A topic that comes up from time to time when introducing the IC DISC to potential clients relates to the sales commissions paid to the IC DISC and not paid out as a dividend to the shareholders of the IC DISC.
Can the money be loaned back to the operating entity for use in the business?
Yes, if structured correctly.
These types of loans are considered Producer’s Loans. Let’s drill down and understand some of the requirements of a Producer’s Loan and the potential benefit of using them.
What are the requirements of a Producer’s Loan?
A Producer’s Loan is an obligation (or loan) paid to a US manufacturing company (typically, the operating entity paying sales commissions to the DISC) meeting the following requirements:
Obligation must be evidenced by a note (written) and have a maturity date of not more than 5 years;
Must be made to a person in the US engaged in manufacturing, growing, extracting, or producing export property;
Must be designated as a producer’s loan when it is written;
The terms of the producer’s loan must be “arm’s length” meaning interest rates or other terms must be those that would be provided to an unrelated third-party.
Does making a Producer’s Loan affect the 95% Asset Test of the DISC?
No, a Producer’s Loan is considered an export asset as defined under Internal Revenue Code Section 993(b) (5) and therefore is included in the calculation.
Why would a company want to use a Producer’s Loan?
A very good question indeed given we have dividend rates at 15% and ordinary income rates at 35%. Currently, it would seem in most instances, that an IC DISC would be best off to dividend their earnings at 15% to the shareholders of the DISC (which in many cases is the operating entity) allowing the funds to be used in the business for growth or operations. If the producer’s loan were to be made to an unrelated third-party, perhaps there may be some business reasons to set up an obligation in this manner. It would accelerate the deduction for the operating entity and delay payment of any taxes on dividends distributed to a later date.
Evidence & Documentation
As noted in the Internal Revenue Code, the producer’s loan must be evidenced by a note with terms that are arm’s length and for not more than 5 years. Terms including payment, interest, term (critical that the term of the loan be included) and any other material conditions are documented in a written obligation at the time it is executed. It should be noted that there a number of additional requirements that are beyond the scope of this article. Please consult an IC DISC expert before setting up a producer’s loan.
What say you my friends?
When might you see a producer’s loan as a better alternative to paying out a dividend?
Do you understand the marginal costing approach to calculating IC DISC sales commissions?
What other incentives might apply to your business that you would like to learn more about?
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Randy Eickhoff, CPA is President of Acena Consulting. With more than 20 years of tax and consulting experience, Randy focused on helping companies successfully document and secure tax incentives throughout the US. He has been a long-time speaker nationally as well as conducted numerous training sessions on R&D tax credits and other US tax incentives.