If your closely held company earns significant income from exporting US-made products – or from engineering or architectural services on foreign construction projects – consider forming an interest charge domestic international sales corporation (IC-DISC).

An IC-DISC is relatively inexpensive to set up and operate, and it can reduce your federal tax rate on a portion of net export income by up to 20 percentage points.

To make the most of this strategy, it’s a good idea to act soon. The IC-DISC’s tax-saving opportunity is dependent upon the favorable 15 percent tax rate on qualified dividends received by individual taxpayers, which Congress recently extended – but only through 2012.

What is an IC-DISC?
A domestic C corporation must request and receive IRS approval to be treated as an IC-DISC for federal tax purposes. It also must maintain its own bank account, keep separate accounting records, and file US tax returns. But it need not have an office, employees, or tangible assets, nor is it required to perform any invoicing or provide services.

Due to its status as an IC-DISC, the company pays no federal income taxes and reduces the exporter’s tax liability by effectively converting a portion of net export income, which is taxable at ordinary income rates as high as 35 percent, into qualified dividends generally taxed at 15 percent.

To qualify as an IC-DISC, a corporation must also:

• Be incorporated in one of the 50 states or in the District of Columbia,
• File an election with and receive approval from the IRS to be treated as an IC-DISC for federal tax purposes,
• Maintain a minimum capitalization of $2,500 of authorized and issued shares,
• Have only a single class of stock, and
• Meet an annual qualified export receipts test and a qualified export assets test.

The last requirement means that at least 95 percent of an IC-DISC’s gross receipts and assets must be related to the export of property whose value is at least 50 percent attributable to US-produced content. There is an important exception for engineering and architectural services related to construction projects outside the US which may also generate qualified export receipts.

How does an IC-DISC reduce taxes?
By virtue of the fact that the C corporation qualifies as an IC-DISC, it is presumed to have participated in the export sales activity for which it is entitled to earn a commission. Your company (the related exporter) is then required to pay tax-deductible commissions to the IC-DISC which are equal to the greater of: 1) 4 percent of your company’s gross receipts from qualified exports, or 2) 50 percent of its net income from qualified exports. Your company’s taxable income is reduced by the amount of the commissions paid to the IC-DISC and such commissions are deductible as ordinary income tax deductions.

The IC-DISC, as a tax-exempt entity, pays no tax on the commission income. When the IC-DISC distributes its income to its shareholders, the dividend income is taxed at the qualified dividend rate of 15 percent. The qualified dividend rate is available only to individuals; thus, you’ll need to structure the IC-DISC so that dividend payments are considered to be received by individuals.

If your company is a pass-through entity – such as a partnership, S corporation, or LLC – you can form an IC-DISC as a subsidiary. Dividends the IC-DISC distributes to your company will retain their character and be passed through to individual shareholders and qualify for the 15 percent rate.

If your company is a C corporation, however, you’ll need to have the corporation’s individual shareholders form the IC-DISC. If you set up the IC-DISC as a subsidiary, the dividends will be paid to the corporation and taxed as ordinary income, i.e., no tax savings.

An IC-DISC in action
Let’s assume an S corporation has $20 million in qualifying export sales and $5 million in net export income on those sales. If the company has an IC-DISC subsidiary, it can pay the IC-DISC commissions up to the greater of 50 percent of its export net income or 4 percent of its export gross receipts. In this case, the maximum commission is 50 percent of net income, or $2.5 million.

The following calculation shows how the owners can save a combined $500,000 in federal income taxes:

Note: The example assumes that the IC-DISC distributes all of its income and that each of the company’s shareholders is an individual in the 35 percent tax bracket.

Other benefits
Although an IC-DISC isn’t required to perform any services, having it do so may enhance its benefits. Services might include promoting your company’s export activities or purchasing receivables from your company at a discount, or “factoring." Just like commissions, income from these services can be distributed to shareholders at the qualified dividend tax rate.

It is also possible to use an IC-DISC as an estate planning tool or to incent employees involved in your export business. There is no requirement that an IC-DISC’s shareholders be the same as the exporter’s shareholders or that they own their shares in the same proportions. However, caution is advised in the event that shares of an existing IC-DISC are transferred – there are obvious valuation issues to be considered.

Finally, you can defer tax on commissions related to $10 million of export sales per year that are left in the IC-DISC by making modest, annual interest payments to the IRS. These interest charges (the "IC" in IC-DISC) are tied to Treasury bill rates, which, in recent months, have been only a fraction of 1 percent.

Act now
An IC-DISC’s tax benefits aren’t retroactive – in other words, these benefits are available only for export sales made after the IC-DISC is established. And with the 15 percent qualified dividend rate set to expire at the end of 2012, the sooner you act, the greater your tax savings. If this favorable rate does expire, dividends may once again be taxed as ordinary income, eliminating the IC-DISC’s ability to reduce your tax rate.

Of course, Congress may decide to extend the qualified dividend rate beyond 2012. But even if it doesn’t, IC-DISCs will continue to provide an opportunity to shift income to lower income tax brackets (taking advantage of the difference between ordinary-income tax rates rather than qualified dividend rates), as well as to defer taxes on export sales

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