Are You Exporting Without An IC-DISC? If So, Why?
by Christopher Nuss >
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If you’re exporting goods without an IC-DISC (an “interest charge domestic international sales corporation”), you’re likely paying more income tax than necessary. By implementing a rather simple, low-risk tax planning strategy, you could realize significant tax savings on your foreign sales.
What are the potential benefits of an IC-DISC?
For individuals, directly or indirectly through pass-through entities such as limited liability companies or S corporations, an IC-DISC may reduce their tax rate on export profits from the ordinary income tax rate (maximum of 39.6% for 2013 plus the new extra Medicare tax for high-earners of 0.9%) to the dividend rate (maximum of 20% plus the new Medicare tax on investment income of 3.8%) – an approximate savings on tax rates of 16.7%, each year. Furthermore, this tax savings due to the gap between ordinary income and dividend tax rates is currently “permanent” (at least until Congress changes the law).
Similarly, closely held C corporations can also benefit from implementing an IC-DISC with what essentially becomes a tax deductible dividend, especially if they declare and pay dividends to shareholders anyway. IC- DISCs can also aid in wealth transfer or executive compensation arrangements for the exporting company.
In the end, the federal income tax savings is typically the difference in the applicable ordinary income and dividend tax rates multiplied by the greater of 50% of the taxable income from exports or 4% of gross export sales. As further discussed below, this is the maximum amount of “commission” that can be paid by the exporting company to an IC-DISC.
What is an IC-DISC?
An IC-DISC is a corporation formed under state law that:
- Has a single class of stock;
- Maintains a minimum capitalization of $2,500;
- Has qualified export receipts and a qualified exports assets (as discussed further below); and
- Elects to be taxed as an IC-DISC.
If all of these requirements are met, an IC-DISC is not subject to federal (and many states’) income tax on commission payments received from the exporting company. Instead, the shareholders of the IC-DISC are taxed on the distribution of those payments by the IC-DISC as dividends.
What are “qualified export receipts” and “qualified export assets”?
To qualify as an IC-DISC, at least 95% of its receipts must be from the sale or lease of “export property” – that is property: (1) manufactured, produced, grown or extracted in the U.S. by a person other than an IC-DISC; (2) held primarily for sale in the ordinary course of business for use outside of the U.S.; and (3) not more than 50% of its value is comprised of imported materials. This is not a difficult requirement to meet for companies that are exporting and does not mean that 95% of the exporting company’s receipts must be from exports. It simply requires that the IC-DISC be paid by the exporting company based on export sales. Through agreements between the exporter and the IC-DISC, we can ensure that the IC-DISC is paid based only on qualified export receipts.
Note that there are certain types of property that simply do not meet the definition of “export property” such as most intellectual property (patents, inventions, designs and the like) and products that deplete like oil, gas and coal.
Export property is considered “manufactured” if there is a “substantial transformation” before sale (e.g., irreversibly change the character or use of the original materials and add economical value to them, such as transforming steel rods into nuts and bolts) or the conversion costs account for at least 20% of the total cost of goods sold.
Importantly, qualifying export sales may be delivered in the U.S. as long as the product is ultimately delivered, used, or consumed outside the U.S. within a year of sale for use outside the U.S. Accordingly, indirect sales can qualify as a qualified export receipt. Qualified exports, however, do not include property subject to further manufacturing or other processing after the sale and before ultimate delivery outside the U.S. Often, obtaining proper documentation for “indirect sales” is critical in this area.
As to qualified export assets, at least 95% of an IC-DISC’s assets at the end of each year must be assets held in connection with exporting activities such as working capital, receivables and producer’s loans. Again, this is generally not a difficult requirement to meet through proper agreements among the applicable parties.
How does an IC-DISC typically work?
Assuming the exporting company is an S corporation or other pass-through entity that wholly owns the IC-DISC as set forth in the diagram below, the S corporation exports the goods and pays the IC-DISC a commission based on those export sales that is deductible for income tax purposes and not taxed to the IC-DISC. Then, the IC-DISC typically distributes back to the S corporation that same amount, which passes through to the S corporation’s shareholders and is taxed to them at the dividend rate, not the ordinary income tax rate that it otherwise would have been without the IC-DISC.
Thus, the S corporation shareholders have paid less tax on these commissions equal to the difference in the applicable ordinary income tax and dividend tax rates. And this is a permanent savings unless/until Congress changes the applicable rates.
A similar, but alternative, structure could include the following.
The amount of the “commission” cannot exceed the greater of 50% of the export taxable income or 4% of export gross receipts. In determining export taxable income, certain directly and indirectly related expenses can be allocated and apportioned between export and non-export activities to maximize tax savings. If one of these two formulas is followed, you can generally avoid the risk and uncertainty of the IRS transfer pricing rules. Further, to determine your export taxable income, there is flexibility in how you categorize sales – for example, by product line or even by transaction – to optimize your commission calculation and thus optimize your tax savings.
Unlike other tax planning strategies, the IRS recognizes that IC-DISCs are not required to have economic substance (e.g., have its own employees and operations) generally because of the desire to incentivize the export of U.S.-manufactured goods. Given that, however, you must be very careful to ensure that all legal and technical requirements are met so to qualify as an IC-DISC. The IRS will certainly ensure that occurs. An IC-DISC is not difficult to form with the help of experienced legal counsel, and it is not overly burdensome, especially given the immediate tax savings that can be realized in the right cases.
The following is an overview of the possible tax savings for an S corporation (or similar pass-through entity), with some basic assumptions.
To further discuss whether an IC-DISC is right for you, please contact Christopher L. Nuss at (515) 242-2432 or nuss@ brownwinick.com or Christopher R. Sackett at (515) 242-2470 or firstname.lastname@example.org.
Note: This article is intended to be a general overview and not a comprehensive analysis of IC-DISC law. Moreover, it does not constitute legal advice. The examples are provided for illustrative purposes of potential permanent tax savings only. There is no guarantee that this would be the tax savings for your unique facts and circumstances. Competent legal counsel should be consulted to apply the relevant legal requirements to your specific fact pattern.