Category: Tax

Choosing the right accounting method for tax purposes

 

The Tax Cuts and Jobs Act (TCJA) liberalized the eligibility rules for using the cash method of accounting, making this method — which is simpler than the accrual method — available to more businesses. Now the IRS has provided procedures a small business taxpayer can use to obtain automatic consent to change its method of accounting under the TCJA. If you have the option to use either accounting method, it pays to consider whether switching methods would be beneficial.

Cash vs. accrual

Generally, cash-basis businesses recognize income when it’s received and deduct expenses when they’re paid. Accrual-basis businesses, on the other hand, recognize income when it’s earned and deduct expenses when they’re incurred, without regard to the timing of cash receipts or payments.

In most cases, a business is permitted to use the cash method of accounting for tax purposes unless it’s:

1. Expressly prohibited from using the cash method, or
2. Expressly required to use the accrual method.

Cash method advantages

The cash method offers several advantages, including:

Simplicity. It’s easier and cheaper to implement and maintain.

Tax-planning flexibility. It offers greater flexibility to control the timing of income and deductible expenses. For example, it allows you to defer income to next year by delaying invoices or to shift deductions into this year by accelerating the payment of expenses. An accrual-basis business doesn’t enjoy this flexibility. For example, to defer income, delaying invoices wouldn’t be enough; the business would have to put off shipping products or performing services.

Cash flow benefits. Because income is taxed in the year it’s received, the cash method does a better job of ensuring that a business has the funds it needs to pay its tax bill.

Accrual method advantages

In some cases, the accrual method may offer tax advantages. For example, accrual-basis businesses may be able to use certain tax-planning strategies that aren’t available to cash-basis businesses, such as deducting year-end bonuses that are paid within the first 2½ months of the following year and deferring income on certain advance payments.

The accrual method also does a better job of matching income and expenses, so it provides a more accurate picture of a business’s financial performance. That’s why it’s required under Generally Accepted Accounting Principles (GAAP).

If your business prepares GAAP-compliant financial statements, you can still use the cash method for tax purposes. But weigh the cost of maintaining two sets of books against the potential tax benefits.

Making a change

Keep in mind that cash and accrual are the two primary tax accounting methods, but they’re not the only ones. Some businesses may qualify for a different method, such as a hybrid of the cash and accrual methods.

If your business is eligible for more than one method, we can help you determine whether switching methods would make sense and can execute the change for you if appropriate.

© 2018

Do you qualify for the home office deduction?

 

Under the Tax Cuts and Jobs Act, employees can no longer claim the home office deduction. If, however, you run a business from your home or are otherwise self-employed and use part of your home for business purposes, the home office deduction may still be available to you.

Home-related expenses

Homeowners know that they can claim itemized deductions for property tax and mortgage interest on their principal residences, subject to certain limits. Most other home-related expenses, such as utilities, insurance and repairs, aren’t deductible.

But if you use part of your home for business purposes, you may be entitled to deduct a portion of these expenses, as well as depreciation. Or you might be able to claim the simplified home office deduction of $5 per square foot, up to 300 square feet ($1,500).

Regular and exclusive use

You might qualify for the home office deduction if part of your home is used as your principal place of business “regularly and exclusively,” defined as follows:

1. Regular use. You use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use.

2. Exclusive use. You use the specific area of your home only for business. It’s not necessary for the space to be physically partitioned off. But, you don’t meet the requirements if the area is used both for business and personal purposes, such as a home office that also serves as a guest bedroom.

Regular and exclusive business use of the space aren’t, however, the only criteria.

Principal place of business

Your home office will qualify as your principal place of business if you 1) use the space exclusively and regularly for administrative or management activities of your business, and 2) don’t have another fixed location where you conduct substantial administrative or management activities.

Examples of activities that are administrative or managerial in nature include:

  • Billing customers, clients or patients,
  • Keeping books and records,
  • Ordering supplies,
  • Setting up appointments, and
  • Forwarding orders or writing reports.

Meetings or storage

If your home isn’t your principal place of business, you may still be able to deduct home office expenses if you physically meet with patients, clients or customers on your premises. The use of your home must be substantial and integral to the business conducted.

Alternatively, you may be able to claim the home office deduction if you have a storage area in your home — or in a separate free-standing structure (such as a studio, workshop, garage or barn) — that’s used exclusively and regularly for your business.

Valuable tax-savings

The home office deduction can provide a valuable tax-saving opportunity for business owners and other self-employed taxpayers who work from home. If you’re not sure whether you qualify or if you have other questions, please contact us.

© 2018

Business deductions for meal, vehicle and travel expenses: Document, document, document

 

Meal, vehicle and travel expenses are common deductions for businesses. But if you don’t properly document these expenses, you could find your deductions denied by the IRS.

A critical requirement

Subject to various rules and limits, business meal (generally 50%), vehicle and travel expenses may be deductible, whether you pay for the expenses directly or reimburse employees for them. Deductibility depends on a variety of factors, but generally the expenses must be “ordinary and necessary” and directly related to the business.

Proper documentation, however, is one of the most critical requirements. And all too often, when the IRS scrutinizes these deductions, taxpayers don’t have the necessary documentation.

What you need to do

Following some simple steps can help ensure you have documentation that will pass muster with the IRS:

Keep receipts or similar documentation. You generally must have receipts, canceled checks or bills that show amounts and dates of business expenses. If you’re deducting vehicle expenses using the standard mileage rate (54.5 cents for 2018), log business miles driven.

Track business purposes. Be sure to record the business purpose of each expense. This is especially important if on the surface an expense could appear to be a personal one. If the business purpose of an expense is clear from the surrounding circumstances, the IRS might not require a written explanation — but it’s probably better to err on the side of caution and document the business purpose anyway.

Require employees to comply. If you reimburse employees for expenses, make sure they provide you with proper documentation. Also be aware that the reimbursements will be treated as taxable compensation to the employee (and subject to income tax and FICA withholding) unless you make them via an “accountable plan.”

Don’t re-create expense logs at year end or when you receive an IRS deficiency notice. Take a moment to record the details in a log or diary at the time of the event or soon after. The IRS considers timely kept records more reliable, plus it’s easier to track expenses as you go than try to re-create a log later. For expense reimbursements, require employees to submit monthly expense reports (which is also generally a requirement for an accountable plan).

Addressing uncertainty

You’ve probably heard that, under the Tax Cuts and Jobs Act, entertainment expenses are no longer deductible. There’s some debate as to whether this includes business meals with actual or prospective clients. Until there’s more certainty on that issue, it’s a good idea to document these expenses. That way you’ll have what you need to deduct them if Congress or the IRS provides clarification that these expenses are indeed still deductible.

For more information about what meal, vehicle and travel expenses are and aren’t deductible — and how to properly document deductible expenses — please contact us.

© 2018

Does your business have to begin collecting sales tax on all out-of-state online sales?

 

You’ve probably heard about the recent U.S. Supreme Court decision allowing state and local governments to impose sales taxes on more out-of-state online sales. The ruling in South Dakota v. Wayfair, Inc. is welcome news for brick-and-mortar retailers, who felt previous rulings gave an unfair advantage to their online competitors. And state and local governments are pleased to potentially be able to collect more sales tax.

But for businesses with out-of-state online sales that haven’t had to collect sales tax from out-of-state customers in the past, the decision brings many questions and concerns.

What the requirements used to be

Even before Wayfair, a state could require an out-of-state business to collect sales tax from its residents on online sales if the business had a “substantial nexus” — or connection — with the state. The nexus requirement is part of the Commerce Clause of the U.S. Constitution.

Previous Supreme Court rulings had found that a physical presence in a state (such as retail outlets, employees or property) was necessary to establish substantial nexus. As a result, some online retailers have already been collecting tax from out-of-state customers, while others have not had to.

What has changed

In Wayfair, South Dakota had enacted a law requiring out-of-state retailers that made at least 200 sales or sales totaling at least $100,000 in the state to collect and remit sales tax. The Supreme Court found that the physical presence rule is “unsound and incorrect,” and that the South Dakota tax satisfies the substantial nexus requirement.

The Court said that the physical presence rule puts businesses with a physical presence at a competitive disadvantage compared with remote sellers that needn’t charge customers for taxes.

In addition, the Court found that the physical presence rule treats sellers differently for arbitrary reasons. A business with a few items of inventory in a small warehouse in a state is subject to sales tax on all of its sales in the state, while a business with a pervasive online presence but no physical presence isn’t subject to the same tax for the sales of the same items.

What the decision means

Wayfair doesn’t necessarily mean that you must immediately begin collecting sales tax on online sales to all of your out-of-state customers. You’ll be required to collect such taxes only if the particular state requires it. Some states already have laws on the books similar to South Dakota’s, but many states will need to revise or enact legislation.

Also keep in mind that the substantial nexus requirement isn’t the only principle in the Commerce Clause doctrine that can invalidate a state tax. The others weren’t argued in Wayfair, but the Court observed that South Dakota’s tax system included several features that seem designed to prevent discrimination against or undue burdens on interstate commerce, such as a prohibition against retroactive application and a safe harbor for taxpayers who do only limited business in the state.

Please contact us with any questions you have about sales tax collection requirements.

© 2018

How to avoid getting hit with payroll tax penalties

 

For small businesses, managing payroll can be one of the most arduous tasks. Adding to the burden earlier this year was adjusting income tax withholding based on the new tables issued by the IRS. (Those tables account for changes under the Tax Cuts and Jobs Act.) But it’s crucial not only to withhold the appropriate taxes — including both income tax and employment taxes — but also to remit them on time to the federal government.

If you don’t, you, personally, could face harsh penalties. This is true even if your business is an entity that normally shields owners from personal liability, such as a corporation or limited liability company.

The 100% penalty

Employers must withhold federal income and employment taxes (such as Social Security) as well as applicable state and local taxes on wages paid to their employees. The federal taxes must then be remitted to the federal government according to a deposit schedule.

If a business makes payments late, there are escalating penalties. And if it fails to make them, the Trust Fund Recovery Penalty could apply. Under this penalty, also known as the 100% penalty, the IRS can assess the entire unpaid amount against a “responsible person.”

The corporate veil won’t shield corporate owners in this instance. The liability protections that owners of corporations — and limited liability companies — typically have don’t apply to payroll tax debts.

When the IRS assesses the 100% penalty, it can file a lien or take levy or seizure action against personal assets of a responsible person.

“Responsible person,” defined

The penalty can be assessed against a shareholder, owner, director, officer or employee. In some cases, it can be assessed against a third party. The IRS can also go after more than one person. To be liable, an individual or party must:

1. Be responsible for collecting, accounting for and remitting withheld federal taxes, and

2. Willfully fail to remit those taxes. That means intentionally, deliberately, voluntarily and knowingly disregarding the requirements of the law.

Prevention is the best medicine

When it comes to the 100% penalty, prevention is the best medicine. So make sure that federal taxes are being properly withheld from employees’ paychecks and are being timely remitted to the federal government. (It’s a good idea to also check state and local requirements and potential penalties.)

If you aren’t already using a payroll service, consider hiring one. A good payroll service provider relieves you of the burden of withholding the proper amounts, taking care of the tax payments and handling recordkeeping. Contact us for more information.

© 2018

Surviving Divorce: Eight Steps to Starting Over

No one ever expects to get to this point.  The anger, deception, frustration and fear have taken over your normally rational mind and you are not thinking clearly.  Your friends, family and work place associates are all experts at telling you what to do, yet they have not been through it themselves and only have few facts relevant to your situation.  The situation creates it’s own momentum and you are confused and unsure of what to do next.  Following are suggestions for getting on track and moving forward.

Continue reading “Surviving Divorce: Eight Steps to Starting Over”

A Road-map for IRS Audits . . . Schedule UTP has Arrived!

The following is part I of a two part blog post, which will describe the specific reporting requirements of Schedule UTP and discuss the IRS’ objectives and rational for its new reporting requirements. Part 2 will apply the  requirements of Schedule UTP to specific factual situations and reconcile the resulting reporting requirements to those requirements under FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”).

The much anticipated IRS audit road-map, Schedule UTP, is now reality for certain large corporate taxpayers.   Corporations that file Form 1120, U.S. Corporation Income Tax Return, Form 1120-F, U.S. Income Tax Return of a Foreign Corporation and certain insurance companies with assets of more than $100 million must file a Schedule UTP starting in 2010. To view Schedule UTP, click here. To view the IRS instructions to Schedule UTP, click here. Schedule UTP must be attached to a calendar year 2010 tax return or to a fiscal year-end return that begins in 2010 and ends in 2011

The initial reporting threshold of $100 million of total assets will be reduced to $50 million starting in 2012 and to $10 million for the 2014 tax year.  Only a corporate taxpayer or related party that has issued audited financial statements covering all or a portion of the corporation’s tax year is required to file a Schedule UTP.  Compiled or reviewed financial statements are not audited financial statements.

Note that a corporation without audited financial statements is still required to file Schedule UTP if it meets the related party definition.   A “related party” is any entity that has a relationship described in IRC Section 267(b), Section 318(a), or that is included in the consolidated audited financial statements in which a corporation with audited financial statements is also included.

A corporation must report tax positions taken on a U.S. federal income tax return if:

  • The corporation has taken a position on its federal income tax return for the current year or for a prior year, and
  • The corporation or a related party has either
    • Recorded a reserve with respect to that tax position in audited financial statements, or
    • Not recorded a reserve for a tax position because the corporation expects to litigate the position.

A tax position taken on a return is defined as one that would result in an adjustment  to a line item on a return or that would be included in a Section 481(a) adjustment (i.e. a change in a method of accounting) if the position were not sustained on upon an IRS audit. If multiple positions affect a single line on the tax return, each tax position is treated as a separate tax position. A tax position is based on a unit of account used to prepare the audited financial statements in which the reserve has been recorded. The unit of account must be the same unit of account used by the taxpayer in its financial statements for purposes of FIN 48.  If no FIN 48 reserve was required, the tax position need not be reported on Schedule UTP.

The initial FIN 48 reserve for financial statement purposes will trigger the reporting requirement on Schedule UTP. Interestingly, subsequent increases or decreases in the FIN 48 reserve will not require additional Schedule UTP reporting. Additionally, no Schedule UTP disclosure is required with respect to tax positions taken on a return before January 1, 2010, even if a corporation records a reserve for financial statements issued in 2010 or later.

A corporation must report on Schedule UTP a tax position for which it did not record a reserve based on its expectation to litigate the position if: (i) the probability of settling with the IRS is less than 50% and (ii) no reserve was recorded in the financial statements because the corporation intends to litigate the tax position and has determined that it is more likely than not to prevail on the merits in litigation.

Schedule UTP is divided into three parts. In part I, the corporate taxpayer reports tax positions taken in the current year that meet the definition of a UTP disclosure position. Part II is used to report tax positions taken by a corporation in a prior year that has not been reported on Schedule UTP.  Part III is used to provide a concise description of each uncertain tax position reported in parts I and II.

For each UTP, the corporate taxpayer must provide the following information:

  • Identify the Internal Revenue Code section related to each UTP (up to three code sections).
  • Indicate whether the UTP is temporary and/or permanent book-tax difference.
  • If the UTP relates to a pass-through entity (e.g. partnership, S corporation, etc.) the EIN of the pass-through must be reported.
  • Disclosure with respect to those UTPs whose relative size (by amount of dollar reserve) is greater than or equal to 10% of all UTPs listed on parts I and II of Schedule UTP for that tax year.
  • All UTPs on parts I and II must be ranked based on size with the number “1” assigned to the largest, “2” to the next largest, and so on. The letter T must be provided for all transfer pricing related issues and the letter G for all other UTPs.

IRS Commission Doug Shulman announced the following goals of Schedule UTP

  • Create certainty regarding a taxpayer’s obligation sooner rather than later.
  • Cut down on the time it takes that IRS to find issues and complete an audit.
  • Provide consistent treatment across taxpayers.
  • Make efficient use of government resources by focusing on issues the pose the greatest risk of noncompliance.
  • Ensure that both the IRS and taxpayer spend more time discussing the law as it applies to the facts and less time looking for information.
  • Help the IRS prioritize taxpayers for examination
  • Help the IRS identify issues where there is uncertainty and where further guidance is necessary.
  • Help the IRS prioritize selection of issues during an audit.
  • Obtain key information regarding uncertain tax positions without getting into the heads of the taxpayer or their advisors as it relates to quantifying risk.

The practical impact of Schedule UTP is that the affected corporate taxpayer must now carefully consider its FIN 48 analysis and disclosure in conjunction the preparation of Schedule UTP and its defense of its tax position.  In part 2, we will apply the new disclosure requirements to specific factual situations.

 

Treasury Issues Final Regulations on FBAR Filing Requirements and IRS Releases Revised FBAR Form

On February 24, 2011, the Treasury Department issued final regulations (the “Regulations”) regarding the Report of Foreign Bank and Financial Accounts (“FBAR”). The Regulations, which can be found here, are effective March 28, 2011 and apply to FBARs for 2010 due on June 30, 2011, as well as any FBARs for prior years which were deferred under prior IRS guidance. The Treasury also noted that it plans to permit electronic filing of the FBAR (once technology updates are implemented), but did not announce a specific time frame for electronic filing.

The Regulations (i) addresses the scope of the persons that are required to file reports of foreign financial accounts; (ii) specifies the types of accounts that are reportable; (iii) provides filing relief in the form of exemptions for certain persons with signature or other authority over foreign financial accounts; and (iv) adopts provisions intended to prevent persons subject to the rule from avoiding their reporting requirement.

Background

The Regulations generally require a US person who has a financial interest in, or signature or other authority over one or more foreign financial accounts that have an aggregate value exceeding $10,000 at any time during the calendar year to disclose that interest to the IRS. The disclosure must be made on Form TD F 90-22.1, FBAR, and form must be filed on or before June 30 of each calendar year for accounts maintained during the previous calendar year.  In March 2011, the IRS published a revised FBAR form with accompanying instructions that reflect the changes made by the Regulations.

Key provisions of the Regulations include:

US Person

  • The term US person includes a US citizen, US resident or domestic entity (including, but not limited to a corporation, partnership, trust, or limited liability company). In the case of trusts, a US trustee must file the FBAR for the trust.
  • A legal permanent resident who elects under a tax treaty to be treated as a non-resident for tax purposes must nonetheless file the FBAR.

Financial Interest

The Regulations state that a US person has a financial interest in a bank, securities or other financial account in a foreign country if:

  • The US person is the owner of record or has legal title to the account, regardless of whether the account is maintained for his own benefit or for the benefit of others.
  • A person acts as an agent, nominee, attorney or in some other capacity on behalf of the US person with respect to the account.
  • The account is held by a corporation in which the US person owns directly or indirectly more than 50 percent of the voting power or the total value of the shares.
  • The account is held by a partnership in which the US person owns directly or indirectly more than 50 percent of the partnership’s profits or capital interest.
  • The account is held by any other entity in which the US person owns directly or indirectly more than 50 percent of the voting power, total value of the equity interest or assets, or interest in profits.
  • A trust, in which the US person is the trust grantor and the US person has an ownership interest in the trust for US Federal tax purposes.
  • The account is held by a trust in which a US person either has a present beneficial interest in more than 50 percent of the assets or from which such US person receives more than 50 percent of the current income.

Signature or Other Authority

An individual has “signature or other authority” over a financial account if he (alone or in conjunction with another) has the authority to control the disposition of money, funds or other assets held in the account by direct communication (whether in writing or otherwise) to the person maintaining the account.

The preamble to the Regulations states that the test for determining whether a US person has signature or other authority over an account (and thus a FBAR filing obligation) is whether the foreign financial institution will act upon a direct communication from such US person regarding the disposition of assets in that account. In addition, the preamble to the Regulations clarifies that officers and employees who are obligated to file FBARs because they have signature or other authority over an employer’s foreign financial accounts are not required to personally maintain the records of the foreign financial accounts of their employers.

The officers and employees with signature or other authority over the foreign financial account of the following entities are not required to report that he has signature or other authority over that account as long as he has no financial interest in the account:

  • Banks that are examined by the Office of the Comptroller of Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, or the National Credit Union Administration;
  • Financial institutions registered with and examined by the US Securities and Exchange Commission (the “SEC”) or the US Commodity Futures Trading Commission;
  • Entities that are registered with and examined by the SEC that provide services to investment companies registered under the Investment Company Act of 1940;
  • Entities with a class of equity securities (or American depository receipts) listed on any US national securities exchange, and US subsidiaries of US entities with a class of equity securities listed on a US national securities exchange if the US subsidiary is identified on a consolidated FBAR report filed by the parent.
  • Entities with a class of equity securities (or American depository receipts in respect f equity securities) registered under section 12(g) of the Securities Exchange Act.

Reportable Foreign Financial Accounts

  • Bank Accounts – A “bank account” is a savings deposit, demand deposit, checking, or any other account maintained with a person that is in the banking business.
  • Securities Account. A “securities account” is an account maintained with a person involved in the business of buying, selling, holding, or trading stock or other securities.
  • Other Financial Account. The term “other financial account” means (i) an account with a person in the business of accepting deposits as a financial agency; (ii) an account that is an insurance or annuity policy with a cash value ; (iii) an account with a person acting as a broker or dealer for futures or options transactions in any commodity on or subject to the rules of a commodity exchange or association; or (iv) an account with a mutual fund or similar pooled fund which issues shares that are available to the general public in addition to having a regular net asset value determination and regular redemptions.
  • The proposed regulations specifically reserved the treatment of investments companies other than mutual funds or similar pooled funds, and the Final Regulations continue to do so. As a result, for the time being, interests in other investment entities such as foreign hedge funds and private equity funds that have periodic redemptions are not considered foreign financial accounts, and therefore FBARs do not have to be filed with respect to such interests.
  • The preamble to the Regulations clarifies that an account is not a foreign account under the FBAR if it is maintained with a financial institution located in the US even though the account may contain holdings or assets of foreign entities. The preamble also clarifies that, in general, the FBAR rules do not apply to omnibus accounts in which a US bank, acting as a global custodian combines the assets of multiple investors and creates pooled cash and securities accounts in non-US markets. The preamble states that as long as the US customer cannot directly access their foreign assets maintained at the foreign institution, the US customer maintains an account with a financial institution located in the US, and therefore will not have to file a FBAR with respect to assets held in the omnibus account and maintained by the global custodian.

Other Special Rules

25 or more Foreign Financial Accounts – A US person that has a financial interest in, or signature or other authority over 25 or more foreign financial accounts is only required to provide the number of financial accounts and certain other basic information on the FBAR report; however, such US person will be required to provide detailed information concerning each account when requested by the IRS.

Consolidated Reports – US entities are permitted to file consolidated FBAR reports on behalf of itself and any entity in which it owns directly or indirectly more than a 50 percent interest.

Participants and Beneficiaries in Certain Retirement Plans – Participants, owners, and beneficiaries in retirement plans under IRC sections 401(a), 403(a), 403(b), 408, and 408A are not required to file a FBAR report for any foreign financial account held by or on behalf of the retirement plan.

IRS Releases New FBAR Form

The Internal Revenue Service has released a revised Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), which can be found here. The revised FBAR Form is used to disclose financial interests in or signature authority over foreign financial accounts where such accounts exceed $10,000 in the aggregate at any time during the calendar year. The revised FBAR Form implements the Regulations as discussed above and is to be used for the upcoming June 30, 2011 filing deadline and can be found here.

The instructions to the revised FBAR Form provide additional guidance to assist filers in completing the Form. Revised definitions, which include “United States Person,” “signature authority” and “foreign financial account,” track the changes described in the final Regulations. In addition, the instructions offer clarifying guidance on how to complete the Form, including, for example, where the filer is an individual with signature authority over a foreign financial account, is a disregarded entity, or is an entity that does not have a United States mailing address.

The revised instructions clarify that consolidated reporting is available for non-corporate as well as corporate affiliates, and instruct filers on how to determine the maximum account value of each account. The revised instructions also provide a reorganized list of exceptions to the filing requirement, which confirms the categories of exceptions as expanded under the final Regulations; this list indicates that the following persons, among others, are not required to file FBARs:

  • owners and beneficiaries of IRAs and participants in and beneficiaries of tax-qualified retirement plans;
  • officers and employees with signature authority but no financial interest in financial accounts of companies, the shares of which are registered with the SEC (including those listed on a US national securities exchange); and
  • officers and employees of entities which are registered with and examined by the SEC and provide services to registered investment companies (i.e., registered investment advisors) with signature authority but no financial interest in the financial accounts of such companies.

 

IC-DISC – THE LAST REMAINING EXPORT INCENTIVE FOR US MANUFACTURERS AND EXPORTERS

An IC-DISC can provide a permanent 20% tax savings (or even more) for qualifying U.S. manufactures and exporters.

Background

For U.S. exporters operating their business via a sole proprietorship or pass-through entity (e.g., limited liability company (LLC), S corporation, limited partnership (LP)), the IC-DISC benefit is essentially tied to the differential between the qualified dividend rates and the ordinary income tax rates. This differential was originally set to expire on December 31, 2010 but Congress extended it in late December of 2010 to December 31, 2012.

Many practitioners strongly believe that this differential will be extended past 2012 even if tax rates on ordinary income increase. In addition to benefiting sole proprietorships and pass-through entities, exporters operating their business via a C corporation can benefit by using the IC-DISC to eliminate double taxation on a majority of their export income, as well as to reduce the need to incur additional payroll taxes on income paid to their shareholders/officers. The IC-DISC is not a tax shelter.

To qualify as an IC-DISC, a domestic corporation must pass two main tests known as the qualified export receipts test and the qualified export assets test. The qualified export receipts test requires that 95% of the gross receipts of the IC-DISC constitute qualified export receipts. The qualified export assets test requires that 95% of the assets of the IC-DISC be qualified export assets. Qualified export assets include accounts receivable, temporary investments, export property, and loans to producers.

Because most of the qualified export receipts categories focus on export property, it is critical that the exporter substantiate that its exports satisfy the definition of export property. Three requirements must be met in order for the IC-DISC to receive income from an export sale. The export property must:

(1) Be manufactured, produced, grown, or extracted in the U.S. by a person other than the IC-DISC.

(2) Be held primarily for sale, lease, or rental for use, consumption, or disposition outside the United States

(3) Have a maximum of 50% foreign content.

Although exporters often think of newly produced property as export property, used equipment and even scrap also qualify.

In its most recent form, the IC-DISC can provide a permanent 20% tax savings (or even more) for qualifying U.S. exporters. In certain cases, it eliminates U.S. tax entirely on the majority of export income. In addition, distributions to individual shareholders are currently taxed at a maximum rate of 15% – providing a way to convert 35% ordinary income to 15% qualified dividend income. Of course, this assumes that the U.S. exporter generates operating profits and is creating taxable income in the U.S.

IC-DISC Structure

The IC-DISC is a “paper” entity used as a tax-savings vehicle. It does not require corporate substance or form, office space, employees, or tangible assets. It simply serves as a conduit for export tax savings. An important feature of the IC-DISC is that shareholders can be corporations, individuals, or a combination of these.

This is how an IC-DISC works:

  • Owner-managed exporting company forms a special U.S. corporation that elects to be an IC-DISC. The election is made on IRS Form 4876-A, which must be filed within 90 days after the beginning of the tax year.
  • Exporting company pays IC-DISC a commission.
  • Exporting company deducts commission from ordinary income taxed at up to 35%.
  • IC-DISC pays no tax on the commission as long as certain qualification standards are met such as the 95% qualified export assets and the 95% qualified export receipts requirements of Section 992(a)(1).
  • Shareholders of an IC-DISC are not taxed until the earnings are distributed as dividends. However, the shareholders must pay annual interest on the tax deferred.
  • Shareholders that are individuals pay income tax on qualified dividends at the capital gains rate of 15%. C Corporation shareholders are automatically considered to have received 1/17th of the IC-DISC’s taxable income even if no distributions are made.
  • The result may be a 20% or more tax savings on commission.

Permanent Tax Savings on Global Sales

Permanent tax savings begin with the exporting company deducting the commission it pays to the IC-DISC from its ordinary income, which is taxed at up to 35%. Tax law sets the commission rate, which is based on export sales revenue, as the greater of either 50% of net export income or 4% of export sale revenue. Because the IC-DISC is tax exempt, tax is paid only on distributions to shareholders. Individual and pass-through company shareholders pay income tax on qualified dividends at the long-term capital gains rate of 15%.

Ability to Leverage Cost of Capital

An IC-DISC is more than a tax-savings vehicle. It can also be used as a deferral tool to leverage a company’s cost of capital. IC-DISC earnings need not be distributed to shareholders; they can instead be used to perpetuate and grow the deductible dividend tax rate savings. Tax rate savings are perpetuated by lending accumulated IC-DISC earnings back to the exporting company in return for a note and interest. The exporting company can deduct the interest expense, and interest income is considered a dividend to the IC-DISC shareholders. Reinvesting IC-DISC earnings back into the exporting business results in additional tax rate savings and diminishes the group’s cost of capital.

Opportunities to Create Management Incentives

Businesses can also use ownership in the IC-DISC to provide incentives. Exporting company management and other personnel can be named as shareholders, which allows them to benefit from additional cash flow created by increasing global sales.

Means to Facilitate Succession Planning

An IC-DISC offers a number of ways to execute a succession plan. Among these, ownership in the IC-DISC can be used as a means of generating cash, which can be distributed to shareholders in a tax-advantaged manner. IC-DISC shareholders participating in a buyout of current or previous shareholders can leverage these tax-advantaged IC-DISC earnings to pursue the buyout plan.

Conclusion

For U.S. exporters, the IC-DISC is the only remaining tax-saving opportunity. If you are unsure about whether or not an IC-DISC will work, ask the following questions:

  • Do you have any transactions outside of the U.S.?
  • Do you use overseas distribution?
  • Does your product cross any borders?
  • Are you generating operating income?

If the answer to any of these questions is yes, an IC-DISC could be a valuable tax-savings vehicle for your business.

On the surface, the rules covering the IC-DISC may seem simple. However, to maximize the tax benefit, a qualified IC-DISC advisor should be engaged. Many times an IC-DISC expert can double if not triple the tax benefit the IC-DISC provides by applying their in-depth understanding of how to structure the IC-DISC and using the complex advance pricing rules that the Internal Revenue Code allows for determining the tax benefit. A firm that has proven IC-DISC expertise, offers fixed fees, and optimizes the IC-DISC on a transactional basis (which almost always provides the best result) should be chosen.