BY CARL GRASSI
Published in Crain's Cleveland Business
April 8, 2013
The recent extension of favorable dividends rates (as compared to ordinary income tax rates) means that U.S. businesses that export their products need to review the potential benefits available through the use of an Interest Charge-Domestic International Sales Corporation, referred to as an IC-DISC.
More and more, smaller companies are seeing opportunities to sell their products abroad.
When the dollar volume of such sales becomes significant, business owners should consider the federal tax savings opportunity available by establishing an IC-DISC. Despite the name, this tax savings technique is fairly straightforward.
The IC-DISC is typically formed as a new, separate corporation with initial capitalization of at least $2,500.
The corporation's shareholders can be either individuals or other types of business entities. These shareholders make an election to treat the corporation as an IC-DISC.
The IC-DISC is paid a commission by the existing business (the exporter). The exporter takes a deduction for the commission payment, reducing the ordinary business income of the exporter, subject to the applicable rules described in part in this article.
The IC-DISC itself is a tax-exempt entity. Tax is paid only by the IC-DISC shareholders when the commission payments are distributed from the IC-DISC to its shareholders as dividends.
Currently, these dividends are taxed at a maximum 20% rate and are generally subject to the Unearned Income Medicare Contribution tax of 3.8%.
This Unearned Income Medicare Contributions tax is new for 2013. For purposes of simplicity, we will assume that the maximum tax rate that applies in this instance is 23.8%.
The tax savings therefore results from the fact that the commission arrangement between the IC-DISC and the exporter provides a deduction against ordinary income (which could be worth close to 40%) in exchange for the tax cost of a dividend to the IC-DISC shareholders (taxed at a maximum rate of 23.8%), generating in some cases a net tax benefit of 16.2% on the allowable commissions paid.
The amount of the commission that can be paid to the IC-DISC is limited to the greater of 4% of gross export sales or 50% of net income from export sales of the exporter.
To give you a rough idea of the potential tax savings, a company with $10 million of gross export sales and $750,000 in net income from those sales could pay the IC-DISC a commission of $400,000 (4% of gross export sales), generating an annual net tax savings of $64,800 based on the rate assumptions set forth above.
An example with more modest numbers would be an exporter with $1 million in export sales generating net income of $200,000. In this case, the manufacturer could pay a commission of $100,000 (50% of export profits), generating an annual tax savings of roughly $16,200.
As one would expect, there are a significant number of requirements that must be met in order to have the IC-DISC qualify as such.
For businesses exporting manufactured products, no more than 50% 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 U.S.
Although this tax benefit is generally thought of as an incentive for manufacturers, architectural and engineering services also qualify for work done on projects outside of the United States. Details on these and other requirements are provided in the Internal Revenue Code and regulations.
There are very detailed rules on what constitutes qualifying exports and the amount of the commission, but this is not a tax shelter transaction or even a “pushing the envelope” tax strategy. The use of the IC-DISC as described above is specifically permitted under current law.
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 also have used these entities to provide equity incentives to key management personnel without the drawbacks of granting an equity interest in the exporter itself. If distribution of commission income is deferred, there is an interest charge imposed on the IC-DISC shareholders, based on the deferred tax liability of the shareholders 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 this initial investment will in many cases produce substantial annual tax savings for the foreseeable future.
Carl Grassi is president of McDonald Hopkins LLC.