This article examines the export tax incentive options for closely held companies in 2002 and offers a number of alternative structures for reducing U.S. taxes and increasing cash flow.  My discussion here is intentionally brief.  It does summarize, however, the many export tax incentive alternatives in the post-FSC era.  I am available, of course, to discuss any or all of the above structures with you.  Contact me at neal.j.block@bakernet.com, if you have any questions.

The Present Situation

By now you are aware that the FSC benefits will expire for most taxpayers on December 31, 2001.  After that date, shipments of export property generally will no longer be subject to the FSC benefits.  Thus, the IRA/FSC structure benefits effectively will end on December 31, 2001.  Keep in mind, however, that the FSC itself may remain in existence after 2001 for the receipt of FSC commissions for shipments made prior to December 31, 2001, as well as to pay dividends or to liquidate, depending upon the circumstances of the FSC's shareholder. 

It is important to note that a liquidation of an FSC may avoid the alternative minimum tax on FSC dividends, while a dividend distribution may not.  To the extent that you may have any questions regarding the impact of the FSC termination on alternative minimum tax, please feel free to contact me for further guidance.

Alternative Export Tax Incentive Structures

Extraterritorial Income Exclusion   The Extraterritorial Income Exclusion (ETI) replaces the FSC.  It has been available since October 1, 2000, and to date remains in affect for the year 2001 and years thereafter.  Basically, it allows for the greater of a 15% of net income or 1.2% of gross receipts (up to 30% of net income) to be excluded from income for qualifying transactions.  Generally, the same transactions that give rise to FSC benefits give rise to ETI benefits.  In addition, certain foreign manufactured goods may qualify. 

The future of the ETI is clouded, however, because a panel of the World Trade Organization (WTO) has already held the ETI to be an export subsidy and in violation of multilateral trade agreements.  As of this date the United States had just finished arguing its position before the appellate body of the WTO.  In the meantime, the ETI benefit is a permanent one, which goes to the individual level in the case of "S" corporations and entities treated as partnerships.  Thus, the 15% to 30% reduction in taxation attributable to the ETI benefit must be weighed against the other alternatives discussed below.

Shareholder DISC  The DISC, the predecessor to the FSC and ETI, provides tax benefits to basically the same types of transactions that qualify for the FSC benefits.  The DISC is allowed to earn net income equal to 50% to 100% of export profits from the sale, exchange or lease of export property.  The DISC is also allowed to earn investment income from the investment of certain qualified export assets.  Dividends from a DISC are taxable to its shareholders.

The DISC structure most commonly used is a commission DISC.  It is an ideal vehicle for closely held "C" corporations.  A DISC held by the shareholders of a closely held "C" corporation permanently avoids corporate taxation on the DISC commission.  As such, it will generate greater federal income tax benefits to a "C" corporation than either the current FSC/IRA structure or the ETI benefit.  In addition, it is not under attack as is the ETI.  Again, I would be pleased to advise you with respect to those closely held "C" corporations that need further information with regard to this matter.

IRA/DISC Structure   The IRA/DISC structure has been agreed to as a valid tax avoidance device by the Internal Revenue Service (IRS or Service).  The IRA/DISC is a DISC that is owned by an IRA and which receives commission in the same manner as the shareholder DISC discussed above.  The DISC commission is fully deductible to the related supplier; however, DISC distributions are taxable to the DISC's shareholders, irrespective of whether they are individuals or individual retirement accounts.  Thus, a DISC that is owned by an IRA will recognize taxable income (unrelated business taxable income or UBIT) upon the payment of dividends by the DISC to the IRAs. 

Roth IRA/DISC    Where a DISC is owned by a regular IRA, the benefits of the DISC may be outweighed by the benefits of the ETI partnership due to the second tax on the IRA's distribution.  However, where a DISC is owned by a Roth IRA, the Roth IRA/DISC is generally the preferred vehicle, since greater cash may be put into the IRA and all future proceeds from the DISC commission are reinvested tax-free and distributed tax-free after the initial payment of tax.  Unlike a regular IRA, there is no double taxation of the DISC commission when the IRA distributes its income to its beneficiaries.