Monday, July 3, 2017
A taxpayer that manufactures, produces, grows or extracts property in the U.S. that is held primarily for sale, lease or rental in the ordinary course of the taxpayer’s trade or business by or to an Interest Charge Domestic International Sale Corporation (IC-DISC) for direct use, consumption or disposition outside the U.S., and not more than 50 percent of the fair market value of the property is attributable to articles imported into the U.S. can get some favorable tax breaks.
The IC-DISC concept may not be that well known, but it can be utilized by agricultural businesses. It’s also a topic that Paul Neiffer and I will cover at our two-day summer ag tax/estate and business planning conference in Sheridan, Wyoming (and online) next week. http://washburnlaw.edu/employers/cle/farmandranchincometax.html
An IC-DISC has as its statutory basis I.R.C. §§991-997. It is a corporate entity (not an S corporation) that is separate from the producer, manufacturer, reseller or exporter. To meet the statutory definition of an IC-DISC, it must have 95 percent or more of its gross receipts consist of qualified export receipts, and the adjusted basis of the qualified export assets of the IC-DISC at the close of the tax year equals or exceeds 95 percent of the sum of the adjusted basis of all of the IC-DISC assets at the close of the tax year. Also, the IC-DISC cannot have more than a single class of stock and the par (stated value) of the outstanding stock must be at least $2,500 on each day of the tax year. In addition, the corporation must make an election to be treated as an IC-DISC for the tax year. I.R.C. §992(a)(1).
As such, it is exempt from federal income tax under I.R.C. §991, and any dividends (actual and deemed) paid-out are qualified dividends that are taxed at the more favorable long-term capital gain rate by converting ordinary income from sales to foreign unrelated parties. I.R.C. §995(b)(1).
“Destination test.” As noted above, the property at issue must be held for sale, lease or rental in the ordinary course of the taxpayer’s trade or business for direct use, consumption or disposition outside of the U.S. This is known as the “destination test.” This test is satisfied if the IC-DISC delivers property to a carrier or a party that forwards freight for foreign delivery. It doesn’t matter when title passes or who the purchaser is or whether the property (goods) will be used or resold. The test is also met if the IC-DISC sells the property to an unrelated party for U.S. delivery with no additional sale, use assembly or processing in the U.S. and the property is delivered outside the U.S. within a year after the IC-DISC’s sale. Likewise, the “destination test” is satisfied if the sale of the property is to an unrelated IC-DISC for the same purpose of direct use, consumption or disposition outside the U.S.
The “destination test,” at least in the realm of agricultural products, has been made easier to satisfy with the advent of rules that require food tracing. This is particularly the case with fruits and vegetables. Growers can trace their products to grocery stores and other end-use foreign destinations. The same is true for grain producers that deliver crops to export elevators. They will likely be able to get the necessary documents showing the precise export location of their grain products.
Once an IC-DISC is set-up (by competent legal and tax counsel), the producer, manufacturer, reseller or exporter can pay the IC-DISC a commission that is tax deductible. This is the most common way that the IC-DISC earns income. The commission is tied to the producer’s (or manufacturer or reseller or exporter) foreign sales or foreign taxable income for the tax year. It is that commission that then can be distributed (after the tax year) to the IC-DISC shareholders as qualified dividends at qualified long-term capital gain rates.
There is a safe harbor for the commission which is the greater of four percent of the qualified export receipts on reselling the property, or 50 percent of the combined taxable income from the export sales. For instance, assume that a Kansas what farmer (sole proprietor) sells wheat to an export elevator for $2 million. The elevator is able to document that all of the wheat was exported. The farmer pays four percent of $2 million ($80,000) to the IC-DISC, and claims a deduction of that amount on Schedule F. The IC-DISC has income of $80,000 (less any expenses incurred). If that income is distributed to the farmer, it takes the form of a qualified dividend which will be taxed at long-term capital gain rates.
What’s the benefit to the farmer? It's in the form of a reduction in self-employment taxable income, and the replacement (to an extent) of ordinary income with qualified dividend income.
There’s also a benefit if the farmer operates in the C corporate form. In that case, the commission that is paid to the IC-DISC reduces C corporate taxable income. As a result, if the IC-DISC shareholders are individuals, there is only a single layer of tax. In addition, as noted, the IC-DISC ordinary income is converted to qualified dividends and taxed at long-term capital gain rates.
Instead of paying tax currently in the form of a qualified dividend, the IC-DISC can also provide income deferral. Deferral is achieved by having each IC-DISC shareholder pay interest in an amount tied to the deferred tax liability associated with the IC-DISC times the base period T-bill rate. Each shareholder does their own computation. Thus, the ultimate tax liability of a shareholder will be determined by that particular shareholder’s marginal tax rate.
The IC-DISC may be unheard of by many farmers and practitioners. However, it can play a role in the overall income tax and estate planning process. As part of an estate plan, if the IC-DISC shareholders are the younger members of the family, value can be transferred to them without triggering federal transfer taxes. In addition, the IC-DISC shareholders don’t have to be involved in the farm business – they don’t have to be engaged in manufacturing, production growing, exporting or reselling. Thus, off-farm heirs can be set-up as IC-DISC shareholders and receive at least a portion of their anticipated inheritance in that manner without being engaged in the farming operation. That will please the on-farm heirs (and, likely, the parents).
The IC-DISC can also reduce tax liability to an extent that exceeds its cost of formation, operation and administration. But, as is the case with any tax tool, all applicable Code requirements must be satisfied, and competent professional help should be utilized in setting up the IC-DISC structure.