This is one of the most misunderstood provisions in the IC-DISC area. An IC-DISC shareholder is required to pay an interest charge to the IRS on the tax liability related to the deferred DISC income, so this concept is important and, as stated above, greatly misunderstood.
The three most misunderstood concepts are i) what is “deferred DISC income at the end of the computation year”, ii) how are the IC-DISC earnings and profits distributed, and iii) in what order are DISC earnings distributed?
First let’s examine the definition of deferred DISC income at the end of the computation year. This is defined in the regulations as the accumulated DISC income at the end of the prior year. It is not the accumulated DISC income at the end of the current year. The deferred DISC income is always computed on a one-year lag basis.
For instance, a brand-new IC-DISC can’t have deferred DISC income at the end of its first year.
A common question is: If I earn $100,000 in my DISC in year 1 and again in year 2; pay the year 1 commission to my DISC and distribute it in year 2; and pay the year 2 DISC commission in year 3, how can I have deferred DISC income at the end of year 2? I paid out the dividend in year 2 and that related to year 1’s earnings.
The answer is that you do have deferred DISC income at the end of year 2. Dividends are paid first from current earnings and profits and second from accumulated earnings and profits. In our example, the $100 income for year 1, is current earnings and profits in year 1, however in year 2 these are no longer current earnings and profits but rather accumulated earnings and profits. The year 2 earnings are now the current earnings and profits. Therefore, the $100 dividend distributed in year 2 is considered to be paid from the year 2 earnings, leaving the year 1 earnings deferred in the IC-DISC.
The ordering rules related to the timing of when events occur within the IC-DISC are the other concepts that lead to a DISC having deferred DISC income. The first thing that happens at year end is that any deemed dividend is computed. If there is a deemed dividend, this is taxable to the IC-DISC shareholder before taking any actual distributions into account. Second, if any cash dividend has been distributed it is first considered a tax-free payment of any earnings that have been previously taxed. Deemed dividends from any previous year plus the current year are considered to be previously taxed and fall into this category. They are found on Schedule M-3 on Form 1120-IC-DISC. Only after the M-3 has been reduced to zero by distributions can a distribution reduce the balance of the accumulated DISC income found on Schedule M-4. If the distributions exceed the M-3 and the M-4, then other earnings and profits found on Schedule M-2 must be reduced. A point of clarification, the M-4 cannot be reduced below zero by a distribution, therefore the M-2 would be reduced for any distribution in excess of total earnings and profits.
The lack of understanding of these rules can lead to some very interesting looking Form 1120-IC-DISC tax returns.
At WTP Advisors we have a deep understanding of these complex rules impacting the IC-DISC and the taxation of distributions from the IC-DISC and would be happy to discuss any questions you might have.