The Benefits of a "Small" Foreign Sales Corporation

Enacted in 1984 as an offspring of the Domestic International Sales Corporations (DISCs) provisions, Foreign Sales Corporations (FSCs) allow domestic corporations to receive tax subsidiaries. By creating a "Small" Foreign Sales Corporation (Small FSC), a business entity can reduce federal and state income tax liabilities.

DISCs, Congress's original legislation that created a tax subsidy for exporters, needed to be modified due to the United States membership in General Agreement on Tariffs and Trade (GATT), a 123-nation agreement on international trade. In general, GATT prohibited a member from providing tax subsidies for exports by a domestic corporation. FSCs circumvent this rule by being incorporated in a foreign country rather than in the United States.

FSC Benefits
FSCs can lower a C corporation's overall effective federal tax rate on foreign trade income by an amount of 5-10% (depending upon which statutory administrative pricing rule applies, as discussed below). Therefore, a C corporation in the highest tax bracket of 34% (with an effective tax rate of the same) could actually realize an effective federal tax rate of between 24% and 29% on these foreign sales.

An FSC is provided an income exclusion on its foreign trade income. This exclusion is 15/23 if the FSCs foreign trade income (i.e., foreign trade taxable income) is determined using the statutory administrative pricing rules. These pricing rules should be used to determine the Small FSC benefit due to their simplicity and lessening of professional fees in most cases. An FSCs accumulated earnings and profits are not taxed upon their distribution to the FSCs parent due to the 100% dividends received deduction. Many states follow the federal FSC provisions in some fashion. A Small FSC may need to file a state corporate tax return but may be allowed to exclude some FSC income.

Small FSC Requirements
Listed below are some of the more important FSC requirements (although not all inclusive): 

1. The FSC must be organized under the laws of a foreign country. This foreign country must have a tax-sharing agreement with the United States. The most common foreign countries for FSCs are the U.S. Virgin Islands, Barbados, Bermuda and Guam. These countries impose minimal taxes on the FSC. It is not beneficial to incorporate in a country that taxes an FSCs net income because these taxes would not be fully creditable for U.S. Purposes. 
2. A corporation must elect to be a Small FSC on Form 8279. The election can be made at any time, including in the middle of its parent's taxable year. The FSC benefits begin accruing immediately thereafter. 
3. One of the FSCs directors must be a U.S. non-resident, no preferred stock may be issued and there is a maximum of 25 shareholders. 

Small FSCs run into none of the technical loops that regular (or large) FSCs incur. Small FSCs are exempt from both the stringent foreign economic process requirements. However, a Small FSC can only apply the FSC benefits on a maximum of $5 million of foreign trading gross receipts. For many corporations not willing to create more of a substantial foreign corporation, this limitation may not initially apply. A corporation can initially organize as a Small FSC and later convert to a large FSC, if warranted.

Administrative Pricing Rules
It is first necessary to determine the overall foreign trade income. This is the taxable income related to the foreign trade gross receipts. As a rule of thumb, this should be the operating company's taxable income multiplied by the percentage of foreign trade gross receipts to total gross receipts.

The overall foreign trade income is then allocated between the FSC and its parent by using either the gross receipts or combined taxable income methods. The method used is whichever method allocates more foreign trade income to the FSC. Under the combined taxable income method, the FSC's foreign trade income is 23% of the total foreign trade income. Under the gross receipt method, it is 1.83% of the foreign trade gross receipts. The gross receipt method is limited to two times the combined taxable income method. The combined taxable income method is applied if the net income to sales ratio is greater than 8%. If the ratio is less than 8%, the gross receipt method is applied.

FSC Candidates
First, an FSC should only be utilized by an existing C corporation. A C corporation would be the FSC's sole shareholder. An S corporation (or individual shareholder) would receive no overall FSC benefit because neither taxpayer is allowed a dividend-received deduction upon the ultimate distribution of the FSC earnings and profits.

The FSC benefit is based on only foreign trading gross receipts, which include: 

1. Receipts or commissions on sales and leases of goods produced in the U.S. and exported to foreign countries, and 
2. Compensation of architectural, engineering and management services provided abroad. 
3. Therefore, operating companies in the manufacturing, distribution and professional service industries should consider an FSC. 

Software Licenses
Software licenses are now considered as export property, even if the license entitles the acquirer to reproduction rights, effective for license periods after December 31, 1997. Prior to this change, only software licenses of standardized computer software on media that are mass-marketed without the right to reproduce for external use qualified as export property.

FSC Cost
An FSC management company should be used to facilitate the foreign corporation and other requirements. A good management company should make the FSC election, incorporate the FSC expeditiously, and provide technical guidance and support.

The annual FSC benefit should be at least $5,000 to offset the annual costs and to receive a net benefit. A Small FSCs formation fee should be approximately $2,500 and the annual management fee should be approximately $2,000. Couple these costs with a foreign country's minimum tax and accounting fees, and the annual costs should be between $5,000 and $6,000.

The Small FSC rules offer a terrific tax subsidy for U.S. exporters of goods and services without incurring significant administrative costs.