[Transcript] IC-DISCs as a Tax Arbitrage and Wealth Transfer Strategy

IC-DISCs as a Tax Arbitrage and Wealth Transfer StrategyRoger Royse:

Roger Royse, I’m the founder of the Royse law firm, we’re a business, corporate and tax law firm located in Menlo Park, San Francisco, and Los Angeles. And today we are coming to you from our Menlo Park office. We have an international tax partner from Moss Adams here today, Chris Ballard to talk about IC-DISCs, interest charge DISCs, tax arbitrage and wealth transfer.

Chris, as I said, is an international tax partner at Moss Adams here in the San Francisco Bay area; she previously was with McGladrey, Frank Rimerman, and Dixon Hughes. She basically focuses on international tax services including US outbound manufacturing and distribution, which is a lot of what we’re going to be talking about today.

If you’re tweeting today, you should tweet #RoyseLaw with an S. RoyseLaw, and you can follow us on twitter, @RoyseUniversity. I want to let everybody know that you’ll notice there is a dialouge box on your screen. If you have questions, go ahead and type your questions in, and we will take those questions at the end of the presentation.

We are recording this presentation today, and you’ll be able to find it, post it probably by the end of the day along with the slides and materials on RoyseUniversity.com. You’ll also find the recorded version on the Royce Law YouTube site, and the audio will also be available for download as a podcast in the iTunes podcast store.

I’d also like to remind people that this is part of a series, a webinar series. We’ve taken the summer off; we’re back now, this is the first one of our fall series. Today is Discs. We’ll be back again on September 1 with policy perspectives on the gig sharing and innovation economy, back on September 13th with the business aspects of the gig-economy and we have two additional presentations on the gig sharing peer-to-peer economy on tax issues and employment law aspects of it. So we’ve got a full series on the gig-economy. Immediately after that, we’ll also have a presentation on disaster planning, and what to do after a disaster, who you’re gonna call when that earthquake comes along and knocks everything down, and you have to get back up and running, you need to get insurance coverage, you need business continuation, et cetera. That’ll be coming up this fall. And also our presentation on pre-transaction MNA planning.

Also for those of you who are interested in the tax law webinars, four of the Royse Law Firm attorneys will be speaking on Thursday for a Strafford presentation on triangular reorganizations. It’s forward and reverse mergers; we’re going to cover tax, employment law aspects, corporate law aspects, and also some of the contract assignment law aspects of that as well. So you can find that posted on our site, it’s for Strafford organization.

So with that, Chris I know you’ve got some slides, and I am gonna turn the program over to you. Before we start, I remember the days when we were talking earlier before Discs when we had FSCs, foreign sales corporations, and of course we all know what happened to those, those were ruled I believe to be I guess illegal, or at least they went away. And Discs, as you’ve noted, has come back in vogue, at least partly because we were talking earlier about what’s happened with the qualified dividend changes. So now this is popular again, and what’s old is new, and gaining more and more popular as people understand what they do.

So with that, Chris, I will let you tell us all about IC-DISCs.

Christine Balla:

Well thank you, Roger, I really appreciate the opportunity to speak with you today. And you know, I’m really excited to talk about DISCs. I find them to be underutilized, but frankly one of the best, in their niche, one of the best tax planning and tax savings opportunities out there.

Without further ado, we’ll get started. I figured we throw the term DISC out a lot, and what does that actually stand for. It’s a bit of an oxymoron. We’ve got an interest charge, domestic, international sales corporation. And as Roger mentioned, they’ve been around quite a while; I think that the original enacting legislation was in 1971. So you know I’ve had clients ask me, “Well is this legal?” And I’m like, “They’re legal, and they’ve been around a really really long time.”

But in their first iteration, probably from 1971 until about 2005, they were really used by large corporate America. And in their current iteration, they’re more of a middle-market play. And really fantastic for owner managed businesses. There are some other opportunities for these as well, and we’ll get into that a little later.

To kind of give you a high-level overview of what’s going on with the IC-DISC, the interest charge piece of it allows a shareholder to defer tax on export income. The DISCs themselves are federally tax-exempt if you observe the formalities. Again, the tax is deferred until the income is distributed, and the shareholders are required to pay an interest charge on that deferral of the income.

What we typically do though isn’t taking advantage of the tax deferral. We really take advantage of the tax arbitrage, and that’s what we’re gonna talk about today.

So what’s this tax arbitrage? Basically, for every dollar, we run through a DISC, we can reduce the federal tax rate on that dollar by about 16%. It is a legal way of converting ordinary income into something that’s taxed as a capital gain, which is pretty exciting, there aren’t that many of them out there.

Now it is limited. You know the exporting company has to be that, it has to export. And we’ll get into, you know, what’s a qualifying export a little later in this. But basically, it gives you a chance to kind of round trip some cash, take an ordinary deduction and push it back out through the DISC as a qualified dividend.

You know, there are parameters here. Again, exports. And those exports have to be profitable. But the rules are really set up in a way to take … it’s not that hard to qualify, and the rules are set up to make it easy to have profits on your exports. And when you think about the policy reasons behind that, you know right now we’re running a pretty significant trade deficit, and it’s been a long-term goal of Congress and the folks trying to manage the economy in the United States to encourage exports. You know, that creates jobs, it grows the economy, it’s good for the trade deficit, so this is really an incentive to export.

Okay. So who typically uses these things? US-based manufacturers and value-added assembly operations, distributors, what I see in California are food and ag, exporting nuts, apples, wine, you know all sorts of things. Recyclers, you know we ship a lot of recycled metals to China, and I see a lot of that running through. And there are two types of services that actually qualify for this benefit, and those are architecture and civil engineering.

Technically it says engineering, but when you really look behind it, it’s things like the Panama Canal, which was designed in the US and project managed from the US, at least in its original form, and that would be a qualified export for this purpose. So we do see architects who largely are building trophy-type projects or managing those projects, and most of the work can be done in the US, it’s the project that has to be overseas. The revenue and the expenses for that can be eligible for DISC benefits.

Just to reiterate, I think it helps to have a few diagrams, and there are a few in this presentation. You know one of the things we always talk about, or I always talk about with the clients is, is your bank gonna get this? Do we need to talk to your bank? Because banks really care about cash flow. Now in the VC-backed, you don’t, you know it’s a lot of convertible debt, they’re running losses, they might be pre-revenue. This really isn’t a player in that kind of space. But again, if you’ve got owner managed businesses, they usually have more traditional financing, then the bank is an important stop on the way of implementations for one of these things because the bank has to understand what’s going on with cash.

You know, very simply, the exporter or the distributor calculates a commission, it enters into a commission arrangement with the IC-DISC, and it pays the commission over. So the exporter takes a deduction, and depending on you know what entity type the exporter is, that generates a tax benefit of 35 or 39.6%. You know the DISC is tax exempt. In California, we’ve gotten some recent rulings from the Franchise Tax Board, so California is neutral with respect to the DISC. So no additional savings or cost at the California level. Then the DISC declares a dividend and pushes it out at a qualified dividend rate. And you can see the arbitrage because you’ve got the tax benefit of the deduction, and the tax cost of the qualified dividend at different rates.

Roger Royse:

Chris, so if I understand you then, California, if the IC-DISC is a California corporation or is otherwise doing business here, it’s going to go ahead and pay tax at regular rates?

Christine Balla:

No. And this would be guidance that came out from the Franchise Tax Board I believe last September. The Franchise Tax Board actually confirmed what was going on kind of in the field. California takes a substance of reform approach with respect to these IC-DISCs, and essentially the DISC just needs to unwind the transactions for California purposes. The DISC does need to file a California return, but its only tax liability is the $800 minimum tax. You know, and for the most part, we’re talking about commission DISCs which are the sort of simplest and most common form of these. If we had a buy-sell DISC where the DISC has its own operations, then it might be possible to get to a different answer.

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

You know, we could set the DISC up say in Nevada, run the business of the DISC in Nevada, and it might be possible to you know strip more out of the exporter that way. Depends.

Roger Royse:

How about the shareholder in California, even if you unwind it, the shareholder still has the money. So I gather what it’s treated as is the exporter paid a dividend directly to the shareholder.

Christine Balla:

Yes or the DISC makes a return of capital distribution. There’s a slide at the end-

Roger Royse:

Okay, I’ll wait.

Christine Balla:

It goes into that in a little more detail, so we can talk about the different scenarios that the Franchise Tax Board has. You know, fortunately, we do have recent and favorable guidance out from the state of California, which the bottom line is California is now on record for how these things are treated, and it takes away the uncertainty of potential double tax at the California level.

Roger Royse:

Great.

Christine Balla:

So …

Roger Royse:

Can I stop you once more?

Christine Balla:

Sure, yeah, go ahead.

Roger Royse:

I noticed you say the tax deduction is at 35 or 39.6, so that means an S-corp can have a DISC, an LLC can have a DISC.

Christine Balla:

Yeah, absolutely. And in fact, our next slide is exactly that. So this would be a pass-through model where the related supplier is either an LLC, partnership or S-corp. And in this case, we typically hang the DISC underneath their related supplier. You can see that there’s really a circular flow of cash. The related supplier pays the DISC commission down, and the DISC pushes the dividend back up. And it is a pure arbitrage, and typically all these transactions happen on December 31st or you know the last day of the tax year.

This is a great structure if you’ve got a lot of minority shareholders that you don’t want to deal with, right? Because the S-corp or the LLC itself controls the IC-DISC. There are no minority shareholders; it’s very straightforward. We see a lot of these, you know from a financial statement perspective, if you’ve just had a single entity exporter, you know then the financial statements become consolidated with the DISC, which you know, I’ll get into how threadbare the DISC really is from a substance perspective in a second. You know the bank doesn’t care, because the cash is running around in a circle, and none of it is actually going to the shareholder until the exporter either has distribution or makes a dividend.

Roger Royse:

So in effect, we’re getting a deduction at 39% here, and we’re taking that exact same amount of income back in income at 23.8%.

Christine Balla:

That’s exactly right. I love it; it’s really quite fun. So to the comment about the DISCs being threadbare, you know most of our DISCs are commission DISCs. And they have one or two transactions a year. They do need a bank account. I get asked that question a lot. But frankly, most of the activity here is in the form of board minutes and spreadsheets to calculate the amount of the DISC commission, and you know one or two checks running through the structure in the course of a year. And a few tax returns.

So while there is very little substance to this, then you know the form becomes important. You know you want to make sure that you’ve documented this well through the process in any given year.

Okay. So I’m gonna move onto our second example which is a C-corp example. Okay. The flow-through entities have the advantage of being that. A flow through. And the character of the income, then, just pushes through. In a C-corp, we have to put the DISC in a side-by-side relationship with the exporter in order to achieve the tax arbitrage. And this is the situation where talking to your bank’s a little more important. Because in the slide, you can see where the dividend now is going to the shareholder and not back to the exporter. I’ve seen situations where the bank says, “Well you can keep 40% to pay your tax, but I want to other 60% to get loaned back into the exporter,” to maintain loan covenants and things like that.

So it’s a way of creating tax savings for the group and providing additional tax flow for the group. This is a situation where having a discussion with an external lender becomes important.

But again, it’s fairly straightforward. You know this is getting to the point where you can start to see there might be other things you can do with a DISC though because the shareholder group and this point doesn’t need to be the same. And therein lies a planning opportunity.

We’re gonna talk about family wealth transfer. You know owner-managed businesses, family wealth transfer is usually a pretty big deal. But it works in other situations as well. We’ll start with the family wealth transfer, and then we’ll talk about some other uses. In addition to the tax arbitrage, the family wealth transfer opportunity here is the ability to actually push that dividend income to another generation.

The key to this whole thing is that the set up of the DISC is usually not considered a gift. The DISC is paid a commission, but that commission is uncertain at any given point in time, it’s dependent on exports, profitable exports, the exporter actually declaring a commission, and a number of other factors, so the actual fair market value of the DISC shares is probably the amount of paid-in capital, which is usually about $2,500. Not a taxable gift. Or you know usually, the kids have enough cash to where they can actually fund it themselves. So not only is the tax arbitrage available, you can actually push the income to other people.

So in a family wealth transfer situation, I’ve found that the patriarch frequently likes to maintain some level of control. They might not necessarily trust their young children to use the money wisely. I have a 22-year-old boy; I would be one of those people if I could take advantage of this. You know he’s a great kid, I love him to death. I’m not gonna trust him with a whole lot of money at this point in time. So what we often do is have the DISC owned by an LLC, have a dad, typically dad is the manager of the LLC, and the kids be the members or partners in the LLC. It could work with a family limited partnership, I suppose, I haven’t actually done that, but it would certainly work.

You can see in this case, the related suppliers getting the deduction, and the income and the cash are going to the next generation on this slide. You can start to see where there are variations on a theme, though.

Let’s say the supplier has a really great sales team, and the sales team doesn’t have a piece of the action right now, this is a more typical family-owned situation where dad owns everything, or you know maybe they’ve begun some kind of wealth transfers, but typically the business is owned by the family, and the key sales guys are just compensated on a commission basis. But it may be possible to take your foreign sales guys and have them substitute your sales team for the heirs in this, and all of a sudden you’ve found a way to compensate your sales team in a way that’s not just a salary.

Roger Royse:

Hm.

Christine Balla:

Now there are some other considerations that come with that. You know, again, is the granting of the DISC interest, you know taxable comp? So there are a few other issues that need to be worked through, but this could be used as a way to compensate executives for growing a particular piece of the business.

Other variations on the theme-

Roger Royse:     Can I stop you quickly?

Christine Balla:

Sure.

Roger Royse:

Are there any … that’s an interesting question whether that’s compensation or not. Are there any rulings or letter rulings, published rulings, any case law or regulations? And I guess primary authority on this?

Christine Balla:

There are no regulations. And there are no rulings or FSAs that I’m aware of. And I have looked into this pretty hard and have set one or two of these things up.

Roger Royse:

Yeah.

Christine Balla:

So …

Roger Royse:

What I like about it is it’s a really tax-advantaged way of letting your sales team participate, isn’t it? Because you’re getting a deduction at one rate, and they’re getting the income at another rate, and we often have this problem here where we want to give bonuses to salespeople or something more direct than just options or other equity compensation that is really only gonna pay out in the back end, and this looks like a good way to do it, especially now that we’ve got  409A limitations that really restrict the types of deferred comp that we can grant people. So this is something that I think ought to be a tool. It ought to be a tool in our box for any company that’s looking to do some tax planning.

Christine Balla:

You know another way of building long-term wealth is an IRA can own a DISC.

Roger Royse:

Hm.

Christine Balla:

And it’s subject to an excise tax on the way in. So the IRA pays a tax on receipt of the dividend, but then all the future earnings are tax-free.

Roger Royse:

Hm.

Christine Balla:

You know if you’ve got somebody my age, kind of mid-career, maybe that’s not a great thing, but back to the 20-year-old, the 22-year-old, well you know that might be a fantastic way of giving him money that he can’t spend right now.

Roger Royse:

Hm. Do you know … what’s the rate of tax on a dividend?

Christine Balla:

It’s an ordinary income, right?

Roger Royse:

Ordinary income, right.

Christine Balla:

Yeah essentially you’re pre-paying the tax, but then you have time value money over 40 plus years of tax-free growth.

Roger Royse:

Right.

Christine Balla:

The case law for regular IRAs is pretty set. For Roth-owned, there’s a couple of cases out there. You know that’s one where there’s a fair amount of risk, a Roth-owned, but there are a few out there. You know for the conservative client, I wouldn’t recommend the Roth-owned, just because the service just doesn’t like them at all, so we’re sort of waiting for these couple of cases to actually work their way through the system.

Roger Royse:

Yeah, because that could be a huge benefit to a Roth. Interesting.

Christine Balla:

Yeah, so one of the other things I like is the foreign-owned IC-DISC, or how to create a tax-deductible dividend. Let’s say I’ve got a US manufacturer; I have one of these, that’s owned by a Japanese parent, I have one of those, that’s publicly traded. And the US Japanese Treaty says that the withholding rate on outbound dividends to a publicly traded Japanese company is zero. You know, subject to the Japanese treatment of this, I get a tax-deductible dividend because my exporter pays the commission, the DISC pays no tax, and pushes out a dividend free of withholding.

Roger Royse:

Right.

Christine Balla:

In that particular circumstance, we have a buy-sell DISC, and the DISC has a couple of employees, and the DISC is actually running an export business.

Roger Royse:

Yeah.

Christine Balla:

And that’s purely for the Japanese rules because we don’t want the DISC to be looked at as some kind of scheme from the Japanese perspective, we would want it to fall outside of their CSC rules.

Roger Royse:

Got it.

Christine Balla:

But it works fairly well with most of our zero-rated treaties. Those are ones, there’s a later in time doctrine, and there’s one it’s 996G, you know where we usually get a tax opinion from a lawyer that says that the later in time doctrine applies to that particular code section, such that the treaty is actually preventing a PE, it’s allowing the zero rate on the dividend, and voila, we’ve got a tax-deductible dividend.

I do happen to know that Japanese parent companies like dividends, they really like dividends, so this is a way of doing it in a tax-deductible manner.

Roger Royse:

That is slick if you happen to have those metrics.

Christine Balla:

Yeah, if you happen to have those metrics, it’s a really nice opportunity.

Roger Royse:

Yeah, yeah. Okay.

Christine Balla:

That might work really well in Europe if you can avoid some of their anti-abuse rules because they typically have participation exemptions such that the dividend from a subsidiary is not taxed.

Roger Royse:

Mm-hmm (affirmative), right.

Christine Balla:

So again, probably a buy-sell DISC might be the right opportunity there to get some substance, but think of the opportunity. I mean I’ve got one of these…I don’t know, $350 million worth of export sales, the commission on that is like $16 million, just particular metrics. That’s a lot of tax savings.

Roger Royse:

A lot of money. You know you said something interesting. It’d be good to have a buy-sell, so you have some substance. So I’m guessing what you’re saying that in order to qualify for the participation exemption, these companies have to be real.

Christine Balla:

Yeah.

Roger Royse:

So they really have to be doing something, not just that paper commission DISC that we talked about that on the last day of the year does an accounting entry and manufacturers a tax deduction. Instead, you’re talking about something that actually will have operations.

Christine Balla:

Yeah. Okay, that said, 99% of the DISCs I see are the commission DISCs.

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

Because 99% of the opportunity is with our owner-managed client base out there.

Roger Royse:

Yeah.

Christine Balla:

But for the foreign-owned ones that come along, this is really nice.

Roger Royse:

Yeah, yeah. Awesome.

Christine Balla:

Yeah, it’s pretty cool. And I guess given that this is the valley, I’m gonna talk a little bit about private equity. I understand it does not venture capital, but for the private equity owned, there’s probably an opportunity to exchange the management fee with a DISC commission and dividend. I haven’t actually worked through, well it works, it’s just complicated, and a lot of people like to just keep it simple in that world, you know, not overly complicate the situation.

So, you know, while everybody is interested, nobody has actually pulled the trigger.

Roger Royse:

Do you have a slide on that?

Christine Balla:

Not in here. But I do have one if you’d like.

Roger Royse:

Okay. But the concept would be that instead of the management fee, your venture fund was set up-

Christine Balla:

Yeah, substitute heirs for your fund or your management team.

Roger Royse:

Yep. And the related supplier is the portfolio company, I assume in that case.

Christine Balla:

Mm-hmm (affirmative), mm-hmm (affirmative).

Roger Royse:

And management teams forms its own DISC, and supplier runs the money through that. So I guess the only risk I would worry about in that is we now have these new partnership regulations about management fee offsets.

Christine Balla:

Okay, so yeah. So those regs came out I guess in about the last year, so I haven’t polished up my other slide, but yes that’s a really good point about the management fee and the new set of regs on the partnership side.

Roger Royse:

So it’s an issue to work through it. It ought to work because the actual DISC payment is not coming from the partnership, it’s coming from the portfolio company. Well, that’s an issue to work through. Interesting.

Christine Balla:

Yeah.

Roger Royse:

It’s like a candy store here, there’s so many different applications and opportunities to use these DISCs.

Christine Balla:

Yeah, but to my original point, you know the vast majority of what we do are this kind of plain vanilla example one, example two IC-DISCs.

Roger Royse:

Yeah, got it.

Christine Balla:

Alrighty. Yeah, I hope everybody is excited about things. Okay, now who actually gets to use them? Manufacturers, producers, and resellers of qualified export property. So what’s qualified export property? It’s goods that are produced in the US with the ultimate destination outside the US, and where the cost of foreign content doesn’t exceed 50% of the sales price.

So let’s talk about this. You know produced in the US is fairly straightforward, I think we get that, you know and the manufacturing plants here in the US. Or the farm, or you know … “with the ultimate destination outside the US,” well that’s an interesting thing in and of itself. Yeah, I spent quite a bit of time in the Washington DC area where I worked with a lot of government contractors. The United States does not include foreign military bases or our embassies overseas. So to the extent that you may be supplying foreign bases and foreign embassies, you’re probably exporting qualified property, and we can use that for you. Now we don’t have that many government contractors in this space, but I suspect in San Diego there might be quite a few.

Okay, and “where the cost of foreign contact does not exceed 50% of the sales price.” You know outside of farming, there’s probably foreign content in just about everything that gets made or some level of it. You know so I was working with an outfit out of New York, and they make high-end fabrics. And the fabric itself, they call it gray is the term, was all sourced from India, China, lots of places, and some domestic. But the real value-adds in that circumstance was the fact that it was actually manufactured in the US and that the artwork for the designs on the fabric was all done in their New York headquarters. So while you think of the fabric as being, you know, fabric, it was really the value of the design and the stamping of the design on that fabric that was created the value. So that was a very nice opportunity for them. And you know, but that’s just an example of where you can have foreign content, and that foreign content is really critical to the end product, but as long as you know let’s say my sales price is $100, as long as my foreign content doesn’t cost more than 50, I can take a qualified export. And frankly, in the United States, the majority of the cost of manufacturing is in labor.

Roger Royse:

Right. You know you had mentioned agricultural products, and that’s a big area of practice for us here. Could you speak a little to that? I mean agriculture is a $46 billion a year business in California, and a very large percentage of that gets exported not only outside the state, but outside the country, people don’t realize that. So this seems like it would be a particularly good and pardon the pun low hanging fruit for a typical ag company.

Christine Balla:

Yeah I’m gonna skip forward a couple of slides because I actually have an example here. And I apologize it’s tiny, I know. And I’m an accountant, so it’s an excel spreadsheet. But this is an actual client. You know when we set up a DISC, we typically do an estimate of the commission calculation in the fourth quarter. Then we drew it up after the numbers were finally settled sometime in January or February. Then we pay up the commission at that point. This is really a high-level estimate calculation that we did base on actual data from a farm. They were exporting almonds and walnuts, and they were exporting 90% of the almonds and 80% of the walnuts, and this gives you an idea of how it actually works.

The commission itself is the greater of 50% of the export sales net income or 4% of the export gross receipts. There is a taxable income limitation that applies to the almonds in this case, but at the end of the day on what was about $100 million of exports, we were able to save the client about $420,000 of tax. And that’s a permanent saving, and that was just for one year.

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

You know the higher your net margin, the bigger the benefit, okay? So if you’ve got volume sales of low margin goods, then the 4% of export gross receipts are usually your best friend. If you’ve got, and typically the manufacturing clients are kind of specialty manufacturing, and they tend to have very nice margins, and that’s where the 50-50 of taxable income is actually the better bet.

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

There are a couple variations on this. In situations where these are grouped, they’re all grouped, right? With DISCs, the way to really squeeze the maximum benefit out is to divide and conquer.

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

We’ve got another client where they sell cheese. They manufacture cheese, and a lot of it goes up to Canada. And you know 5,000 lines of invoices later, you know we had used these two basic methods and two variations on these basic methods to get them a $19 million commission, you know, and that’s going to one family, you know providing benefits for one family. And there were even some sales that were at a loss, but in that case, there’s an overall margin method that can be applied so that we can even take a commission on loss transactions. We could also assume for those loss transactions that they should get a margin that’s at least equal to the overall net margin-

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

… For that transaction.

Roger Royse:

Yep.

Christine Balla:

So let’s say the overall net margin was 2%, I have an automatic 2% profit on every export.

Roger Royse:

So in this calculation, I notice your IC-DISC commission is 2.6 million.

Christine Balla:

Mm-hmm (affirmative).

Roger Royse:

How do we get that number? Because 50% is 1.3 and 4% is 3.58.

Christine Balla:

Except that yeah, except that only 90% of the almonds are getting exported, and only 80% of the walnuts are getting exported. So there’s another formula that’s not-

Roger Royse:

Oh. So the 1.35 is 90% of 1.8 million.

Christine Balla:

Mm-hmm (affirmative).

Roger Royse:

Got it.

Christine Balla:

Mm-hmm (affirmative). And then the 1.35 is the overall taxable income limitation in this particular example.

Roger Royse:

Oh I see. So it’s because there’s a taxable income limitation?

Christine Balla:

Mm-hmm (affirmative), yep. Now when we got down to the final calculation, we were looking … these are two groups, almonds and walnuts. We actually got down to customer level grouping, and we were able to squeeze a little more out when we did the true-up.

Roger Royse:

Yeah, so combined taxable income in this example at $3.1 million, you had a tax savings of $420,000, that’s pretty significant. And that’s where you got your 16% that we started with.

Christine Balla:

Yeah.

Roger Royse:

Okay.

Christine Balla:

Yeah, so this one is a pass through, the tax savings is the 39.6.

Roger Royse:

Hm.

Christine Balla:

Most farming operations are set up in pass-throughs. So who gets it? In the farming operations, the farmer, the grower will get it. And the distributor usually gets it. The way this is usually set up is that the grower grows the nuts. They need to get those nuts shelled.

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

Typically the shelling is a service, and the grower maintains title throughout the shelling process. And once the shelling is complete, the title is passed to a package. Well, the packager, the packaging is not considered substantial transformation for this purpose, you can package and ship overseas. So not only does the grower have a DISC, our packager has a DISC. Now they’ve got to work together a little bit, because the grower has to say, “Hey, we meet the domestic content,” which is pretty easy with this farm stuff, and the package is also shipping has to say, “Well we send it out within one year,” which is typically the case as well with farmed goods because, you know, they have a limited shelf life.

Roger Royse:

Okay.

Christine Balla:

But that would work for other manufacturers as well. You know when I talk to clients, you know kind of traditional brick and mortar manufacturing about this, we look at their direct exports, but then we ask, “What kind of indirect exports do you have through distributors? Should we go talk to your distributors to see who they’re shipping to?”

Roger Royse:

Okay.

Christine Balla:

Okay. Let me back up a little then. Okay, the whereas’s and wherefores here. This is where the lawyers come in handy. The DISC has to be a separate entity, and it has to be a C-corp. I like Delaware because Delaware is easy, Delaware is not gonna tax the DISC. You know it might need to be domesticated in California, but you know we don’t run into trouble. Now Nevada just, you know we’re in California, so I see a number of DISCs set up in Nevada. Nevada just put in a new gross receipts tax. We do have a position on that, and right now as long as we don’t have the grower or the exporter doesn’t have sales attributable to Nevada, you know we don’t think it’s subject to the Nevada gross receipts tax, but again I like Delaware.

Roger Royse:

Yeah, then there’s also a business license requirement in Nevada, so it’s become less attractive and more complicated. I’m with you, most of what I do is in Delaware these days.

Christine Balla:

The DISC has to make an election. It’s in this form 4876, and you would want to file it within 90 days of the tax year that the election is gonna take effect. Or if you set up a DISC mid-year, you really want to get it filed within 90 days of setting up the DISC. Because any exports that happen before that election is effective cannot be run through the DISC. So unlike EPI, you can’t really go back to things that happened, you know, before you decided to implement.

It can only have one class of stock; you know a single class of stock. The minimum capital is $2,500, and there has to be a commission agreement between the DISC and the exporter to do this. Okay, I’m not gonna get into any of the technicalities of that agreement, but the agreement is really what makes this whole thing work.

As we saw on the example, there are two primary methods that are used for commission DISCs, it’s 4% of the qualified gross receipts, and then there’s 50% of combined taxable income. Now there is an ordering rule around because you’ve got the domestic manufacturing deduction and you’ve got your IC-DISC, those are actually simultaneous equations. They do impact each other a little bit.

We did talk about buy-sell DISCs. In that case, you typically have a transfer pricing study done to determine what the inter company’s sales price is going to be and to provide the DISC with the necessary substance; it typically has one or two employees.

The commission itself should be paid within 60 days of the close of the year. So back to the comment I made a little bit earlier about we run around in November and December, and we calculate an estimate, and we typically try and get that paid out by December 31st. But under no circumstances can it wait beyond February 28th. Then as long as that estimate is 50% of the final number, we can pay an True-up sometime between February 28th and the filing of the DISC return which is September 15th for the calendar year.

DISCs have to have the same year-end as their majority shareholders. So in the S-corp example, most S-corps are the calendar year, the DISC will have to have the same year-end as its majority shareholder. So most of the DISCs I see are calendar year-end, but we’ve got a couple September 30ths, and you know a couple C-corps out there. You know, so …

Okay. Again, these things are highly paper-driven. There’s really not a lot of them. We’ve got an agreement and a bank account and a company that has two transactions a year. So it becomes important to just mind some of the P’s and Q’s here.

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

The DISC has to meet a couple requirements on an annual basis. As of the balance sheet date, the end of the year, 95% or more of the gross receipts are qualified to export gross receipts. So you know in a commission DISC, that’s not a problem because it’s 100% of your gross receipts are qualified gross receipts.

The adjusted basis of the qualifies export assets on the balance sheet date to have to be 95% or more qualified export assets. Basically what that means is you can’t have too much cash on the DISCs balance sheet at the end of the year, and you can have a DISC commission receivable, but that DISC commission receivable has to be paid within 60 days. Otherwise, it’s no longer a qualified asset, and you blow your balance sheet test. So I do run around in January and February and make sure that the estimates that we calculated earlier in the year actually get paid so that they meet their balance sheet test.

We typically work with the auditors, you know, to make sure that all this gets reflected in the financial statements as well. I mentioned this before, but the DISC really can only have one class of stock, there should be no different rights available. So if you need the flexibility of having voting and non-voting and things like that, you drop the DISC into an LLC and you put a manager on it who can then you know either … or a trust where you can sprinkle the income around or vote the shares in a block to give whoever the control they’re looking for.

The par value of the stock has to be at least $2,500 for each day of the tax year. Again, we want a bank account; it should have $2,500 in it. We typically don’t like to see a lot more than that, because the DISC doesn’t really have … unless it’s a buy-sell DISC. A commission DISC really has no need for working capital. It has to maintain separate books and records. Frequently those are in excel, and then you have to have the election to be effective for the tax year or a portion of the tax year you’re working with.

You know one way to get around that qualified export gross receipts and juice your tax benefit, is to enter into a factoring arrangement. The DISC can agree to buy the exporter’s receivables on export sales. And those can go out some period of time. And you know the factoring, you have to get the right factoring in place, and typically that’s another transfer pricing study. You know, but then that’s not subject to the overall taxable income limitations, so even in years where we’ve got a loss and can’t take a commission, we can usually get some benefit out of the factoring run through the DISC.

So plain vanilla is a commission DISC. What we’re talking to most of our commission DISCs these days is about adding factoring to their existing IC-DISCs to push more money through them.

I don’t have an example of the factoring. Again, you know the factoring is a little more complicated. You know for people who don’t have a ton of this, and the DISC is a nice benefit, but not a big benefit, factoring may or may not make sense. You know so there’s sort of a threshold. But once it makes sense, it usually makes a ton of sense.

Okay, so maintaining the status. The qualifies export assets to include the export property, which that’s kind of inventory, right? Assets in connection with the qualified export property, and that’s where the factoring is permitted. Sufficient cash to meet working capital needs. In a commission DISC, again, they don’t need a lot of working capital so we really typically don’t see cash sitting around inside the IC-DISC.

Then there are certain types of presco paper and things like that out there that you can invest in that’s also considered qualified export property. There are folks that do that; typically I don’t see that. You know, but there are a couple things you can do to convert that cash on your balance sheet into something else so that you maintain your qualification. You would do that when you’re actually trying to use the tax deferral option on the IC-DISC. You know in a straight commission DISC where you’re looking to just take advantage of the arbitrage, the cash comes and goes, you know in pretty short order, and we don’t typically need to worry about the balance sheet test.

If we’re looking to defer income in the DISC, then maintaining the status of the balance sheet on the last day of the tax year becomes much more important, and we need to go find other qualified assets. And you know, the factoring is one way of doing it, and then the pesco paper is another.

Okay, California. We’re getting toward the end here. I bought, I think September 17th or something like that; I was in the heat of battle with the deadline when California came out with a ruling. 2015-2. Actually, Moss Adams, I guess coaching the Franchise Tax Board through on the ruling. We have a liaison group, an FTB liaison group, and this was done in conjunction with the cal CPA. And the ruling is great. For the commission DISC, it essentially unwinds the DISC transactions. The DISC files its own California return, and it pays the 800 minimum tax. A lot of certainties, you know, so it’s an $800 a year insurance policy for California, which is pretty good, you know? You know I’ve had clients before this ruling came out, you know go to some pretty significant lengths to put enough substance in their IC-DISC to where its neck is attached to a different state as a way of trying to get out of having the DISC income subject to California tax. With this ruling, it just became a lot easier.

Roger Royse:

Okay, well thanks very much. One question, are the slides available? They will be available on the Royse University webpage. We also usually post these on slide share if that’s okay. If not, please email us directly, and I’ll put you in touch with Chris to get the slides directly from Chris.

So let me ask you, have you seen … it just seems like not as many companies do use a DISC that should use the DISC. Is this something that’s catching on and people are starting to figure this out? Especially here in Silicon Valley in the technology industry.

Christine Balla:
Yeah, I guess it’s certainly rarer here in the valley itself you know where the focus is on tech. You know some of this comes down to how companies view themselves. You know they may think of themselves as you know a software company or this or that or the other thing, but when you really dig down into it, they look like an exporter. You know software company can be an exporter, you know? You’re putting your stuff up on a hosted website, and somebody is downloading it in Singapore.

Roger Royse:

Mm-hmm (affirmative).

Christine Balla:

Well if that comes with a shrink-wrap license or something that looks like a shrink-wrap license, I probably got us a qualified sale.

Roger Royse:

Yeah, I suppose this ties into those 6118 rigs where we have to characterize transactions as services as opposed to sale of articles, and that’s probably where you start with this, so a lot of companies might view themselves as being… may actually be selling products or articles for purposes of these DISC rules.

Christine Balla:

You know, and sometimes they don’t want to hear it. But I do think most folks are interested in saving cash, but you know if you’re an law company, this may not be of interest, at least not right now.

Roger Royse:

Right.

Christine Balla:

But I think over the last couple years with the economy improving, you know a number of our clients have gone from losses to profits, you know, and maybe they’re NOL  limitations because of a change in control, this is one way of managing some of that process and harder sink some cash out of a business who’s actually starting to have cash flow now.

Roger Royse:

Yeah.

Christine Balla:

I think even for clients that we’ve talked about DISCs and for whatever reasons they said no, you know we try and revisit it every couple of years because the facts and circumstances change. You know, the company that was small before might be exporting now. What was a small export before is now you know like a Pandora’s Box of opportunity? So even for our clients where we’ve talked to them, and they’ve said, “no thanks,” you know we typically try and go back to them every couple of years and just check in and make sure that you know that’s still the right answer.

Roger Royse:

Yeah.

Christine Balla:

It is one of the things that we talk to client prospects about a lot, you know, “Does this make sense for you?” Unfortunately not every CPA really knows about these things-

Roger Royse:

That’s why we do these presentations.

Christine Balla:

Yeah. And you know, for some smaller CPA firms out there, I’m not looking to take your clients, I’m really not. I’m really looking to add value to the client experience. And we do IC-DISC work for clients where that’s the only piece of work we do.

Roger Royse:

Okay. Okay well, I see we’re approaching the top of the hour here. I really want to thank you, Chris, for this presentation, I hadn’t really sat down and thought about some of the issues you’ve raised until now, and some of the different uses and applications of this strategy, especially as a wealth transfer tool. Really interesting stuff, quite fascinating.

I’d like to remind everybody that if you are tweeting, it is #RoyseLaw and you will also find the links to this webinar on twitter @RoyseUniversity. It’ll also be posted on our Royse University website as well as the Royse Law YouTube site where you’ll find a recording of this presentation, and it is available for download in the iTunes podcast store.

Our next webinar is the gig-economy September 1, policy perspectives, we have a panel of legal and policy experts to talk about some of the new issues and new directions in the gig innovation sharing and peer-to-peer economy, following up with some presentations from some gig-economy businesses and the regulatory environment business aspects that they deal with, tax considerations following that as well as employment law considerations.

I hope you’ll subscribe to our series here and join us for our upcoming webinars. Once again, thank you, Chris, for being here, and with that, I am going to conclude this webinar.

Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.
Royse Law Firm
royse@rroyselaw.com
X