IC-DISC Optimization

IC-DISC Optimization

IC-DISC Maximization – 

Not All Calculations are Created Equal

If you have not fully maximized your IC-DISC commission deduction you could be leaving significant tax savings on the table. These are tax savings you are entitled to. Maximizing the IC-DISC commission is usually synonymous with performing a Transaction by Transaction (“TxT”) calculation.  What is a TxT calculation and are all TxTs the same?  As you can likely guess from the title of this article the resounding answer is NO.  We’ve performed thousands of TxT calculations over the last 20 plus years, and have come to realize that TxT means different things to different people.  We also realize if you are not performing a “True TxT” you are likely either leaving a lot of cash on the table OR you are taking too much IRS audit risk, both of which are bad answers.  Following is our view of a true “TxT”;

Let’s start with the most obvious first.  A computation completed in Microsoft Excel is not a true TxT calculation.  Microsoft Excel is a spreadsheet and as a spreadsheet is simply not capable of running all of the permutations required of a true TxT calculation.  A true TxT computation occurs when “cleansed and reconciled” transactional data is run through a powerful algorithm.  The “cleansing and reconciliation” is usually completed in a database such as Microsoft SQL Server.  The algorithm determines the maximum allowable commission by calculating every allowable calculation combination and selecting the best option by crawling through the results.  Options tested include:

  • A commission calculation on each transaction using the Overall Profit Percentages at all levels of the product hierarchy.
  • The commission is calculated at all grouping levels, i.e., all Products, all Product Lines, etc.
  • Loss optimization is performed.  Loss optimization excludes certain transactions from Product groups typically to maximize the 4% of sales method where taxable income is a limit or a marginal costing method where marginal cost taxable income is a limit.
  • Once all available options have been calculated, an algorithm crawls through every permutation to determine the maximum commission allowed under the law.
  • The software then generates detailed reports to support the commission as calculated in case of IRS audit.
  • Form 1120 IC-DISC Schedule Ps are generated as an attachment to Form 1120 IC-DISC

The software algorithm of a true TxT typically results in a supportable commission calculation 30% or higher over Microsoft Excel.  If a provider is using Microsoft Excel AND getting a result similar to a database software algorithm I’d be extremely nervous as that means they are likely being overly  aggressive somewhere else in the computation.  The most likely cause is extremely aggressive and unsustainable expense allocation and apportionment, but there are also other areas where they could be overly aggressive.  Other aspects of a true TxT include:

1)      The source data is a single line item on an invoice.  The sum of all of the invoice line items totals very close to book sales and cost of goods sold.  The valid TxT data includes not only export sales, but also domestic sales.  Some of the IC-DISC pricing methods rely on an average profit which to be calculated properly requires the inclusion of all sales.  

 

2)      Using software or a database, the source data is cleansed of credit memos, invoice adjustments, etc.  Why you might ask?  If data is not cleansed of “bad transactions” you often get a great answer, but the IRS may deem the TxT computation invalid resulting in a very difficult situation for the taxpayer.  

 

3)      Adjustments are posted against the source data to reconcile it to tax sales and tax cost of goods sold.  This is important.  We see a lot of calculations where the TxT data is never reconciled to the tax return or the difference between cost of goods sold of the transactions and cost of goods sold on the tax return is simply plugged to domestic.  Other cost of goods sold usually include variances, overhead, and other costs which relates to all sales and need to be allocated or apportioned as such.  IC-DISC is a tax concept and it is a requirement that the data must reconcile to the related supplier’s tax return.  Failure to do so may result in an embarrassing situation for the client upon IRS audit.  

 

4)      Other deductions, interest expense, charitable contributions and research & development are allocated or apportioned under Treas. Regs. Section 861 between IC-DISC qualified and non-Qualified sales and then into the TxT data to reconcile the data to the tax return.  The end result should be a Profit and Loss by Invoice and Line Item which reconciles to the tax return. Time and effort is needed to apportion these expenses between qualified export sales and non-qualified export sales.  The expense allocation process is “part Art and part Science”.  Rules exist that require certain apportionments of R&D and interest, while “any reasonable method” can be used to allocate and apportion other expenses.  We often see situations where taxpayers get extremely aggressive with unreasonable methods in the allocation and apportionment of expenses putting the validity of the computations in jeopardy.  

 

5)      A standard industry or trade usage Product Hierarchy is created from the transactional data.  At the most basic level a Product Hierarchy contains two levels.  The “Product Level” is typically a SKU or Product Number or Product Description.  The second level would then be “All Products”.  When creating a more detailed product hierarchy you will often have products flowing into product lines. Product lines flowing into product groups, etc.

 

Bonus: Pitfalls or Crazy Things We’ve Seen and Heard

1)      Taxable income of 1,000,000. Domestic taxable income of -5,000,000.  Export taxable income of 6,000,000.  Hmmm, something doesn’t smell right.

 

2)      Lack of ability to support the numbers when requested.  Just trust us, this thing is legit. 

 

3)      Lack of ability to produce form 1120 IC-DISC Schedule Ps to support the calculations.

 

4)      Situation where a client provides sales and cost of goods sold data at the transactional level. The provider ignored the cost of goods sold as provided and reattached the cost of goods sold solely on a method which would yield a great answer.  Sure the answer is great but on audit that calculation will blow up.

 

5)      Well Bob, the IC-DISC is the “Wild, Wild West,” no one is ever going to look at this.  You can do whatever you want.  That logic works until it doesn’t.  When it doesn’t, the pain and cost associated with an invalid calculation will be many times greater than any tax benefit received from the original calculation.  Most of us remember the pain of the 2008 housing crisis, well a bad IRS tax audit audit is a similar pain.

 

6)      Similar to number 1 above, 99% of selling, general and administration are apportioned to domestic sales even though 50% of sales are export. The client says “Wow, ABC is getting a great number.”  We respond “That isn’t sustainable under audit because….”  The client says, “But that is a really great number!”  We say “Do you take an exemption for your two dogs, three cats, turtle and each fish on your individual return?”  They respond “no, you can’t do that?”  We respond, “well that IC-DISC commission calculation is no different than doing EXACTLY that.”

 

Conclusion

Don’t let greed overrule fear just because this is a specialized area of the tax code.  When doing an IC-DISC calculation, maximize the commission you are entitled to, but maximize it with a good TxT.  Don’t maximize it by putting yourself and your company in jeopardy with the IRS.  Like anything else in life, you get what you pay for.  A good TxT is not cheap, however a good TxT is the right combination of audit sustainability while simultaneously generating tremendous value for the client.

With tax reform moving forward in Washington, D.C., now is an opportune time to look at your open tax years to determine if a TxT; or a re-do of an existing TxT makes sense for your company.  Please contact us at brian.schwam@wtpadvisors.com or jim.fyhrie@wtpadvisors.com for a complimentary consultation regarding your existing TxT or to explore TxT for the first time.

 

Global Contact Jim Fyhrie

Jim Fyhrie
Principal
612-605-4439
jim.fyhrie@wtpadvisors.com

Global Contact Brian Schwam

Brian Schwam
Principal
414-839-5525
brian.schwam@wtpadvisors.com