Although dividend rates increased for some taxpayers, these rates are still significantly lower than the tax rates on ordinary income. Therefore, any U.S. business that exports its products should review the potentially significant tax savings available through an “Interest Charge-Domestic International Sales Corporation”, referred to as an “IC-DISC”.
IC-DISCs have received much attention over the last several years, proving to be a very low cost technique to realize significant tax savings, all in a way that is specifically approved by the IRS. While some businesses have resisted implementing an IC-DISC due to concerns that dividend rates would be increased significantly, these concerns have mostly disappeared with the recent tax legislation that set dividend rates at 15 percent to 20 percent for the foreseeable future.
How the tax benefit is provided
The IC-DISC is typically formed as a new, separate corporation with initial capitalization of at least $2,500. The corporation’s shareholders, which can be either individuals or other types of business entities, make an election to treat the corporation as an IC-DISC. The IC-DISC is paid a commission by the existing exporter (Exporter), which takes a deduction for the commission payment. This deduction would normally generate a tax benefit of 35 percent to 39.6 percent to the Exporter. The IC-DISC itself is a tax exempt entity and pays no tax on this commission; tax is paid only by the IC-DISC shareholders on dividends received from the IC-DISC. Currently, these dividends are taxed at the increased but still favorable 20 percent rate for higher-income taxpayers. Therefore, the tax savings are based on the commission arrangement between the IC-DISC and the Exporter, which provides a corporate deduction (usually worth 35 percent to 39.6 percent) in exchange for the tax cost of a dividend to the IC-DISC shareholders (taxed at only 20 percent), generating a typical net tax benefit of nearly 20 percent on the allowable commissions paid. The Exporter can be a corporation (S or C), LLC or partnership.
The amount of the commission that can be paid to the IC-DISC is (based on the simplest calculations) limited to the greater of four percent of gross export sales, or 50 percent of net income from export sales. The following are two examples of the potential tax savings:
- A company with $10 million of gross export sales and $2 million in net income from those sales could pay the IC-DISC a commission of $400,000 (four percent of gross export sales), generating an annual net tax savings of roughly $80,000 based on the rate assumptions set forth above.
- An Exporter with $1 million in export sales generating net income of $200,000 could pay the IC-DISC a commission of $100,000 (50 percent of export profits), generating an annual tax savings of $20,000.
These examples represent the minimum amount of allowable commissions; there are more sophisticated methods of calculating the allowable commission that can yield much greater tax savings. For example, if the Exporter has different product lines with differing profit margins, the commission can be analyzed by product line, producing a larger commission than the normal four percent or 50 percent calculation.
Requirements for qualifying as an IC-DISC
As one would expect, there are a significant number of requirements that must be met in order to qualify as an IC-DISC. Exported products must be manufactured, produced or grown in the United States, although the Exporter using the IC-DISC does not have to be the manufacturer. Brokers and distributors of products manufactured by another business can also qualify. Operations which are generally considered to be manufacturing should qualify if those operations are substantial in terms of creating the ultimate product. No more than 50 percent of the manufactured goods themselves can be attributable to articles imported into the United States. In addition, the goods must be exported for direct use, consumption or disposition outside of the United States. Certain services, including architectural and engineering services for construction projects located outside of the United States, can also qualify for this benefit.
It is important to note that there is no requirement that the IC-DISC have an actual place of business or employees. The IC-DISC is not required to actually perform any services for the Exporter. The IC-DISC concept has been developed under the Internal Revenue Code and the regulations thereunder as a mechanism for providing a tax benefit to exporters who meet the criteria discussed above.
Although there are very detailed rules on what constitutes qualifying exports and the amount of the commission, this is not an aggressive tax strategy. The use of the IC-DISC as described above is specifically permitted under current law.
Additional planning opportunities
There are a number of related planning opportunities associated with this technique. An IC-DISC can be used as a succession planning tool to accumulate cash on a tax-advantaged basis to facilitate a buyout of the Exporter itself. Exporters have also used these entities to provide equity incentives to key management personnel without the drawbacks of granting an equity interest in the Exporter itself. Care must be taken in structuring these types of arrangements if the shareholders of the IC-DISC are not the same as the shareholders of the Exporter, although such arrangement is permitted.
Because the IC-DISC does not pay income tax, and its shareholders are only taxed when distributions are made, other planning opportunities exist if these shareholder distributions are deferred. For instance, the IC-DISC can loan the commission payments back to the Exporter. Interest paid on this indebtedness generates another deduction for the Exporter, and the interest income is treated as a dividend to the shareholders. The same tax savings described above are effectively realized on the financing transaction. If distributions of commission income are deferred, there is an interest change (which is deductible for corporation shareholders). This interest change is based on the deferred tax liability of the shareholder and the base period Treasury Bill rate.
As with any tax planning technique, the detailed requirements must be analyzed and applied to the Exporter’s fact pattern to determine if a benefit can be derived. The description above is not a comprehensive recitation of these rules, but should serve as a guide to determine whether a closer examination is warranted. The Exporter's attorneys and accountants should be involved in this process. In addition, the Exporter must be prepared to keep appropriate records to show that the exported goods meet the requirements discussed briefly above. The process of setting up an IC-DISC is relatively inexpensive, and in many cases, this initial investment will produce substantial annual tax savings for the foreseeable future.
For more information, please contact:
Tax planning needs to be strategic. We consult with businesses at all stages of their development, from the initial choice of entity, through acquisition and other growth transactions, to business succession planning, and dispositions. Our tax advisors also work closely with clients on individual tax planning. Our attorneys provide businesses and individuals with comprehensive counseling in all areas of federal, state and local taxation.