During the start of a new year, taxpayers are generally in a scramble to close year-end financials. In the midst of these year-end closings, some companies will confirm that they experienced a break-even or a net loss for the year. This type of challenging financial tax year often creates the perception that a company cannot benefit from an IC-DISC calculation, either because of the “no loss rule” or the owner of an S corporation or LLC may not have enough basis to utilize the loss created by an IC-DISC. However, we’d like to clarify this misconception and discuss how a commission may still be calculated and provide value.
The Treasury Regulations state that neither the gross receipts method nor the combined taxable income method of calculating an IC-DISC commission may be applied to “cause in any taxable year a loss to the related supplier.” However, it is important to clarify that the application of this rule refers to the calculation of a commission on each individual sales transaction. Therefore, through the use of a transaction-by-transaction calculation, either of these methods may be applied to any and all transactions, to the extent it does not cause a loss to that specific, individual sale.
Once it is determined that a commission can still be calculated, an additional concern arises in how the commission expense will affect the shareholder’s basis in an S corporation or an LLC. In the case of a break-even or net loss year, applying a commission expense would further a shareholder’s ordinary business loss reported on Box 1 of their Schedule K-1. This causes some individuals to hesitate using the IC-DISC based on the thinking that this can only reduce the shareholder’s basis and ultimately negate the benefit. However, even though the commission expense furthers a shareholder’s ordinary loss, an income amount equal and opposite the commission expense will appear in the “qualified dividends” box 5b (6b for LLC’s) of the shareholder’s Schedule K-1, which may serve to mitigate the initial impact of the ordinary loss on basis.
Ultimately, the use of the IC-DISC benefit by itself does not change a company’s total net taxable income (loss) or the shareholder’s basis in that entity. Instead, it re-characterizes the shareholder’s income by changing a portion of it from ordinary income to qualified dividends. Therefore, in a loss situation, a taxpayer could recognize income at a capital gains rate and may carry forward NOLs taxed at their marginal rate to apply in future years.
Any U.S.-based company that exports goods they manufacture, produce, grow or extract may potentially qualify for the IC-DISC. Contact McGuire Sponsel today to discuss how our IC-DISC team can help maximize IC-DISC benefits for your clients.