Today we have a very special episode of the IC-DICS Show.
It’s special because it’s the first time we’re speaking with a returning guest and it is the first time that we’re talking with two guests. But the most important part is who those guests are.
Today we’re talking with Neal Block and David Berek of Baker McKenzie. The release date of this episode (1/28/20) is also Neal’s last day before he retires after 50 years with the firm; David is Neal’s successor.
The show was a lot of fun. As you’ll remember from Neal’s last appearance, his experience gives him a wealth of insights. It was great to get both of their opinions on the different ways to structure an IC-DISC. Even during the show, I took many notes to that I could go back to our clients with new ways of structuring a second and third IC-DISC.
So there is a lot of really great information here for you, especially for closely-held family business that are trying to transfer inter-generational wealth as tax-efficiently as possible. For the advisors, the CFOs, and the owners of these types of companies, this episode is worth listening to.
I wanted to thank Neal for his time and wish him the best in his next step, and thank David for his insights. I know we’ll be hearing from them both again in the future, but for the moment, there is a lot to listen to in this episode.
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To find out more about the services Baker McKenzie provide, your can call (312) 861-8000, or visit www.bakermckenzie.com
IC-DISC Show 013 Transcript
Dave: So, this is a very special episode for several reasons. One, it’s the first time we’ve had a guest on the show a second time, and that would be Neal Block of Baker & McKenzie. This is his second time to be on The IC-DISC Show. Additionally, this is also the first time we’ve had two guests at the same time. Neal will be joined today by his colleague, Dave Berek. And are you there, Dave?
David: I am. Hello.
Dave: Awesome. And then the third thing that’s unique about this: it’s with mixed feelings that I’m announcing that one of my all-time favorite IC-DISC experts is retiring at the end of this month. You want to just talk a bit more about that, Neal?
Neal: Sure. Well, I’d say 50 years at the same firm is probably about enough time to say that I’ve had a full legal of career, and so I’m going to be retiring. It’s been the only law firm I’ve worked for since I got out of law school. I spent two-and-a-half years in the tax court before that, but once I joined Baker & McKenzie in 1969, I’ve been there ever since. So, as all good things come to an end, it’s about time that we do so now.
Dave: Okay. Well, thank, you again, for your dedication to the profession these last 50 years.
So Neal was on episode 4 of The IC-DISC Show. Anybody that wants to reference that and go back to some of the background of the IC-DISC, they can do so. Since we’ve already covered on that episode, we will skip that for this time. What I wanted to talk about… Well, really several things. I wanted to talk about, with Neal, a bit of different IC-DISC structure types, and then I want to hear more about Dave’s practice and some of the ways that dovetails with the IC-DISC. Now, Neal, my understanding is that Dave is effectively your successor to the IC-DISC practice. Is that accurate?
Neal: That’s correct. He’ll be the contact for Baker & McKenzie on IC-DISC questions in a general nature. We have two other people that will be involved. One is Maura Ann McBreen, who’s our ERISA expert, and she specializes in the Roth IRA structure. At least knows everything about ERISA regarding Roth IRAs.
Neal: And then David would be the contact for the … the wealth building aspect of the IC-DISC structures.
Dave: Okay, so that sounds good, and in fact, pardon the fact I seem to be kind of bouncing around, like I said, this is the first time we’ve had two guests on the show. Why don’t we switch gears to Dave, and Dave, why don’t you just share a bit of your background, where you went to undergrad, law school, how long you’ve been at Baker and McKenzie, and just talk a bit about your practice, because I know it encompasses more than IC-DISC.
David: Sure, so I started off as an accountant. I went to DePaul University here in Chicago, and I’m an accounting major. I’m a CPA. I worked in public accounting for about ten years, specializing in tax, and then I went to law school at night at John Marshall Law School. I’ve got an LoM in employee benefits, and I focus my tax practice in wealth management, which at Baker McKenzie means really like trusts and estates.
So I deal a lot with wealthy, multi-generational family groups, and I’ll do the planning from a wealth transfer perspective. And that’s one of the ways that Neal and I started working together more and more, because many of his clients that put in place a DISC happen to be family businesses, and they tended to be multi-generational, so this just one aspect of their over all planning. So the DISC kind of fit nicely into the, my perspective, the general wealth planning for a family owned business group.
Dave: Okay, well that sounds great.
Neal: Let me just interject.
Dave: Yeah, go ahead.
Neal: Basically, Maura Ann of course knows everything about ERISA, and David would know structuring and how to maximize the use of the Roth IRA, for example, in getting ownership just outside of any strict Roth IRA structure somebody might have, but expanding it to using other members of the family to own the Roth IRA, other companies that would be involved, and so it’s sort of a building block on a structure that’s become successful up to now in its own right.
David: Another way to put that is, as Neal retires, we basically have a whole team coming in to back support what his practice has been for the past 50 years, because he’s really incorporated a number of different practices.
Dave: Or said another way, perhaps, is that what Neal was able to do by himself, it’s going to take a whole team of people to replace him, is that one one way to look at it?
Dave: Okay, so with that, why don’t we just dive into the Roth IRA? We spoke some on episode four, Neal did, as far as kind of the history of the Roth and its winding its way through the courts, but the bottom line is that it’s a structure that has withstood IRS challenge, and the comfort level with using this structure seems to be higher than it was several years ago. Is that a fair characterization, or how would you … would either of you characterize the Roth IRA structure?
Neal: I would say that that’s a very fair characterization. There’s still one case involving a FSC which could have an impact on the legal aspects of the Roth IRA, but at this point, we have now had the Roth IRA structure, which is the … basically, it’s a disproportionate ownership structure whereby the Roth IRA ownership is disproportionate to the ownership of the related supplier, which is a normal case, whereas the DISC is owned by the same person or persons that own the related supplier.
So, in and of itself, the structure itself is an estate planning vehicle, in that it’s a shifting process, of shifting wealth from the owner of a corporation to the sons, daughters, etc. with no gift tax or estate tax consequences. So it’s become a fairly good estate planning vehicle. The reason it’s stronger now than it was before, is because we’ve now survived quite a few court cases. The most recent one was Summa holdings, where actually the tax courts stepped in and tried to put a stop to the structure, but then we appealed the case to three separate circuits because of the residency of the taxpayers, and as a result, we’ve gotten opinions from the first, second, and sixth circuit upholding the Roth IRA structure, and we got eight out of nine possible votes in the court of appeals.
So, having the only outstanding authority being the US Court of Appeals cases, we feel fairly comfortable that, without any congressional action, this is a good structure.
Dave: Okay, and then, Dave, do you want to just maybe add to, from your perspective, on this structure, on some of what makes it appealing to your clients?
David: Sure, yeah, sure. I think as a general premise, wealthy clients don’t typically have large holdings in IRAs or, therefore, Roth IRAs, just because a lot of it is inherited wealth, but the benefit of a Roth IRA, is that you can pay the tax to get the Roth funded, and then as the earnings accrue on the underlying assets in that Roth, they’re not subject to tax, and when they come out, they’re not subject to income tax, and they’re just distributed to the beneficiary. So, from my perspective, although Roth IRAs I think were targeted at the rank and file, they really probably were used more so by the wealthier employees, because they were the ones that could afford to pay the tax up front to convert to a Roth IRA.
So you take that concept, that you’ve got a tax … no-tax wrapper for a period of time, and if I can fund … if I can have one of the investments as a DISC, that’s potentially highly successful, it’s a nice match of two techniques. So that’s why I think that it was a unique utilization of the two at the time, when Neal came up with the idea.
Dave: Okay, well that’s … yeah, that’s great. And why don’t we just walk through the mechanics, because this is a question I get a lot, when I’ve brought this idea up with our clients, and their first comment is, “Well, none of my children have any IRAs”, and they sort of feel like they’re stuck there. So can one of you kind of sort of go through the mechanics, starting at the beginning? Like, in theory, if someone does not currently have an IRA, how might they go about getting the ball rolling to make this structure work?
David: Let me start off and have Neal kind of fill in, because what you just said, David, is really what I just said a moment ago, is that a lot of clients, wealthy clients, don’t have IRAs, necessarily, and so it’s important to recognize that the DISC Roth IRA is not a precursor that you have to have an IRA. So Neal, why don’t you take it from there.
Neal: Okay, what I was going to say is, during my lectures, I commonly point out that the Roth IRA is a good estate planning vehicle for children, grandchildren, and sometimes even the unborn, and people say, “Well, how is a three month old infant going to get an IRA when they have to earn income?” And the answer is, in many cases, you just take a picture of the child, and you pay them a modeling fee, and that starts you off with enough money to fund an IRA, and then convert that IRA into a Roth IRA, so basically, even though you might not have the income to qualify for a Roth IRA initially, you may have enough earned income to get an IRA, and then convert it into a Roth IRA, which can be done almost immediately. It’s called a back-door Roth IRA, but that’s how you get the thing in place.
Basically, you have to have a custodian that will be the custodian for a Roth IRA, and most brokerage houses qualify. Getting some to be custodian for a Roth IRA which owns a DISC has been a challenge, because they don’t understand DISC, and they don’t understand that they have to form the DISC themselves in order to get the ball rolling. So you have to choose, and we’ve got some custodians that will do the job with a Roth IRA owning a DISC, and we sort of recommend that, because the ones that we use don’t charge a lot of time for their own education and trying to figure out what’s going on.
Once they get the Roth IRA, the Roth IRA will form a DISC, and that basically is the way the business starts. The DISC can … the reason this has been successful is there’s … it’s avoided prohibited transactions, in that the Roth IRA does not use any of its assets in order to earn income from the DISC. The DISC is basically a device, as you’ve already pointed in numerous broadcasts, the DISC does not have to do anything. It’s a paper corporation that only has to exist receive commission income, and then distribute that income out.
So, basically the function is that by having the DISC and having qualified exports, the profit on those exports in part is paid into the DISC, the DISC pays a dividend to the Roth IRA, or to a holding company which pays a dividend to the Roth IRA, and now you’re in business and accumulating wealth. There is a tax, an up front tax on the distribution of the DISC dividends to an IRA or to a holding company, so that tax has to be paid at normal corporate rates, but once that tax is paid, and the funds are in the Roth IRA, they become reinvested tax free until withdrawal.
Dave: And that corporate tax rate being the 21% current corporate tax rate, correct?
Neal: Yeah. Incidentally, that’s something that the instructions for the form 992 for the UBIT tax says to use the trust rate, but we’ve got the service convinced that it’s the corporate rate that’s used, and they were supposed to change the instructions, but they have changed their computer programs so that when you pay at the corporate rate, you’re not questioned anymore.
Dave: Okay, and so then once the dividends are paid to the Roth, and the Roth pays the tax, then that money can be invested in any vehicle that the custodian is comfortable with, correct, like mutual funds or such, correct?
Neal: Well, the way we’ve set it up is, in many cases, the clients aren’t interested in using the custodian, so what we do is have the Roth IRAs establish an account with a brokerage firm of the client’s choice, so that the fund will then, after they’re paid out as a dividend into the Roth IRA, the Roth IRA will then invest as directed by the beneficiaries into an account which is … it can be any account. It could be Merrill Lynch, it could be Morgan Stanley, it could be any one of those companies, Schwab for example, and as long as they accept the Roth IRA account, they can now invest as they wish with the advice and experience of the brokerage houses they want.
Dave: Okay, and so just to show the magnitude of this, let’s just assume that you had a company that had a DISC that was producing a million dollars a year of IC-DISC commissions, and there were two children whose Roth they wanted to own it, so you get the IRAs established, convert them to the Roths, and then those Roths would actually purchase the initial stock to capitalize the DISC, correct?
Neal: Yes, although if you want to follow the cases that we tried, the Summa cases, what happened there was that the Roth IRAs formed the DISC, and then they formed a holding company, a C-corporation holding company, and dropped the DISC into the holding company, so that as the DISC commissions were earned, the DISC paid a dividend to a holding company, and that way the Roth IRA did not have to pay any tax on the DISC distribution. The corporation did, and that was all under the control of the client and its accounts. Then, when the tax was paid at the corporate level, the balance was paid out as a dividend to the Roth IRA, and since dividend income normally is tax free to a Roth IRA, these dividends from the C-corporation were tax free because of the tax already having been paid up front at the corporate level.
And this is all pointed out in the court opinions and blessed by them, so that structure works quite well. You don’t have to have the holding company. You can have the dividends paid into the Roth IRA, but then the Roth IRA pays the tax on the dividends at the corporate rate, and some taxpayers find a little messy to have to rely on the Roth IRA to pay the tax, and so that’s why they use the holding company.
Dave: Sure, so that makes sense, and then when you just look at the magnitude of this, on this example, there was a million dollars being paid to the holding company, or holding companies. Let’s assume that there was just a single Roth for this point, and so they’re paying $210,000 for the UBIT tax, and then the remaining $790,000 is being distributed to the DISC, and then, again, that money grows tax free, so if you would imagine, like if somebody had just a five year old child, let’s say, and they did this for 10 years, you’re talking about 7.9 million dollars going into the Roth, and then because of the time value of money and compounding, that number over 30, 40, 50 years, could grow to 10s and even 100 million dollars, right?
Neal: In the cases that we tried, I believe, I can’t remember how many years were involved, but it got a lot of play, because they say a $2,500 investment got converted into 3 million dollars a year for each of the two children of the owner of the company, so it can grow quite rapidly, but remember, you’re not saving … you may be saving some tax, because the corporate rate’s a bit lower than the individual rate, but the savings is not from the payment of the DISC commission and then the commission dividend into the Roth IRA, the savings is the tax free growth in the Roth IRA.
Dave: Right, and then the other … go ahead.
Neal: In the case we had, even though there was 6 million dollars between the two Roth IRAs, that all came from the DISC commissions. There was no, really, income that was earned by the Roth IRA or any basic tax savings, because tax was paid up front in that case.
Dave: Right, that makes sense. And then another benefit that we didn’t mention, I know that in … is my understanding correct, that in some states, qualified retirement assets are effectively creditor proof, and would the Roth fall under that umbrella?
David: Yeah, that’s correct.
Dave: So that’s another kind of perk to it. Okay, well that is very helpful. So, let’s switch gears a little bit and go to Dave. So, Dave, maybe give kind of a typical example of how you’re seeing the Roth used as part of an overall wealth transfer strategy, and just kind of speaking generically. Could you maybe give an example of how this might be one of several elements that you might help a client with?
David: Sure. I’ll give you kind of a typical profile of a client that we work with, and I found this working with Neal, as I met the clients, when they start asking me other questions outside of the DISC area, their profile looks very much like my typical client profile. It’s just that not all my clients have DISCs, for example. So the concept is this: if you build a family business, you start accumulating wealth in the business, and now you’re looking for ways to minimize income taxes and potentially pull money out of the company and get it to the right individuals in the family.
And so, a DISC can be one of those techniques. You can bifurcate where the wealth is generated. If you generate it solely in the business, then that owner upon death is going to transfer it to whoever, the descendants, and pay an estate tax. If you can bifurcate some of it to an ownership in a DISC, gather some wealth, pull some money out of a company through a DISC strategy, now you can have different owners of that DISC, and you can transfer some wealth that way.
If you take your ownership of the business, and you transfer it to your children, that’s another way to transfer some of the wealth, but we’re limited, each taxpayer, as to how much they can actually give for free, and so this year it’s roughly 11.6 million dollars. Indexed for inflation, it was doubled under the 2017 tax act, and potentially that goes back down to roughly 7 million in 2026, if Congress doesn’t extend the law.
So families that have businesses are kind of struggling with, “I spend my whole life building up the wealth in this business, and then, upon my death, the government’s going to get 40% of it, and my family only get 60%, even though I’ve been paying income tax all the way along to build the new plant expansion and so on and so on.” And so, we look at different strategies that we can utilize to minimize the transfer tax to families, to get the wealth spread out amongst the right buckets, so to speak, or generations or descendants, and of those different techniques, the DISC is just one of our tools. It’s one that we can add to a family that’s got exports, so …
Neal: And the point with the DISC, of course, in the Summa cases, remember, we have the father and the two children. Basically, all of the income in the Roth IRAs represented a transfer of wealth from the father’s ownership, to the children without any gift tax, and also, when he dies, it will be without any estate tax. So that’s the … for the wealthy, so to speak, that’s the advantage.
Can we just switch now to a couple of other planning techniques that you can use with a DISC?
Neal: One is, in addition to using it to create wealth for the children and the grandchildren, what have you, the DISC can be used to transfer wealth to key employees, and what we’ve found is, in lieu of a bonus, we have key employees own stock in a DISC, and as a result, the income from the DISC becomes capital gains income, or the employees can establish their own Roth IRAs and have the DISC earn income and then pay it as a dividend to the Roth IRAs, and that again, will avoid any … actually, avoid any tax to the employees. That’s another way of shifting wealth, and it was the topic of the conversation with the Sixth circuit, which when he was trying to point out that it wasn’t only the very wealthy that could be advantaged by this structure, but the less wealthy, the employees for example.
Dave: Yeah, and as I understand it, one of … there’s several benefits through effectively paying the bonuses, or having DISC commission income in lieu of bonuses, and that is that the payroll taxes would be less by the employer, less by the employee’s share, and then you have the lower tax rate on the dividend income versus if it came out as ordinary income.
Neal: That’s right. There’s no employment taxes, and capital gains tax on the DISC dividends, whether to the Roth IRA or to the shareholder himself. The structure is used not only for Roth IRAs, for example, it’s just used as additional compensation to the key employees.
We actually have structured it so that the owner of the company can almost determine how much of the DISC income goes to the specific employees or to himself, because in many cases, he’s one of the owners of the DISC, so there’s a fair amount of flexibility in the structure.
Dave: Yeah, and so with that, we’ve seen this scenario, and one of them is to have two DISCs, like one owned by the related supplier, and then one owned by like the key employees, and then to first pay out the kind of bonus portion, and then the remainder to be paid to the DISC owned by the related supplier. Is that similar to some of the structures you’ve seen?
Neal: Yes, and there is a possibility of having just employees own the DISC, and then basically have their commission not be part of the portion that’s allowable, because there’s a ruling that says that might be an arm’s-length commission, not a safe harbor commission, so … We don’t recommend it, because it looks a little bit too greedy, but basically what we do is we take the normal DISC commission that’s allowable if the owner of the company received it, and then use that same amount to be in part the bonus for the employees.
Dave: Okay, and do you normally … like, what do you do if there’s like, say, five or six people on that management team that’s receiving the bonuses? Do you end up with separate DISCs for each, or how do you handle like if an employee leaves or is fired, how do you handle that sort of turnover at the executive ranks?
Neal: That’s a good question, and what we usually do, is we don’t have the DISC owned by the employees, we usually have a limited liability company own the DISC, and then have the employees be members of the limited liability company. And then we would have the owner of the related supplier be the manager of the LLC, and he would determine what the DISC benefits were to the individual employees.
Dave: Right, and I’ve seen that language, that you give that manager … I think the term is “broad discretion” on how the funds are distributed from the LLC to the recipients.
Neal: Yeah, and we have been involved … one of the things we do is we can do the management agreement for the LLCs to accommodate how it’s going to be distributed out, and that’s, Bob Wilson is the person that generally will draft those documents. So, as I was saying before, we have a team that can handle all the aspects of the thing, from planning to implementation.
Dave: Okay, so that’s on the employee ownership of the DISC, but I sense that there are some other structures you had in mind.
Neal: One of the other important uses of the DISC, and this is one that has not been challenged in court, or there’s no court decisions, but to the extent that we have a US company that does exporting, and that US company is owned in part or solely by a foreign corporation, if that foreign corporation is in a country that has a treaty with the United States, then if the treaty is later in time to the DISC provisions, but these days, almost all of them are, because the last DISC provision was in about 1989 or ’90, in that case, the treaty provisions will prevail over the DISC provisions. So, under the code, DISC dividends to a foreign shareholder are taxed as unrelated business taxable income. Or, I’m sorry, effectively connected with US trade or business, subject to tax at ordinary rates.
But under the treaty, you cannot do that unless you have a permanent establishment in the United States, and ownership of a US subsidiary does not create a permanent establishment. So, because of the treaty provisions, and you have to read each treaty very carefully, but because of the treaty provisions, the DISC dividends do not get taxed at ordinary income rates, but at the withholding tax rates on the treaties. So that’s another structure that’s been in place, and benefits foreign shareholders, and they can be large or small.
Dave: So, just to have an illustration of that, let’s just say that a foreign company has a wholly owned US subsidiary, and the DISC is established, would the shareholder of the DISC be the foreign corporation?
Neal: It would be the foreign corporation or a subsidiary of it in the same country.
Dave: Okay, and then let’s just say that there was a million dollars of commission paid in a year, can you walk me through kind of the mechanics, let’s say it was England, let’s say, is where the company was based, or just a country that you’re kind of familiar with the treaty specific rates, and just see how that million dollars ends up flowing through to the ultimate foreign corporation?
Neal: Sure, let’s just say we had a million dollars of DISC commission. There’s some confusion sometimes as to what the DISC … the DISC isn’t allowed to earn the entire commission, just the portion of it that’s in the rules, but let’s assume there’s a two million dollar profit, and the million dollars goes into the DISC, and the DISC now is owned by a UK corporation, and the treaty now applies, and so we take the position that the DISC dividends to the UK corporation … well, the million dollars of commission to the DISC is deductible by the US company.
The million dollars of income to the DISC is tax free to the DISC, because the DISC is a tax-exempt entity. The DISC dividends then become … would normally be taxed as effectively connected income, but under the treaty, we’d apply the treaty withholding rate, and for dividends out of the US to the UK, the rate is either … I think generally 5% or 0, depending on the holding of the company and how long it’s been held, and other factors.
In any event, we’ve not got a deduction at say 21% or even higher, if the company is not paying at corporate rates, and the income going into the UK company is taxed at 5% or 0, and under UK provisions, there’s no tax in the UK.
Dave: Wow, that’s really … can be really powerful. I’ve also seen where under that same structure, they’ll do kind of a blending, like we talked about earlier, with the employee owned DISC, where they might structure that where they’ll have some of the employees in the US be either a part owner of the DISC, or the owner of a second DISC, and so you’re kind of combining the two strategies there.
Neal: Well, I think the point that you’re raising is that there is no limit to the number of DISCs that can be created in what they call a controlled group, so if you want to use a DISC for one purpose, and other DISC for a different purpose, and a third DISC for even a different purpose, there’s no prohibition.
Dave: Okay, so Dave, I know you’re listening quietly. What thoughts has that prompted in your mind, based on some of these conversations, that you’d like to add some commentary to?
David: Yeah, I guess the first thought is that the DISC has survived a number of years and is still thriving. I think Neal can probably add a little history to that, but that is something that we’ve constantly been looking at to see if, well, is there going to be a change in the law that eliminates the ability to do a DISC, and I think our opinion is not that we know of, although you never know. And then the second point is that it’s … many times, it’s highly treaty sensitive, and so I think maybe we’ve been fortunate to have a kind of a hold on new treaties, recently, but that’s always something that impacts the analysis, and I think that’s something that Neal brings kind of a deep history of how this has all worked out over the years. Neal, do you want to comment on that?
Neal: Yeah. I think one of the caveats, if I can use the legal word, in the use of the treaty, is you have to look to see what the country that you’re dealing with is going to do with the DISC commissions, and in some countries, such as Japan or France, you might have difficulty under local taxing provisions, because they’ll treat the DISC dividends or the DISC income the same for US purposes, in other words, you won’t get the benefit the normal corporation might get in the treaty country, because of the fact that the DISC is tax exempt.
Dave: Yeah. I can see why that is so country specific.
David: So it’s important on the structuring on the front end, to determine where the right set up is. Neal, do you want to just talk about your experience over the past 50 years with legislation?
Neal: Yes, well, over the past 50 years, the DISC has always been on the way out. It was … I think the DISC came in in the ’70s under the Gerald Ford administration, as a Republican measure to encourage exports and give exporters a tax benefit. A few years later, the Republicans decided they didn’t want the DISC anymore for whatever reason, and the Democrats said, “No, keep it,” because the DISC was being used by small exporters to their advantage, and they didn’t want the small exporters to be disadvantaged.
Subsequently, the DISC was found to be in violation of the General Agreement of Tariffs and Trade, and the foreign sales corporation was organized to replace the DISC. The foreign sales corporation was a foreign corporation in a selected or qualifying jurisdictions, that had the same benefits as the DISC had, and was being used by the larger corporations to reduce their tax rate by about 15%, but rather than getting rid of DISC, they kept the DISC as quote interest charge DISC, and basically, made the DISC more attractive to small exporters, because there’s a 10 million dollar deferral amount that they allowed, and the FSC had unlimited amounts.
So at the same time, the DISC, which was a deferral mechanism at the time, allowed all the Disc income to be repatriated tax free, so that was an encouragement to the larger corporations to go into the FSC, but the DISC survived, and then when the capital gains rates came in, there became an arbitrage advantage to having the DISC pay dividends to shareholders so that the dividends got taxed at capital gains rates while the related supplier got taxed … got ordinary income deductions.
So that moved along, and then, I can’t remember what year it was, but then there was a proposal to eliminate DISC all together, and then because there was such a hue and cry from small exporters, that failed. And then, I think … there’s been a number of attempts to limit this, but the most recent one is, I think tax reform act of 2017, whatever they call it, and which under the Senate bill, this was supposed to be eliminated, but once again, the lobbying groups for the small exporters convinced the one Republican, whose vote was needed to pass the bill to oppose any change in the DISC provisions, and as a result, the DISC provisions remained intact.
So, it’s always had people trying to get rid of it, and the IRS doesn’t like it, because it’s an entity that doesn’t do anything but saves taxes. Presently, as Dave points out, the Congress is so split that they can’t agree on anything, so until that gets resolved, we don’t see any change in DISC.
Dave: Hey, one quick question to go back on the Roth-owned DISC, let’s say you have somebody that owns a business, they export, but let’s just say they have no heirs, if that person was, say, 25 years old, and planned to work for decades, I’m guessing that using the Roth structure would still make sense for them, but maybe if somebody was in their 60’s, it may not make so much sense, you know, if they’re not using an heir strategy, but just a tax saving strategy. Can one of you comment on if you’ve explored that issue, and if there seems to be kind of a rule of thumb of kind of the age of the person, where it starts to be more attractive or less attractive?
David: I’ll take a first crack. I mean, I think it’s a combination of the dollar amount and the age. So, if it’s a deferral mechanism, then it doesn’t really matter how old you are, if you think that you’re going to use the money in the future, then you want to minimize the income tax in the short term. If it’s a dollar amount, like you’ve already … maybe you have heirs, but you’ve already given them enough, and so you might just leave the Roth to charity, for example, you could do that. Most people, as a general premise, when we’re talking about Roths, we’re saying, “I’m going to pay tax on my IRA, and then convert it to a Roth and have it grow tax free.”
And so, by definition, I’m going to leave it to somebody. You wouldn’t pay tax up front and then leave the Roth to charity, for example. With a DISC Roth scenario, you’re not paying … I mean, you don’t … we said this at the beginning, but I think it’s really important to highlight. You don’t need a big IRA to convert to a Roth. You can start up, so long as you can start up an IRA, you can start up a Roth with nominal funding, and then it can be the beneficiary or the recipient of the distributions from the DISC.
So to me, it’s a business planning tool. It’s less of, obviously, a retirement tool. So your example with a 60 year old that doesn’t have descendants, he still may do it just to have like a little nest egg that they will take out after they sell their business or what have you.
Dave: Okay, and I guess another use of it for somebody without the heirs is just the asset protection aspect, if they’re an estate that recognizes that.
David: Totally right.
Dave: Yeah, so let’s just say the person had a $20 million net worth mostly in the business that’s exposed, but over the course of say five years, they’re able to basically transition five million of that 20 million to the Roth-owned DISC, that may have its own appeal just from the asset protection, so …
Neal: Could I interject with-
Neal: … one case that we have right now, and this is one where actually, there’s a mother, and she’s got I think three or four children, and basically, she’s been transferring the stock to them and suddenly realized she wanted to spend some money, and so she had them establish a DISC owned by her, so that she could get the money in her own hands so that she could spend it and take her own vacations and pamper herself for the rest of her life. So that … this was a reverse estate planning vehicle, where she wanted the money back in her own hands, so that not every person who is dealing with wealth necessarily wants to use it for leaving the money to their heirs, but spending for themselves.
Dave: Okay, that is interesting. Okay … is there any other ownership structures that come to mind, Neal, that we need to talk about?
Neal: Yeah, there’s a number of them. Apart from the IRAs, and the treaty country ownership, there’s another thing too that is overlooked sometimes, and that’s a partnership. In many cases, there’s a company that’s closely held but has a partnership with let’s say a publicly owned company, or a joint venture. And if they form a partnership, the partnership income earned by the closely held company will qualify for DISC benefits, because if the partnership is exporting, each partner is deemed to be an exporter in his own right, and therefore can take advantage of the DISC provisions even though the company that’s doing the exporting is quite large and is mostly held by a C corporation which has no use for the DISC. So that would be one advantage.
Dave: Hm, okay.
Neal: Let me see what else we have here … we have the … as I said before, we use the … for estate planning purposes, you don’t need the IRAs. You can just have the DISC owned by the children or grandchildren of the owner. It’s not necessary to use a Roth IRA or an IRA structure, it’s just simply another way of shifting the wealth, the same as to the employees, but in this case it would be children.
Dave: Yeah, that’s a good point, and I’ve seen … is my understanding correct, I’ve seen situations where folks have gotten in trouble with that, because they’ll take an existing DISC and transfer some of the stock to the children, and then perhaps creating a valuation issue, so that the best practices would be to form a brand new DISC? Is that accurate?
Neal: Well, actually, we have had some difficulty with estate planners when they see the value of the DISC, and the DISC is turning all this income … it’s one of the greatest investments start putting a value on the DISC at a high level, but there is a revenue procedure, Rev-Proc 8154, which is normally a bad ruling, but it does say that the fair market value of DISC stock at any given time is book value.
Dave: Oh, okay, so that reduces that risk of a valuation issue upon transferring it.
Neal: Right. Now, in many cases, we have a DISC owned by an S corporation, which is fine, because the S corporation income flows through to the shareholders, and they pay tax at capital gains rates, but the disadvantage is it takes away planning opportunities for the shareholders to use their own Roth IRA or do their own generation skipping. So, in some cases, rather than using a DISC owned by the S corporation, the shareholders of the S corporation may be better off owning the DISC stock.
Another situation which generally results when we have farming companies … remember that the only benefits that the DISC can take in the normal course are income from exports, but in many cases, if you take a farm for example, the farm is originally found by mom and dad, and they had four or five kids, and then mom and dad got older, and they wanted to keep the kids in the business, so each kid got a little bit of the business. One got the crops, one got the processing facilities, one got the machinery and equipment, one took care of the marketing.
And so, as a result, you might have four or five different companies or entities earning income from the farming operation, but that results in a very small amount of income from the export activities, so one way we’ve gotten around that is to form a partnership of all of the family members, so that the members become, each one of those little businesses, now contributing to the partnership, and the partnership export income is now the entire export profit that would have been the case if mom and dad had still owned the farm.
Dave: Oh, I see, okay.
Neal: So what we do is … and basically, our partnership people get involved in this transaction, and for the most part, they’ve been saying that, really, what they’ve had all along is a partnership any how, they just haven’t … they’ve just divided it up, but in many cases you find that these families sit down and decide how much each person’s going to make anyway.
It’s also possible for unrelated parties, but you have to watch it a little bit more closely so you make sure that the partnership agreement provides what the different partnerships want. When we use an LLC, for example, we’ll use different classes of LLC interests in order to get the parties’ desires the way they want them, and in some cases, it’s used to give one party a greater percentage of the profit, and the other one would have … where you wouldn’t get that with just a straight DISC ownership.
Dave: And speaking of the farming … oh, go ahead, Neal.
Neal: Oh, it’s okay, go ahead.
Dave: So, speaking of the farming operations, I had a question yesterday about a company that … it’s a farming company, and their situation, though, they sell to a co-op, and the co-op exports a portion of what they’re selling them, which on the surface appears to be problematic to qualify for the DISC, because of the co-mingling of the grain. Is that something you’ve had any experience with, co-ops, and is there a way to make that work from a structural perspective or operational perspective that you’ve seen?
Neal: The answer is yes. I’ve been involved in the co-op situation. I’ve actually been involved with trying to get a ruling from the IRS on how the co-op would work, and it’s not been very easy. The service is still refusing to give rulings, as far as I know. One of the problems in the co-op, is how you measure the DISC profit, because what do you do with the expenses of the farmer, and when you sell to the co-op, what is the co-op’s basis, and what’s the farmer’s share of the co-op profits? How is that going to be taxed, and is there going to be an offset for his profits for DISC purposes against his crop growing expenses?
So there’s a number of issues that have to be worked through in terms of the co-op, but basically the co-op structure does lend itself to the DISC benefits, but getting the rulings from the service that would bless this structure have been difficult.
Dave: Oh, okay. Dave, do you have anything to add, since again we’ve kind of kept you out of the conversation for the last 10 minutes?
David: That’s okay. I suppose I just would note that the new SECURE act that’s effective January 1st, changed the stretch out rules for IRAs, which would include Roth IRAs, meaning that you can’t stretch it out over the life expectancy of the beneficiary, it’s got to be paid out 10 years after the death of a participant, essentially. And so, not great, but I don’t think it has much of an impact. It just means that if you do a DISC Roth technique, then once the owner passes away, it’s going to be distributed out of that Roth IRA within 10 years, still not subject to tax, but something to note.
Dave: Okay, well, thank you for that clarification.
Neal: I might weigh in on one thing. It becomes sort of the holy grail of DISC, but if somebody’s new to DISC … is that you want to have the DISC owned by a shareholder who’s going to at least get the capital gains rate on DISC dividends, and the capital gains rate, I’m talking about the 23.8% rate, not the normal, because DISC dividends are taxed as ordinary income, but if you’re an individual, you pay tax at the capital gains rate, so this sort of leaves out corporations owning DISC stock, because the corporations will pay tax on DISC dividends at regular corporate rates, and then the dividends from the corporation to its shareholders would be taxed again, so you’ll have double taxation.
Neal: So the theory is that the DISC stock is to be owned by a pass-through entity, or a low tax entity.
Dave: Got you.
Neal: And that’s why, in the foreign shareholder situations, because we get the treaty benefit, we can have the corporation own this stock without suffering the detriment.
Dave: Okay. Wow, well, we have covered a lot, and the time has flown by. Normally, this is where I would ask for your contact information, Neal, but given your retirement, perhaps we should get Dave’s contact information. Dave, could you share your contact information?
David: Sure. I can be contacted at Baker McKenzie, at my e-mail, which is my name, David dot Berek, that’s B as in boy, E-R-E-K, at BakerMckenzie.com. And my telephone number is (312)861-8184.
Dave: Okay, and then the person that … the other attorney Neal mentioned, the female ERISA expert, you would be able to forward the appropriate questions to her, correct?
David: Right. In Neal’s absence, we’re putting together a team, and that would be Maura McBreen, of our benefits, comp and benefits group, Bob Wilson, puts together a lot of the structure, he’s a paralegal in our corporate practice, and then we’d bring in other collaborative attorneys as needed. So we recognize that we have some very big shoes to fill with Neal retiring, and we’re encouraged by the challenge, so …
Neal: I might mention that Maura Ann McBreen is the co-attorney with me, co-counsel, in a case called Swanson Tools, which is an IRA DISC case, and so she was actually on the brief and wrote the ERISA portion, which frankly won the case, and the only other thing is I did publish a B&A portfolio this last year on DISC, so even though I’m not going to be in the office, if anybody wants my learned opinion on the DISC stuff, they can look at the portfolio.
Dave: Okay, that sounds good. With just a couple minutes left, Neal, do you mind retelling one of my favorite stories you tell, about the benefits of specialization, when you were at law school, and the professor talked about the more narrow your focus, the less bright you have to be? Do you mind just kind of retelling that?
Neal: Sure. One of the gems I kept from law school was in my corporations class, the instructor was in private practice, and he said, “A word of advice: you don’t have to be the sharpest tack in the shed, but if you know more about a subject than anybody else, the world will beat a path to your doorstep.” And I took that to heart, so when I came off the tax court and became an attorney with Baker McKenzie, the DISC stuff was just being introduced, and I said what better way to become a specialist, than to get in on the ground floor.
Neal: I didn’t realize there was something called a foreign western hemisphere trade corporation before that, but that’s what I did, so that became my guiding light. And so, 20 years into my practice, I was in the elevator in the Prudential building, where our offices were, and somebody said, “Neal, do you remember this professor from law school?” And I said, “Oh of course. It was Mr. Chaplin.” And they said, “Well, here he is.” And there he was, and so I said, “You said something to me that was my guiding light.” And he said, “What did I say?” And I told him about the sharpest tack in the shed business, and you know what he said? “Did I say that?”
Dave: That is great, and then lastly, I would like to share my other … so that story had a huge … or that comment by your professor had a huge impact on your career, and although he did not make that comment to me directly, I still picked that up somewhere, and that’s why our business is solely focused on the IC-DISC, and to the best of my knowledge, we’re the only firm like ours that’s focused purely on the IC-DISC.
But the other big lesson I learned from you, do you remember about eight years ago, I called you about a question, and you answered the question in like three minutes, and then you started inquiring about my family and the weather and such, and so I quickly interrupted you, because I said, “Hey, Neal, at your billing rates, it’s like 20 dollars a minute for talking to you, so we might need to cut this call short.”
And I don’t know if you remember this call, but you said, “Well, hold on Dave, I mean, you are correct. You’re going to get a bill for our time today, and don’t worry, I won’t charge you for anything past that point,” but you said, “I’m the cheapest attorney you’ll ever have.” And I said, “Why? I mean, your billing rates are, on an hourly basis, are some of the highest of any attorneys we work with.” You said, “Yeah, you’re going to get a bill for this conversation, and it’s going to be a few hundred dollars, but somebody else paid me $10,000 to research this matter before, and thus I had the answer off the top of my head, and that’s why, Dave, that the more expert somebody is, the more specialized they are, the higher their hourly rate must be, because otherwise they cannot capture the full value they’re delivering, because somebody else has already paid for them to get the research.”
And I’ve never forgotten that, and I keep that in mind as I hire experts and professionals in the future, and I’ve seen first hand, when you have a generalist, and you ask them a question, their first response is, “Well, let me start the research on that, because I don’t know that answer off the top of my head.” So anyway, do you remember that story or that conversation?
Neal: I remember you relating it to me, so I think it must be true.
Dave: Okay, so … and is there anything … and Dave, would you agree with Neal’s point that it’s not a bad strategy to use experts?
David: I agree. One of the comments that I make to my clients is, “The more you talk to me, the more money you’re going to save.” So, the more you can spend on … the more that you can invest into specialists or experts, the more profitable you’re going to be. The question for the client is, “When do I need an expert?” When we get to our practice areas, it’s pretty apparent.
Dave: Well, awesome. Gentlemen, I can’t believe the time has flown so quickly. I could listen to Neal Block’s stories for hours upon end, but all things must come to an end. Neal, thank you again for just being such a great resource for my firm and our clients, for the last decade or two, and I just wish you the best of luck in your retirement.
Neal: Well, David, thank you very much. I appreciate it. And I appreciate being able to close off my career by being on your podcast.
Dave: Yeah, all right. If I was smart, I would make this my last podcast and just end on a high note, and just retire the podcast, but we’ll have to think about that. Well, thanks a lot guys. You both have a great day, okay?
David: All right, take care.
Neal: Thank you.
Dave: There we have it, another great episode. Thanks for listening in. If you want to continue the conversation, go to IC-DISCShow.com, that’s IC-DISCShow.com, and we have additional information on the podcast, archived episodes, as well as a button to be a guest. So, if you’d like to be a guest, go select that and fill out the information, and we’d love to have you on the show. So that’s it. We’ll be back next time with another episode of the IC-DISC Show.