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 as much as 20 percent.
To make the most of this strategy, the IC-DISC should be established as soon as possible because the tax benefits can only be claimed on export sales after the formation of the IC-DISC.
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 the exporter’s net export income, which is taxable at ordinary income rates as high as 39.6 percent, into qualified dividends generally taxed at 20 percent after 2012.
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 bank account,
- 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 that allows IC-DISC benefits for engineering and architectural services related to foreign construction projects (even though the services are performed in 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, and due to that participation, it is entitled to earn a commission. Your company (the related exporter) is then allowed to pay tax-deductible commissions to the IC-DISC which are equal to the greater of: a) 4 percent of your company’s gross receipts from qualified exports, or b) 50 percent of your company’s 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 against ordinary income.
The IC-DISC, as a tax-exempt entity, pays no federal tax on the commission income. When the IC-DISC distributes its income to its shareholders, their dividend income is taxed at the qualified dividend rate of 20 percent. The qualified dividend rate is available only to individuals; thus, you’ll need to structure the ownership of the IC-DISC so that the IC-DISC dividends 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 that the IC-DISC distributes to your company will retain their character and be passed through to individual shareholders and qualify for the 20 percent rate.
If your company is a C corporation, however, you will need to have the corporation’s individual shareholders form the IC-DISC as a sister corporation in order to obtain the lower tax rate on dividends. If you set up the IC-DISC as a subsidiary instead, the dividends will be paid to the C corporation and taxed at regular corporate income tax rates, i.e., no tax savings.
An IC-DISC in action
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 commissions to the IC-DISC equal 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.
If we further assume the IC-DISC distributes the entire $2.5 million of commission income as a dividend to its shareholders and that each of the S corporation’s shareholders is an individual in the 39.6 federal percent tax bracket not subject to the 3.8 percent surtax on investment income, the consequences are as follows:
- The S corporation incurs an ordinary tax deduction of $2.5 million for the commission paid to the IC-DISC.
- The commission expense passes through to the S corporation individual shareholders which yields a 39.6 percent federal tax benefit.
- The IC-DISC receives $2.5 million of nontaxable commission income.
- The IC-DISC pays a dividend to the S corporation of $2.5 million, which also flows through the S corporation to its individual shareholders.
- The S corporation shareholders pay 20 percent federal income tax on the IC-DISC dividend income.
- The S corporation shareholders receive a 19.6 percent net reduction of their federal tax liability on the $2.5 million IC-DISC commission or $490,000.
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 for the privilege of deferring the federal tax on the dividend income. These interest charges (the "IC" in IC-DISC) are tied to Treasury bill rates, which, in recent years, have been only a fraction of 1 percent.
An IC-DISC’s tax benefits aren’t retroactive; these benefits are available only for export sales made after the IC-DISC is established. The sooner you act, the greater your tax savings.