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.

 

 

Form 5471 – A Harsh New Reality for US Shareholders of Foreign Corporations

Who is required to File Form 5471?

Certain US persons who are shareholders (both corporate and individual shareholders), officers or directors of a foreign corporation may be required to file Form 5471 on an annual basis. Here, is a link to the IRS Website on filing requirements l.

There are four categories (including corporate shareholders) that may be required to file the form, as follows:

1. A US person who is an officer or director of a foreign corporation in which any US person owns or acquires 10% or more of the stock of the foreign corporation.
2. A person who becomes a US person while owning 10% or more of the stock of the foreign corporation.
3. A US person who had control of a foreign corporation for at least 30 days.
4. A US shareholder who owns stock in a foreign corporation that is a controlled foreign corporation for an uninterrupted period of at least 30 days and who owned that stock on the last day of the that year.

What Information is Required?

The required information may be as minimal as the identification of the US shareholder and the name and address of the foreign corporation – or it may be as extensive as a comprehensive balance sheet and income statement converted from multiple foreign currencies into US dollars, including computations of cumulative earnings & profits and disclosure of related party transactions.

When is Form 5471 Due?

Form 5471 is due with the income tax return of the affected shareholder. For most corporations, that would March 15th or the extended due date. For most individuals, that would be April 15th or the extended due date.

How Long does it take to Prepare?

The IRS estimates the average time to prepare Form 5471 is approximately 38 hours, exclusive of record keeping time and the time required to learn about the relevant law and the instructions. The learning time could be much longer for someone who is not familiar with the pertinent sections of the tax law.

Harsh Penalties – A New Reality

For many years, it was extremely rare to get any IRS reply regarding a filing, even if the form was very late. The IRS has been warning in public statements that the Form 5471 penalties were coming and would be automatically assessed by the IRS computer. The penalty under IRC Section 6038(b)(1) is $10,000 for each late or incomplete Form 5471.

Remember, very often, the information on this form does not result in any taxable income or tax due for the taxpayer.  So, the $10,000 penalty is a “disclosure” penalty, unrelated to the actual tax consequences of the information provided on the Form 5471. The $10,000 penalty is real and is now being automatically assessed.

If the failure continues for more than 90 days after the date the IRS mails notice of the failure, an additional $10,000 penalty will apply for each 30-day period or fraction thereof during which the failure continues after the 90-day period has expired. The additional penalty is limited to a maximum of $50,000.

Why should a US Corporation with NOLs still be Concerned?

With the economic downturn, many US corporations have build-up significant net operating losses (NOLs). Thus, management may not be overly concerned about filing Form 5471, based on its belief that the company’s NOLS will shelter any potential exposure. However, because the failure to file Form 5471 results in a penalty (not a tax), NOLs do not any shelter this exposure.

Thus, the often unforeseen result is a FIN 48 liability and hit to the P&L for $10,000 for each unfiled Form 5471. For example, a US corporation with four foreign subsidiaries for which Forms 5471 have not been filed in the three most recent tax years would be required to accrue a $120,000 (a $10,000 penalty for each unfiled Form 5471 x 4 subsidiaries x 3 tax years) FIN 48 liability and current year P&L expense, which can be a huge P&L hit for company with no US taxable income.

Additionally, the three year statute of limitations with respect to the underlying tax income tax return (Form 1120, 1040, etc.) does not start running until Form 5471 is properly filed, as the return was not complete at the time it was originally submitted.

 

 

 

Why You Shouldn’t Kill Your Rich Uncle Just Yet: Things You May Not Know About the Estate Tax Repeal

Estate and FInancial PlanningThe day is finally here. After hearing about it for the past nine years, the estate tax is repealed as of January 1, 2010. Yet, many questions remain. For example, one may wonder what will happen next year when the estate tax (presumably) returns and one is puzzled why U.S. Congress did not address the “estate tax issue” during the 2009 tax year.

The one-year repeal of the “death tax” was a typical congressional compromise. It involved the gradual decrease in marginal tax rates and increase in tax free amount (unified credit) through 2009 and the repeal of the tax for just one year in 2010. The current law reads that in 2011 the rates from 2001 will apply again (P.L. 107-16, 115 Stat 38 (June 7, 2001)).

What does this mean for taxpayers? Let’s assume Uncle Joseph’s taxable estate is valued at $5 million. If he died in 2001, $675,000 of the estate would have been tax free and the rest would have been taxed with a top marginal rate of 55%. Tax liability would have been about 2.17 million and effective tax rate about 43%. Had Uncle Joseph died in 2009, his tax due would have been $675,000 and his effective tax rate around 14% while a 2010 death would mean zero liability (see Table).

Year Top Marginal Tax Rate Unified Credit
(Exemption Equivalent)		 Tax due after credit on $5 million estate Effective Tax Rate
2001 55% $220,550 ($675,000) $ 2,170,250 43%
2002 50% $345,800 ($1,000,000) $ 1,930,000 39%
2003 49% $345,800 ($1,000,000) $ 1,905,000 38%
2004 48% $555,800 ($1,500,000) $ 1,665,000 33%
2005 47% $555,800 ($1,500,000) $ 1,635,000 33%
2006 46% $780,800 ($2,000,000) $ 1,380,000 28%
2007 45% $780,800 ($2,000,000) $ 1,350,000 27%
2008 45% $780,800 ($2,000,000) $ 1,350,000 27%
2009 45% $1,455,800 ($3.5 million) $    675,000 14%
2010 NA NA No tax N/A
2011 55% $220,550 ($675,000) $ 2,170,250 43%

Questionable Policy Incentives

The stated policy reason for estate taxes has been that too much concentration of wealth is not good for a society. Aside from the fact that the estate tax has not done much in terms of reducing income and wealth inequality, the fact that Congress did not change the one-year repeal before January 1 of 2010, is an example of implementing quite questionable incentives. As the situation above shows, all else equal, the best year for Joseph to die is 2010. His heirs will receive the entire $5 million instead of only $4.3 million if he died in 2009 or $2.8 million if he dies in 2011. Of course, death of natural causes cannot be timed. What happens though if Joseph was in a serious accident in late 2009 without a DNR order in place? Would his heirs insist that he’d be kept alive until January 1 and then taken off life support? What if Joseph has an accident in December of 2010?

In order to prevent anybody of literally making life or death decisions in order to save taxes, Congress should have addressed the estate tax in 2009 before the repeal-year started. There were several proposals on the table. Considering the current budget shortfall and the Democratic majorities in both the House and the Senate it is not unlikely that the legislators will pass a law retroactively changing the 2010 repeal. Since tax returns are not due until nine months after the decedent’s death, a retroactive change is possible. For example, it may be possible that a “patch” (i.e., keeping rates and credit like it was in 2009) will pass for 2010. Thus, contemplating death in light of a possible tax free year would be unwise considering the irreversibility of such action.

Other Negative Consequences

During 2001–2011 inflation was relatively low (around 2.3% on average). Using consumer price index measures, the value of a dollar in 2001 is about 1.25 more than in 2011. Given that in 2001, over 108,000 estate tax returns were filed, compared to only 38,000 in 2008 , we can assume that reverting back to 2001 law would mean that at least 130,000 returns will be due in 2011. This is good news to tax accountants but bad news for many individuals who did not expect to be subject to estate taxes.

In addition, the repeal of the estate tax for 2010 means that assets transferred at death during this year do not get a stepped-up basis. Thus, beneficiaries will have to pay larger amounts in income taxes when they sell the inheritance.

Last, the one-year repeal is also bad news for estates below the exemption equivalent. For these estates, the tax savings are zero while the elimination of the step-up in basis increases beneficiaries’ income tax when they sell the assets received. One can make the argument that this is a rule against the middle class and upper middle class since presumably most of these individuals would have never paid estate tax anyway but their heirs would benefit from the step-up in basis. If the law reverts back to 2001 law in 2011, the step-up will be back next year. Thus, while individuals with large estates have an incentive to die in 2010, others (most middle and upper middle class taxpayers) who have an estate below the exemption equivalent should not die in 2010.

Would SOX 404(b) Have Protected Koss?

Koss Business Fraud & EmbezzlementLast week Koss, the manufacturer of high quality head phones, disclosed that their principal accounting officer had embezzled between $4.5 million and $31 million between 2005 and December, 2009. The advocates of requiring small issuers  to annually file integrated audit reports on their respective internal control systems immediatley pointed  at Koss as justification for requiring the  implementation of 404(b) beginning in June, 2010. Is this adequate justification?  For several reasons, I don’t believe it is.

This was an intentional fraud. Neither financial statement nor internal control audits are designed to guarantee the detection of fraud.  Yes, an internal control audit would have disclosed the existence of significant deficiencies and material weaknesses. An expanded internal control review might have even stumbled across the defalcation. More likely it would have only resulted in an adverse opinion on the internal control systems by the company’s auditor. This could have been an alert to investors, but more likely it would have been ignored as the SEC’s own studies have indicated. Integrated audits have not resulted in a higher level of confidence by investors. Fraud audits for all issuers require a lower level of materiality that can not be justified economically.

If in this particular case the amount embezzled was material for any of the five years effected it would seem that it should have been detected under normal financial statement audit procedures in at least one year. A failure by the audit firm  to properly complete an audit is not justification for adding another layer of regulation on small issuers under SOX.

The company had retained the same national audit firm for the past five years. Based on the professional fees disclosed in the proxy statement it is possible that Koss was a small fish in the big pond of this national firm and may or may not have gotten the service it needed and deserved. Some large national firms have been known to ‘rank’ their clients. If you are not the big dog on the porch you are not likely to get the same level of expertise, experience and service as the bigger clients.

Cost. Certainly for Koss  the cost of an ICFR program – including both the external audit fees and the internal program costs –  would have been less expensive than the amount embezzled, but requiring all firms to bear a cost to ‘potentially’ prevent an occasional fraud loss of this type is ridiculous. Theoretically, 404(b) would cost a firm similar in size to Koss, $250,000 annually (ballpark WAG).  One-third to one-half of that being for the external auditors. So the investors in Koss would have been out something in excess of a million dollars. The cost/benefit equation for requiring this universally just wouldn’t seem to balance, unless you subscribe to the premise that something graeter than 10% of all statements are fraudulent.

There are already criminal and civil penalties in place to protect the investor from this type of malfeasance as we’ve discussed in our prior posts. Another in the form of 404(b)  is not needed. The responsibility to the shareholders rightfully lies with the Audit Committe of the Board, the Board of Directors and management. If more company oversight is needed and beneficial those charged with governance are ostensibly sophisticated enough and in the best analytical position to know and provide it.

I still view the cost of 404(b) as an ineffective unsupportable dissipation of investors equity. We’ve had some great dialog on this topic in the past.  Did I change anyone’s mind?

IFRS – Time to Panic?

IFRS is a ticking time bomb!In recent months the focus of discussions related to adoption of the International  Financial Reporting Standards have centered on differences with US GAAP (such as LIFO inventory), timing and implementation. I don’t want to debate the necessity of adopting a world standard given our weakening  influence over the world economy, or the esoteric benefits or detriments.  My concerns are much more basic. Without tort reform in the United States, IFRS is a time bomb with a very short fuse resulting in a cataclysmic disaster waiting to happen.

Currently, US GAAP is a rules based set of standards. While the end result of their application frequently results in worthless unsupportable financial reporting, the issuer and their auditor have but to point to the ‘rules’ in defense. On the other hand, IFRS is principles based, and simpler to apply.  But it can and frequently does require the issuer and his auditor to exercise judgment.  Judgment that can be questioned, criticized and  litigated.

Please don’t misunderstand.  Professionally in my opinion the quality of financial reporting will be significantly improved by the application of sound principles. IFRS is long overdue. Without liability reform, however, I fear financial reporting and assurance services will quickly follow the health care industry in terms of cost to the providers.

Maybe I’m just paranoid in my advancing years.

S Corporation Pitfalls – Part 1

S Corporation PitfallsS Corporations are a popular business entity – they allow for limitation of liability, may reduce self-employment taxes, and income is passed through to the owners, resulting in only one level of taxation, while providing a “corporate veil” for liability protection.  There are a number of possible pitfalls for the unwary, particularly if the company operated as a C Corporation prior to electing S Corporation status.  This series on S Corporation pitfalls will discuss some of the more common issues, and some of the more serious… pitfalls that can have costly results without proper planning…

First, as a rule of thumb, do not hold appreciable assets, such as real estate or passive investments in an S Corporation. Why not? You probably know that there is generally no resulting tax when cash is distributed from S Corporation earnings. What many people fail to realize is that the distribution of appreciated property will result in a taxable transaction. When property is distributed from any type of Corporation (S Corporation or C Corporation) the distribution is made at the property’s Fair Market Value. This means that there is a realized taxable gain on the difference between the Fair Market Value at the date of distribution and the tax basis. You will pay tax on the transaction, and your resulting tax basis in the asset after distribution will be its Fair Market Value at the date of distribution.

This problem is most commonly avoided by distributing cash from the S Corporation to the owners, who then use the funds to purchase real estate, or other passive investments.  These assets are frequently purchased through a limited liability company (LLC) to preserve pass through treatment of the income.  If the real property is used by the S Corporation in its business, the property is then rented back to the S Corporation. The difference is that distributions from LLC’s (and partnerships) are made at the asset’s tax basis, with no gain or loss recognized on the distribution (resulting in a deferral of tax until the property is actually disposed of). Your basis in the distributed asset will be the same as it was in the hands of the LLC.

Placing appreciable assets into LLC’s instead of S Corporations will provide greater flexibility for future tax planning, and possibly defer the payment of income tax.

Oil and Gas Accounting – SEC Issues SAB 113

Oil & Gas IndustryThe Office of the Chief Accountant through Corp Fin recently published Staff Accounting Bulletin 113.  There are four main areas of focus within this SAB which will likely affect everyone to some degree:  valuation methodology of oil and gas reserves; clarification of methodology related to write-offs of excess capitalized costs under the full cost method; extending appliability of guidance to include unconventional methods of extracting oil and gas from sand and shale;  and removing information from the guidance which is no longer necessary.

For the most part SAB 113 is pretty straight forward, however, as is the case with many of the SABs, hidden in the minutiae are land mines for the unwary or uninformed.  Correspondingly you would be well served to skim through it for any matters that might affect your company, and then discuss them with your audit firm.

Additionally, on October 26, 2009 additional Oil and Gas Rules were released.  These compliance and disclosure interpretations (C & DIs) relate to Regs S-X and S-K.  There is some important information here which is very relevant and brief!

Hip Hip Hooray! Permanent exemption from 404(b) for Small Business is Possible!

Permanent Exemption PossibleRecently, the House Financial Services Committee passed H.R. 3817, the Investor Protection Act. The bill includes an amendment, which would permanently exempt small public companies from complying with Section 404(b) of the Sarbanes-Oxley Act of 2002. The bill must still be voted on by the entire House of Representatives, but it is nice to know that there is hope.

As noted in the October 19th blog post by Mark Bailey, the 404(b) requirement for small business issuers is not beneficial in most cases and thus the passing of this act by the House Financial Services Committee is welcome news.

Taking the Life out of LIFO

Taking the Life out of LifoFor many companies the transition to IFRS will not result in a major change… the big exception is in the manufacturing and retail industries, as IFRS does not allow the use of LIFO (the Last In First Out method of accounting for inventory). Because LIFO treats the last item to be purchased as the first item to be sold, the use of LIFO generally increases the cost of goods sold during periods of inflation.  This reduces a company’s assets and earnings, but can result in large tax savings. It is because of this dichotomy that the IRS requires businesses to use LIFO for their book accounting records and financial statements if they wish to use it for tax purposes. Additionally, use of LIFO is generally restricted to mid-to-large sized companies, as it requires additional administrative work to track multiple LIFO layers for each type of inventory, and to prepare tax Uniform Capitalization adjustments on each layer.

Enter IFRS (from 2014 to 2016 for publicly traded companies – transition dates for privately held businesses have not yet been announced). Exit LIFO.  If companies can no longer use LIFO for book accounting purposes, they will not be able to use it for tax accounting. This will give rise to a flood of paperwork to the IRS, as each company requests permission to change accounting method (which must be formally requested, even though the change is required and unwanted). More importantly, it will  result in a huge income tax liability for nearly all companies required to make the transition.

So far the IRS has not offered any hint of resolution on this matter… and it looks like our manufacturers and retailers may pay the price.

Critical Accounting Policies and How They Differ From Significant Accounting Policies

Critical AccountingIn an effort to help improve my client’s filings, and of course avoid SEC Comment Letters,  I am constantly reminding them that the disclosures required by SEC Rules Release 33-8098, contained in the MD&A, are considerably different than the significant accounting policies disclosed in the footnotes. Too frequently issuers simply cut and paste their summary of significant accounting policies into this section, which I believe will result in comments from the SEC if selected for a full review by Corp Fin.

I believe the intent of the critical accounting policies disclosures is for issuers to identify and disclose only those accounting policies that require significant judgment and estimation with a degree of uncertainty. Further, simply narrating the assumptions used in a Black-Scholes model for valuing stock options does not provide the appropriate information contained in the rules release. Disclosures related an issuers critical accounting policies (estimates) should include the methodology used in developing assumptions and the corresponding estimates, how the estimates impact the financial statements, and the effect of a change in the estimates and / or underlying assumptions.

The SEC provides two questions issuers need ask in making the “critical” determination:

  1. Did the estimate require making assumptions about matters that are highly uncertain?
  2. Would reasonably developed, different estimates / assumptions, at the time or in future periods, have a material impact on our financial statements?

When both questions are answered yes, it should be included in this section of the MD&A.

The included disclosures should not simply be boilerplate (like significant accounting policies tend to be) or be overly accounting technical (as “plain English” as possible). Further, the SEC expects varying numbers of critical accounting policies amongst issuers, but they have indicated three to five as a reasonable range.

The rules release provides several examples of disclosures that can help issuers develop the approach and content for appropriate inclusion in future filings.