BACKGROUND
The purpose of an IC-DISC is to encourage businesses in the United States to export their products. This incentive is particularly lucrative when there is a wide margin between the ordinary income tax rate and the dividend rate. This is because, through the use of an IC-DISC, an exporter can essentially convert ordinary income into dividend income. In turn, this drastically decreases the federal tax liability of the exporter's shareholders, members or partners (the "owners").

After all, the current federal tax rate for ordinary income of C corporations is as high as 35 percent and the top rate for individuals on income from pass-through entities (S corporations, LLCs and partnerships) is 39.6 percent. In contrast, the maximum dividend rate for individuals is 20 percent. Thus, the conversion of ordinary income into dividend income nearly cuts in half the tax liability for the income paid through the IC-DISC.

In addition to reducing the tax rate that the owners ultimately pay, IC-DISCs also allow the owners to defer income for up to one year. For each tax year, an IC-DISC may only defer income attributable to qualified export receipts of $10 million or less. In order to benefit from the deferral, the owners must follow a number of special rules to prevent the IRS from classifying the deferral as a deemed distribution.

REQUIREMENTS
In order to obtain the beneficial tax treatment, IC-DISCs must satisfy certain requirements. IC-DISCs must be C corporations in the United States, issue only one class of stock, and timely file the election for IC-DISC status. In addition, an IC-DISC must also pass the qualified export receipt test as well as the qualified export asset test.

First, the qualified export receipt test says that at least 95 percent of the exporter's gross receipts must be related to:
 

• The sale or exchange of export property;
• Rents for the use of export property outside the United States;
• Services related to export sales or rents;
• Dividends with respect to stock of a related foreign export corporation;
• Interest on any obligation which is a qualified export product;
• Engineering or architectural services for projects located outside of the United States; and
• The performance of managerial services in furtherance of production of other qualified export receipts of an IC-DISC.

The definition of "export property" includes property that is:

• Manufactured, produced, grown, or extracted in the United States by a person other than an IC-DISC;
• Held for sale, lease, or rent in the ordinary course of a trade or business by, or to, an IC-DISC for direct use, consumption, or disposition outside the United States; and
• Not more than 50 percent of the fair market value of which is attributable to articles imported into the United States.

The second test is the qualified export asset test. This requires that at least 95 percent of the exporter's assets be used in furtherance of generating qualified export receipts. Qualified export assets include:

• Export property;
• Assets used primarily in connection with the sale, lease, rental, storage, handling, transportation, packaging, assembly, or servicing of export property or specified services relating to the production of qualified export receipts;
• Accounts receivable;
• Temporary investments; and
• Loans to producers.

ENTITY STRUCTURE
In addition to satisfying the IC-DISC requirements, the entity structure should also adhere to general corporate law. Similar to setting up any corporation, an IC-DISC should be formed pursuant to applicable state laws and obtain federal and state identification numbers. Unique to the requirements of an IC-DISC are that it must be a C corporation and file Form 4876-A within the first 90 days of the beginning of the first tax year to elect IC-DISC status. If an IC-DISC meets all of the applicable requirements, then it can use all foreign sales from the related exporter to calculate commissions, beginning with the effective date of the election.

The entities in an IC-DISC structure should also be organized in a way that maximizes the tax benefit for the owners. When using an IC-DISC, the exporter can be set up as an S corporation, LLC, partnership, closely held C corporation or sole proprietorship. The exporter can own the IC-DISC directly as long as the exporter is not a C corporation. However, the exporter's owners are typically the shareholders of the IC-DISC. This allows all parties to capitalize on the sizeable difference between tax rates on ordinary income versus dividend income.

In either case, the exporter performs its own business activities (manufacturing, sales, marketing, distribution, etc.). The IC-DISC, in contrast, does not perform any activity between the exporter and the customer. Instead, the IC-DISC exists solely as a vehicle to achieve the tax benefits.

The following three examples illustrate common entity structures involving IC-DISCs:
 

Example 1: If the exporter is a closely held C corporation, then the exporter can deduct the commission paid to the IC-DISC. This commission is based on a percentage of the exporter's foreign sales or foreign taxable income for the year (see the operation section below). The IC-DISC does not have to recognize the commission payments as income. The IC-DISC must list the commission payments it received on Form 1120-IC-DISC and does not pay taxes on the commission payments. The IC-DISC then makes a qualified dividend payment to the IC-DISC's shareholders. This qualified dividend payment is taxed at the dividend rate when the shareholders receive it. Assuming the exporter is paying taxes at the 35 percent marginal rate and the individual shareholders of the IC-DISC are subject to the 20 percent rate on qualified dividends, this demonstrates a classic example of being able to leverage the power of an IC-DISC to significantly reduce the tax liability of the corporation and pass income to shareholders at a reduced rate. 

Example 2: If the exporter is a pass-through entity, then the outcome is basically the same as in Example 1. The exporter pays the tax deductible commission to the IC-DISC and the IC-DISC still does not recognize the commission as income. The IC-DISC then pays a qualified dividend to the owners. However, because the top individual ordinary tax rate of 39.6 percent is higher than the top individual rate of 35 percent, there is greater potential to reduce the owners' tax liability. The ordinary taxable income of the pass-through entity has been reduced by the commission expense and they have received a qualified dividend from the IC-DISC at a reduced tax rate.

Example 3: Apply the same facts in Example 2, except that the pass-through entity is also the shareholder of the IC-DISC. The exporter pays the tax deductible commission to the IC-DISC and the IC-DISC then pays a qualified dividend back to the exporter. As a result, the exporter passes through to its owners less operating income and more dividend income. The effect is that the owners get to recognize more of the income at the dividend rate as opposed to the much higher ordinary income rate. 

OPERATION
Once the entity is created, there are operational requirements that the IC-DISC must achieve in order to receive the tax benefits.

First, the exporter and IC-DISC must execute a commission agreement, which describes the terms of the relationship and the commission to be earned. Safe harbors generally allow the commission fees to be the greater of either 50 percent of combined taxable income of the related exporter and the IC-DISC or four percent of gross export income of the related exporter. In order to take advantage of the tax benefits, the commission should be paid to the IC-DISC within 60 days after the tax year.

In addition, as with any scenario where entities with common ownership wish to be treated as independent, the IC-DISC must open its own bank account and maintain separate books and records and adhere to its own corporate formalities. This not only isolates the appropriate liabilities in each respective entity, but it also protects the IC-DISC's tax-favored status.

Finally, the IC-DISC must continue to adhere to the qualified export receipt test as well as the qualified export asset test. These tests are described in greater detail in the requirements section above. If an IC-DISC fails to satisfy these tests, then the IRS may revoke its tax-favored status.

TAKING STEPS FORWARD
IC-DISCs provide remarkable tax benefits for companies that export their products. For this reason, if your business makes a lot of overseas shipments, it is imperative to discuss with your tax professionals how to reduce your company's tax liability in a huge way and boost your profitability to new heights. Contact a member of the firm's national manufacturing practice in Detroit 313 964 1040, Farmington Hills 248 354 1040 or Sterling Heights 586 254 1040, or visit us on the web at www.uhy-us.com.

By Daniel Willingham, Senior Tax Specialist (St. Louis, MO)

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MITIGATING DIFFUSION OF RESPONSIBILITY IN MANUFACTURING

Individually we have all been taught that taking responsibility for our actions is the right thing to do. However, in manufacturing it is common to work as part of a cell, team or group with shared responsibility. The responsibility may be running a piece of equipment or you may have the responsibility for maintenance on a specific machine. The reality is that we are seldom individual contributors where we can only rely on ourselves to get something done. Instead, we are all part of a broader group that has a combined responsibility for the company, plant, machine and/or finished good. With this in mind, have you ever stopped to wonder what impact group mentality has on individual responsibility?

'Diffusion of responsibility' is a psychological phenomenon in which people are less likely to take action or feel a sense of responsibility in the presence of a large group of people. Let's take a minute to think about how this applies to a manufacturing environment.

If three people are assigned to complete one task, diffusion of responsibility suggests that people naturally assume the other person is taking responsibility for completing the task. Unfortunately, this often results in tasks not being completed. In addition, when a problem occurs someone is bound to ask "who's responsible?" When you start digging to identify the reason why a task was not completed, you can often expect to hear "I thought 'so and so' was completing that task."

Typically, diffusion of responsibility is not a conscious decision. It is a natural response to unclear assignments. As such, companies should put tools and routines in place to keep their teams from falling into this pattern of behavior.

Today's manufacturing operations need to utilize systems and processes to ensure clearly defined responsibilities combined with an accountability process. All team members need to realize each individual has an important role to play in order to operate efficiently and cost effectively while also driving results, and it begins with accepting personal accountability.

ASSIGNMENT AND ACCOUNTABILITY
In almost all manufacturing environments, you will find the use of tools that utilize metrics in an attempt to assign responsibility. These tools measure performance and are typically developed to support a specific process or group of processes. This can lead to diffusion of responsibility in that assignments are not specific enough for the task at hand. Without responsibility assigned to a specific person, it is easy to waste time following up on tasks that haven't been completed or even started.

For example: Jason, Luke and Beverly work as a team to complete inventory counts. At the beginning of the week during their team meeting, management assigns the task of completing an inventory count for racks 1-12 in Storeroom A by the end of the week in addition to their normal daily activities. At the same time this special assignment occurs, Jason, Luke and Beverly have an influx to their normal workload. Without a plan that includes specific rack assignments for each individual, they each assume the other team members will complete the inventory counts for Storeroom A. So what happens at the end of the week? The task is either incomplete or has not even been started.

TAKING RESPONSIBILITY
UHY Advisors' Optimal Performance Management System (OPMS™) is customized for a specific company and/or area. This system is based on leading practices, which can organically evolve versus best practices that are fixed and do not easily adapt. Using this system, each team member is accountable for reporting on specific assignments during daily stand up meetings. These meetings "roll up" from the bottom, which gives leadership more visibility to operations at all levels of the organization.

These meetings are more productive since they are timely and each team member has a specific responsibility. If someone has an issue, it is discussed and action items for mitigation are developed. If everything is running smoothly, this information is also stated and the success is freely shared. With specific assignments, responsibility and accountability are clearly defined. The result is less time spent focusing on what happened and more time spent on why an issue happened and what can be done differently.

Looking at the example above, if the team manager had specifically assigned Jason to inventory racks 1-4, Luke to inventory racks 5-8, and Beverly to inventory racks 9-12, the responsibility would have been clearly laid out. Daily accountability meetings would have allowed for timely intervention from management, which could have prevented an issue from occurring in the first place by reassigning counts based on team member availability. Under this approach, you can eliminate diffusion of responsibility as a potential root cause. If an issue does arise, management can focus on other possible root cause issues such as training or capacity.

John Coleman, a writer for the Harvard Business Review, has said "it is only when we, as individuals, take full responsibility for a problem that we focus our full attention on it and feel the pressure we need to drive results." With OPMS, each team member has clearly outlined action items, assignments, and due dates; and everyone-from the shop floor to upper management-is held accountable. Through the use of customized tools and daily stand up meetings, information that is important and meaningful to specific teams and individuals is shared timely.

PERSONAL ACCOUNTABILITY
By using OPMS, manufacturing teams have clear responsibilities and accept personal accountability. Each team member must participate in every meeting and report on the status of their current assignment. As an added benefit, individuals are empowered to take ownership of their assignments, which can motivate them to improve personal performance. This system helps facilitate conversation, collaboration and accountability. Through mitigating diffusion of responsibility, teams can focus their efforts on identifying the root cause of an issue, developing a solution and driving results. OPMS helps combat human nature through the use of specific assignments, behavioral routines and personal accountability-without the diffusion of responsibility.

For more information or questions on this topic please contact a member of the firm's national manufacturing practice in Detroit 313 964 1040, Farmington Hills 248 354 1040 or Sterling Heights 586 254 1040, or visit us on the web at www.uhy-us.com.

By Frank Fenello, Managing Director, Management & Technology Consulting Practice (Atlanta, GA)
  

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