One way for C corporations to reduce taxable income is to utilize an interest charge – domestic international sales corporation (IC-DISC). However, when dealing with C corps, it is imperative the IC-DISC’s ownership structure is correctly established at the onset.
In general, a C corporation does not realize a tax benefit by owning an IC-DISC as the dividends-received deduction is specifically disallowed between the two pursuant to IRC §246(d). Treasury Regulation 1.995-1(a)(5) explains the rationale: “Since a DISC is not taxed on its taxable income, section 246(d) and §1.246-4 provide that the deduction otherwise allowed under section 243 shall not be allowed with respect to a dividend from a DISC, or former DISC, paid or treated as paid out of accumulated DISC income or previously taxed income or with respect to a deemed distribution in a qualified year under §1.995-2(a).”
That seems straightforward, but we do get some pushback from practitioners who promote the use of an LLC between the C Corp and the DISC, wherein the C corp would own the LLC, which in turn would own the IC-DISC. The DISC pays its dividend to the LLC, which would pass it along to the C corp via its K-1 and, voilà, the IRS doesn’t “see” the IC-DISC source of the dividend (or the chain of ownership of the dividend has been disrupted) and the dividends received deduction is utilized between the C corp and the LLC, resulting in a non-taxed dividend made to the C corp.
The problem with this strategy is the Tax Court and Board of Tax Appeals determined in CWT Farms, Inc. vs. Commissioner, 79 TC 86, that dividends paid out of a DISC’s previously undistributed accumulated income didn’t qualify for the dividends received deduction as the regulations under §§1.246-4 and 1.995-1(a)(5) were valid interpretations of both the statutes’ and Congress’ intent to tax income from a DISC once. This reasoning is supported by IRC §246(a)(1), which lays down the basic rule that dividends sourced from a tax-exempt entity are not permitted the dividends received deduction.
In its opinion, the Tax Court offered this explanation: “Generally, a corporation receiving a dividend from a domestic corporation is entitled to a deduction under section 243. The purpose of such intercorporate dividends received deduction is to prevent, for the most part, the multiple taxation of dividends as they pass from one corporation to another. However, since a DISC is generally not subject to taxation on its earnings and profits (sec. 991), Congress saw no reason to provide for an intercorporate dividends received deduction for dividends distributed to corporate shareholders of a DISC.” The court further stated: “Where the income of the DISC is not subjected to corporate tax, there is no reason to allow its corporate shareholders a dividends received deduction.”
Worth noting is the court’s reference to what is now IRC §1504(b)(5): “Such section provides that a DISC, or a former DISC, may not be included in a group of affiliated corporations which elect to file a consolidated tax return. The congressional rationale for enacting such provision was that the effect of including a DISC within an affiliated group which files a consolidated return would be to allow a 100-percent dividends received deduction on dividends flowing from one member of the group to another. The allowance of this treatment, like the allowance of the general dividends received deduction, is not compatible with the principle that earnings of a DISC are not to be taxed in the hands of the DISC but rather are to be taxed in the hands of its shareholders."
So the court’s focus was not on the source of the income to be distributed, but on its ultimate destination. The court summarized its opinion in the headnote to the case: “Since accumulated income of DISC wasn't taxed, allowance of deduction on deemed distribution to parent would result in no tax on income.” Therefore that income is going to be taxed somewhere along the line, and in this case it would be in the hands of the ultimate recipient, the C corporation shareholder (again rendering the DISC of no benefit to the C corp parent).
This determination has not been successfully challenged in a higher court. Consequently, it illustrates the importance of incorporating a DISC in a way that shareholders can recognize the tax savings.
