07 Nov 2016 Use of DISCs For Export Tax Incentives in Farming
U.S. producers and distributors of goods for export are often advised to consider using an interest charge domestic international sales corporation (the “IC-DISC”). This special entity can give exporters enormous tax savings. Unfortunately, due to their use of cooperatives, farmers have more difficulty using DISCs than other kinds of exporters. While industry representatives are working to clarify the interaction of DISCs and cooperatives, farmers should be aware of the challenges they currently face.
What is a DISC, and Why Use One?
Any domestic C-corporation can be an IC-DISC, provided it meets a large checklist of requirements in its capital structure, assets, and how it earns its income. IC-DISCs earn income in two ways: they can either buy and sell exports, or can be paid a commission on exports sold by a related company. Such exported property must be of certain types, must be produced in the U.S., and must be produced largely from U.S.-sourced components. The maximum allowable amount of commission payable to a commission DISC is a rate calculated on the base of either receipts or income from the exports. Because commission DISCs are easy-to-set-up, shell corporations consisting of little more than a bank account with books and records, they are the dominant form of DISC.
Either way, the money going into the DISC generally will not be taxable at the DISC level. At the same time, commissions will generate ordinary income deductions to the payors and buy-sell DISCs will shift ordinary income to the DISC (for similar results). However, a DISC’s distributions of earned income will be taxable to its shareholders — although much lower capital gain rates will typically apply. It should be noted that DISCs must distribute a certain amount of their income and assets yearly, with commission DISCs typically needing to be virtually empty at year’s end.
Thus, at their core, DISCs convert export income taxed at ordinary income rates into income taxed at nearly half that. The tax planning advantages are obvious. Further, just about anyone can be a DISC shareholder, making DISCs into effective tools for shifting wealth to relatives, certain retirement plans, employees, and perhaps even non-U.S. persons paying favorable dividend rates.
Why Do Farmers and Cooperatives Face Special Challenges with DISCs?
Farmers, understandably, are highly interested in using DISCs for their exports. Unfortunately, the current rules governing DISCs create several headaches for farmers. The issue here is that farmers commonly sell their produce through cooperatives, and the rules for mixing cooperatives and DISCs are unfavorable and uncertain.
The idea of a cooperative is this: each farmer transfers his produce to the cooperative, which then mixes the produce of that farmer with other fungible produce from other farmers. The cooperative then sells such produce onward, divvying up the resulting profits to the farmers based on the quantity or value of what they put in.
Let’s say that a particular farmer has an IC-DISC and attempts to pay it a commission based on her grain exported through the cooperative. As noted above, the DISC’s commission is to be calculated via formulas based on relevant export receipts or income. So now the question becomes: what are the amounts of these receipts or income? Under Rev. Rul. 77-484, unless we directly trace each item of produce from the farmer to its final destination, we apparently cannot treat any of the farmer’s produce as being exported. Thus, if we had not performed tracing (which there is no non-tax reason to do), the farmer apparently should have zero export receipts or income on which to calculate a commission. As the National Council of Farmer Cooperatives (NCFC) has pointed out, this is illogical; if 50% of the cooperative’s sales are exports, why shouldn’t 50% of the income the farmer receives through the cooperative be treated as coming from exports?
Under another structure, rather than the farmer having her own IC-DISC, the farmer instead, through a partnership, could co-own the DISC with all other farmers in the cooperative. The cooperative itself would pay the DISC a commission. Under this structure, we no longer have a tracing issue, as the relevant exports are clear relative to the cooperative. However, we have a new problem: under subchapter T of the Internal Revenue Code, cooperatives calculate their income in a special manner. For example, cooperatives take deductions for paying farmers their share of profits. If these deductions were to be taken into account for calculating commissions based on income, then the commission base would be unrealistically low.
This is a nonsensical outcome. The NCFC has thus written to the Department of Treasury, requesting guidance. These requests are well-founded on all fronts. There is no reason that farmers should face negative or uncertain tax treatment for their use of cooperatives. Hopefully, Treasury will heed the NCFC’s inquiries and proposed solutions.
If and when that happens, farmers in cooperatives should take a renewed interest in using DISCs as a legal vehicle. In the meantime, famers not using cooperatives are well advised to consider the considerable tax advantages of using a DISC.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.