition, our spectrum of

international tax services can provide

assistance in the areas of :

Foreign business investments -

structure active business

investments in offshore

subsidiaries to minimize U.S. and

host country taxation. Analysis of

the U.S. CFC and PFIC rules for

individual investors.

Offshore profits importing -

plan for the repatriation of active

foreign profits.

Foreign tax systems -

analyze host country deductions,

exemptions, and incentives,

including foreign tax credits with

host country tax advisors.

Miami Office Waterford Business Park Miami, Florida 33126 (T) 305.671.3179 (F) 305.402.0552

Corporate Office 8130 Lakewood Main St, Suite 208 Bradenton, Florida 34202 (T) 941.361.1147 (F) 941.827.9929

For more information on our services Please contact us at our offices or visit us at our website www.ogleintltax.com

An IC-DISC can act as a buy-sell entity or a commission-based entity.

In any event, the transfer price between the IC-DISC and related supplier must be calculated under one of the three following methods:

4% gross receipts

50% combined taxable income (CTI)

Sect. 482

68




Under both the 4% gross receipts and 50% CTI methods, the DISC does not need to perform any economic functions or have any employees.

Under both the 4% gross receipts and 50% CTI methods, the DISC can increase its commission by 10% of its export promotion expenses (EPEs), if the DISC is a buy-sell DISC vs. a commission DISC [Reg. 1.994-1(a)(2) and Computervision Corp v. Comm (96 T.C. 652)].

EPEs include general administrative and selling expenses, certain freight paid to U.S.-flagged carriers, packaging costs, and design and label costs for export products incurred by the DISC.

(Note: EPEs paid by a related party can qualify, if a contract existed between the related party earmarking the EPEs for the buy-sell DISC before the transaction took place.)

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The pricing method chosen is required on a

transaction-by-transaction basis (TxT); however, an

annual election can be made to group transactions in

accordance with products or product lines.

Neither the gross receipts method nor the CTI

method may be applied in a way that causes, in any

taxable year, a loss to the related supplier. There is a

special rule that allows the 4% gross receipts

method to apply where the overall profit percentage

is not exceeded [Reg. 1.994-1(e)(1)(ii)].

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When utilizing the CTI method, overhead costs generally are allocated between export and domestic sales, based on detailed rules [Reg. 1.861-8].

However, if the profit margin on export products is less than profit margin on worldwide sales of the same products, then marginal costing rules may be applied to allocate only marginal or variable costs against export receipts under the CTI method [Reg. 1.994-2].

Overall, the CTI method generally produces a larger benefit than the gross receipts method, when exports have a greater-than-8% profit ratio.

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Related Supplier Income Statement Before IC DISC

Commission

Domestic Sales 300

Export Sales 100

Domestic COGS (150)

Export COGS (50)

GP 200

Overhead (100)

Taxable Income 100 25%

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DISC Commission Calculation

Method 4% CTI

Export 100 100

COGS (50)

GP 50

Overhead (25)

Net Income 25

Total Commission 4 12.50

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Starting with the 2013 tax year, Section 1411 provides that a

3.8% “Net Investment Income Tax” (NIIT) applies to Net

Investment Income.

For joint taxpayers, the tax applies to the lesser of:

Net Investment Income, or

The excess of “modified adjusted gross income” over

$250,000

Dividends are generally subject to the NIIT. In certain factual

situations, a reasonable position may exist to treat dividends

from an active buy sell IC DISC as not subject to the NIIT.

However, a March 10, 2014 BNA article by Lydia Beyoud

provided the following quote from David Kirk, attorney from the

Office of Chief Counsel at IRS, at the Federal Bar Association

Conference:

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For the purposes of calculating income that may be excluded from NII tax, practitioners and

taxpayers should also keep in mind the interplay between activities considered to be “derived

in the ordinary course of a trade or business” and the working capital rule, Kirk said.

The IRS has received a number of questions on what happens when a partnership owns a

corporation underneath it. Even if a partnership acquires C corporate stock in a proximately

related business, if they are receiving dividends, the income will continue to be treated as

dividends, he said.

“Even if you could say that these businesses are so proximately related to each other that it is

derived in ordinary course of a trade or business under case law, or whatever it is that you can

find” to support your claim, “you step into the working capital rule of 1411(c)(3),” which cross

references § 469(e)(1)(B), as well as additional rules on ways in which an item is derived in

the ordinary course of trade or business for purposes of § 469, Kirk said.

“The only way you are getting dividends out is if you are a dealer” in stock or financial

instruments, he said. Entities that own domestic corporations or an interest-charge domestic

international sales corporation (IC-DISC) will fall into the category of businesses unable to

exclude their dividends from a subsidiary or “brother-sister” structure from NII, said Kirk.

“Dividends coming out will always be dividends; interest the same way,” he said.

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In the Preamble for Treasury Decision 9644, 78 FR

72393-72449, Section 1.469-2T(c)(3)(ii)(D) was cross

referenced as guidance for when dividends could be

“derived in the ordinary course” of a trade or business.

Section 993(e)(3)(B) provides the notion of how

transactions related to a DISC can be in furtherance of

transactions giving rise qualified exports. Consider whether an individual that wholly owns an S Corporation

which in turn wholly owns an active buy sell disc could reasonably

argue that the NIIT should not apply to IC DISC dividends because

the DISC dividends are part of the S Corporation’s trade or business

and the individual materially participates in both businesses?

Overall, any position that involves DISC dividends not

being subject to the NIIT should carefully consider

potential penalties and the inherent uncertainty with

newly enacted taxes.

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Initial IC-DISC election is made on Form 4876-A within

90 days of the start of the taxable year (must be signed

by all shareholders).

A Form 1120 IC-DISC is required to be filed annually

on or before the 15th day of the ninth month following the

close of the tax year.

Attached will be Schedule K, Shareholder’s

Statement of IC-DISC Distributions (indicates actual

and deemed distributions that are taxable)

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A Form 8404 must be filed by all IC-DISC shareholders on or before the original due date of their tax returns (no extensions are permitted).

Form 8404 requires any deferred interest-related costs to be paid (estimated tax payments are not required on a quarterly basis).

Deferred interest is calculated on hypothetical tax based on ordinary rates vs. qualified dividend rates.

Form 8404 anticipates that estimates are likely needed, and amended procedures are outlined in form instructions.

Various states have different state income tax filings required.

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The DISC must make an initial estimate of the commission at the end of the year, and the related supplier must pay the commission within 60 days of the close of the year [Reg. 1.994-1(e)(3)(i)].

Reasonable estimate requires at least 50%

Payment should generally be in cash to avoid non- compliance risk [TSI, Inc. v. US (977 F.2d 424) and Thomas Int’l Ltd v US (773 F.2d 300)].

True-up commission requires payment in 90 days.

Failure to optimize available methods such as TxT, marginal costing, overhead allocation under CTI, EPE and factoring of qualified export-related accounts receivable [Rev. Rul. 75-430]

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