United States exporters continue to benefit from powerful tax savings through the use of Interest Charge Domestic International Sales Corporations (IC-DISCs). By establishing an IC-DISC, the owners of a US operating company can save tax at the rate of up to 20% on commissions paid to the IC-DISC on qualifying foreign sales. Because Congress extended the preferential capital gains rates to qualifying dividends for another two years, the IC-DISC continues to be a viable tax saving tool.

Here’s How it Works
A United States exporter can pay income tax on ordinary operating profit at a rate as high as 35%. Once an IC-DISC is established, the operating company can pay to the IC-DISC a commission on foreign sales, which is generally equal to 4% of qualified export gross receipts or 50% of taxable income, whichever is greater. The commission is taken as a deduction by the operating company which in turn saves income tax at its bracket rate.  The IC-DISC does not pay tax on the income it receives. Rather, the IC-DISC distributes some or all of its profit to its shareholders as qualified dividends taxed to the shareholders at the preferential capital gains rate (as high as 15%).  Therefore, by establishing an IC-DISC, the owners of a US exporter may convert income which would normally be taxed at rates as high as 35% into qualified dividends taxed at rates as high as 15% (thus the 20% savings mentioned above).  It is important to note that only individuals, including shareholders of pass-through entities such as S corporations and limited liability companies, are entitled to the preferential capital gains rate on qualified dividend income.

The IC-DISC is not required to currently distribute all of its profit. For any amount not distributed, the shareholders will incur a small interest charge on the deferred income tax amount.  The IC-DISC tax regime gives U.S. exporters the ability to defer up to $10,000,000 of income per year almost entirely tax-free.  Because there are some costs involved in creating and maintaining an IC-DISC, history shows that in order to benefit from the creation of an IC-DISC, the operating company must generally have foreign sales of at least $500,000.  And because foreign sales cannot be counted until the IC-DISC is actually established, the sooner one establishes the IC-DISC the better.

Establishing and Operating the Entity
To receive the tax savings of an IC-DISC, it is first necessary to establish the entity. Tax benefits will only be applicable to income transferred to the IC-DISC after the entity is created. The IC-DISC is a domestic corporation that may be established in any state in the United States for which a valid IC-DISC election can be made on Form 4876-A.  All shareholders of the IC-DISC must sign form 4876-A.  Particular attention needs to be paid to the proper incorporation state, as some states offer additional tax savings over others.

To qualify as an IC-DISC for a taxable year, the IC-DISC must have, on every day of the year, at least $2,500 of capital and only one class of stock.  We recommend starting the company with $3,000 so as not to run afoul of this rule.

95% of the gross receipts must be qualified export receipts.  This criterion must be satisfied on an annual basis.  In addition, 95% of the entity’s assets must be qualified export assets.   This test must be satisfied on the last day of the entity’s tax year.  Qualified export assets include:

1. Customer accounts receivable
2. Commissions receivable (if paid within 60 days of year end)
3. Stock and securities in related foreign export corporations
4. Producer’s loans
5. Certain financial assets (PEFCO paper)
6. Cash not in excess of excess of working capital needs of the IC-DISC

The entity must not be a member of a controlled group of which a FSC (Foreign Sales Company) is also a member. The entity must also not be an ineligible corporation.  Examples include Personal Holding Company, a Financial Institution, and an Insurance Company operating under Subchapter L, Regulated Investment Company, Electing Small Business Corporation and China Trade Act Corporation among others.

Taxpayers should enlist the assistance of Hill, Barth & King LLC’s experienced tax practitioners to ensure that qualification requirements are met and maximum tax savings potential is achieved.

If you have any questions about the content above, please contact the HBK team member with whom you regularly work.

Joe Ledford is a Principal at Hill, Barth & King and leads the firm’s Manufacturing Group. Joe has over 23 years experience serving clients in the manufacturing industry.

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Whether a taxpayer may “write-down” year-end inventory depends upon 1) the inventory method chosen and, 2) the type of inventory involved.  With respect to inventory methods, a taxpayer generally will have chosen to value ending inventory either at cost, or at lower of cost or market (LCM).  And with respect to inventory type, a taxpayer will generally be sitting on either “normal” or “subnormal” goods.  Normal goods in inventory may generally not be written down below cost unless the taxpayer has elected to use LCM, and the current bid price (replacement or reproduction cost) of all inventoriable costs is lower than cost reflected on taxpayer’s books, or the goods had in fact been offered for sale prior to the inventory date at a net realizable value lower than cost.  Subnormal goods, on the other hand, may be valued at net realizable value regardless of whether the taxpayer has elected to use LCM.

The term “cost” is generally defined as the invoice price less trade or other discounts.  To this net invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods.  For taxpayers acquiring merchandise for resale that are subject to the uniform capitalization rules of §263A, additional amounts may be required to be included in inventory costs.  For merchandise purchased for resale by taxpayers with average 3-year annual gross receipts over $10 million, cost also includes purchasing, handling, storage, and a portion of general administrative costs.  In the case of merchandise produced by the taxpayer, cost is generally defined to include the cost of raw materials and supplies consumed in connection with the product, expenditures for direct labor, and indirect production costs incident to and necessary for the production of the particular article.

For purposes of the LCM, “market” is generally based on the current bid price (replacement or reproduction cost), not the price at which the goods can be sold.  The concept of net realizable value, although acceptable for financial reporting purposes, is only acceptable for tax purposes if the merchandise has been offered for sale prior to the inventory date at a price lower than its replacement cost.  The final income tax regulations issued under §263A made revisions to the definition of market.  The regulations now state that under ordinary circumstances and for normal goods in an inventory, market means the aggregate of the current bid prices prevailing at the date of the inventory.  The basic elements of cost include direct materials, direct labor, and certain indirect costs.  Thus, for taxpayers to which §263A applies, the basic elements of cost must reflect all direct costs and all indirect costs properly allocable to goods on hand as of the inventory date at the current bid price of those costs, including but not limited to the cost of purchasing, handling, and storage activities conducted by the taxpayer, both before and subsequent to acquisition or production of the goods.

For financial reporting purposes, a taxpayer has the option of performing an LCM analysis on the basis of item-by-item, group of items, category of inventory, business segment, or for inventory as a whole depending on the particular facts and circumstances.  For tax purposes, however, the market value of each article on hand must be compared with the cost of the article to determine each article’s lower of cost or market value.  The requirement of valuing each item separately prevents a taxpayer from using a percentage write-down approach even though it would be permitted for accounting purposes.

Regardless of the inventory valuation method employed by the taxpayer (cost or LCM), “subnormal” goods should be valued at net realizable value.  Subnormal goods are any goods that are unsalable at normal prices or in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes, including second-hand goods taken in exchange.  Subnormal goods originally acquired for resale, or produced finished goods should be valued at bona fide selling prices less direct costs of disposition.  Bona fide selling price means the price at which such subnormal goods are actually offered for sale during the tax year or within 30 days after the tax year.  The “30-day rule” has been strictly applied by the IRS in cases involving goods acquired for resale and finished produced goods.  Thus, even where subnormal goods exist, the taxpayer must be able to prove the actual offering at less than cost.  Verification must be made through contemporaneous recordkeeping.

Mark R. Giallonardo, JD, LLM is a Principal in HbK’s Tax Department and currently supports HbK’s Florida offices. Mark has been developing tax planning strategies for owner-operated companies for more than 20 years and may be reached at (239) 263-2111 or mgiallonardo@hbkcpa.com.

One of the most commonly missed tax credits for construction and warehouse activities is the Alternative Fuel Tax Credit for taxpayers that use propane powered forklifts. The forklift use qualifies for a 50 cent per gallon credit for both “C” corporations and pass-thru entities. To be eligible for the credit, a taxpayer must first register with the IRS. This is accomplished on Form 637, Application for Registration (For Certain Excise Tax Activities). This credit could be a significant benefit to any construction or warehousing operation. For Example, four forklifts that consume approximately 5 gallons per day for 250 days in a year, would typically consume approximately 5,000 gallons of propane. That equates to a $2,500 tax credit per year.

Form 637 is completed only one time to obtain the initial registration number. Once registered, the
company simply keeps track of the gallons of propane used and claims the credit on Form 4136 –
Credit for Federal Tax Paid on Fuels. Please contact a professional at Hill, Barth & King LLC if you
have any questions or would like assistance in preparing Form 637.

William E. North, II, CPA, CCIFP is a Principal in the Sarasota, Florida office of Hill, Barth & King LLC and is a member of HBK’s Construction Industry Group.

Beginning in February 2010, the IRS is launching an examination of 6,000 randomly selected companies to focus on employment tax issues. This will involve taking a close look at 2,000 random companies per year over the next three years. The primary focus will be on worker classification, executive compensation, fringe benefits, non-filers and reimbursed expenses.

The IRS states the audits will provide data for its first statistical analysis since 1984 of how often companies misclassify workers to avoid tax obligations, fail to pay taxes on fringe benefits (such as personal use of company cars and of corporate owned vacation property) and improperly pay taxes for company executives.

The goal is to increase compliance in the payroll tax area, thereby increasing overall tax collections. Companies should conduct a thorough review of their current payroll tax practices in advance of these audits, with special focus on worker classification and fringe benefit policies.

Most of the audits will be conducted face to face. Keep in mind… the IRS is not the only one interested in how workers are classified.

Employee Misclassification

Federal agencies have raised concerns about whether employers are properly classifying workers as company employees or independent contractors. Employee misclassification could be a significant problem with adverse consequences since it defrauds the government of tax revenue and employees out of labor protection. The Government Accountability Office (GAO) stated that employees who are improperly classified as independent contractors can be denied health benefits, overtime pay and unemployment insurance.

The classification of an employee versus an independent contractor is not easily defined and is subject to an analysis of facts and circumstances. The IRS has a 160-page internal training guide for its agents to help classify workers. This guide was originally drafted in 1996 and is still being used by agents today.

Under common law the treatment of a worker as an independent contractor or employee depends on whether the employer has the “right to direct and control the work” of the worker. The IRS looks to three categories of evidence to determine whether there is a right to direct and control a worker:

1) Behavioral control – Who has the right to direct or control how the worker performs a task such as when and where to do the work? What tools or equipment to use or how to accomplish the task at hand?

2) Financial control – Who has the financial control of activities undertaken? If the worker is required to make a significant investment? Who bears the cost of business expenses? Is payment for services guaranteed or paid on an hourly basis or flat fee basis? Does the worker have an opportunity for profit or loss?

3) Relationship of the parties – what is the intent of the parties? Is there a written, contractual agreement? Are there employee benefits (paid vacation, participation in tax qualified retirement plans)? What are the discharge or termination policies concerning the worker? Is the work performed by the worker integral to the employers’ business and not easily be done by others?

The IRS came out with a new form in 2009 (Form 8919 Uncollected Social Security and Medicare Tax on Wages) allowing workers who feel they were misclassified as independent contractors to report their share of uncollected Social Security and Medicare taxes due on their compensation. They would pay their half of the uncollected Social Security and Medicare tax with their personal return (as opposed to the full Self Employment tax) and the IRS will likely come knocking on the businesses doors for the other half!

Fringe Benefits

Executive and non-executive fringe benefits policies and expense reimbursement procedures should be reviewed for any discrepancies that may have monetary implications to the employee or employer in an audit.

Fringe benefits include items such as transportation benefits, education assistance, employee discounts, etc.

Section 409A

Code section 409A was enacted in 2004 as a broad-based statutory reform for nonqualified deferred compensation plans. Deferred compensation is compensation earned in one taxable year which is or may be payable in a later taxable year. Violation of these complex rules (whether operational or documentary) can result in severe penalties to the recipient of such deferred compensation.

Qualified Plan Corrections

A preemptive internal review of all qualified plans may permit employers to correct errors and pay smaller penalties than if these errors are discovered during an IRS audit. In addition, such a proactive approach to corrections may be looked at favorably by the IRS if there is an audit at a later date and errors are discovered. The Employee Plans Compliance Resolution System (“EPCRS”) allows employers to correct qualified plan errors while preserving the plan’s tax benefits. Plan sponsors should review qualified plans now in order to protect the tax-qualified status of the plan and pay reduced fees for errors that would cost much more if found during an audit.

Conclusion

With increased pressure on the IRS to collect amounts that have previously fallen between the cracks and with the focus on executive compensation by Congress, the Treasury Department and the press, the IRS is more likely to zero in on employee related issues within company tax audits. A current review of all employee related plans and practices will increase the likelihood of employers finding most if not all discrepancies. This would reduce the company’s potential exposure in an IRS audit.

If you have any questions about the content above, please contact the HBK team member with whom you regularly work.

Joe Ledford is a Principal at Hill, Barth & King and leads the firm’s Manufacturing Group. Joe has over 23 years experience serving clients in the manufacturing industry.