Companies have doubled their after tax income by using it, Forbes magazine estimate 6,000 companies use it, the Journal of Accountancy estimates 12,000 more companies are overpaying $1 billion in taxes by not using it, few companies appreciate its widespread availability, congress promised to reduce America’s trade imbalance with its creation in creation in 1984 and 2003, and nobody is sure why it is poorly named the Interest Charge International Sales Corporation (IC-DISC)!
What is an IC-DISC?
Simply put, An IC-DISC (Interest Charge International Sales Corporation) is an affiliate corporation established and used to obtain a tax incentive for manufacturers, producers, re-sellers, and exporters of goods produced in the United States with an ultimate destination outside the United States. What counts as a manufactured good is also broader than many people realize – it can include software, films and many agricultural products.
Who can use the IC-DISC?
Any partnership, LLC, or corporation with products or services directly or indirectly exported should evaluate using an IC-DISC. Traditionally, the IC-DISC was for a tax incentive for small and medium manufacturers involved in exporting. The application has been expanded and there are typically three main businesses who will use and benefit from the IC-DISC: 1) A company that directly exports goods it manufactures. Example: Company X manufactures widgets in Ohio and ships to China. 2) A company providing architectural or engineering services that are conducted in the U.S. for a structures built outside of the United States. Example: An architectural firm based in Los Angeles designs a building that is built in Canada. 3) A company manufactures a good that is included in a product that is exported. This is probably the largest missed opportunity for businesses when it comes to the IC-DISC. IC-DISC tax incentives are also available in a situation where a company makes a component part that is included in a good that is exported. Example: Company Y makes tires that are included in a tractor that is shipped to South Africa.
The assets to use in the export calculation include export property itself, and assets used primarily in connection with the sale, lease, rental, storage, handling, transportation, packaging, assembly, or servicing of export property. Additionally, the value of accounts and interests which are owned by and promote the interest of the DISC should be included.
How does the IC-DISC work mechanically?
The most common form of the IC-DISC, as mentioned above, is the commission IC-DISC, whereby the actual exporter and the IC-DISC enter into a commission agreement. That is, the company pays the IC-DISC commissions for its supposed role as a sales agent such that the exporter company receives a tax deduction for paying the commission and the IC-DISC, which is not a taxable entity, pays dividends to its shareholders. To be clear, the commission IC-DISC generally does not have any employees, office, tangible assets, or any other indication to even the customers of its existence.
Be advised, if the IC-DISC retains the commission income instead of timely distributing it to the shareholders, the IC-DISC shareholders will pay a small interest charge based on T-Bill rates (2.4% in 2015) on the deferral of the tax payment.
The alternative IC-DISC structure allows the IC-DIUSC to actually take title to the goods and sell them outside the Unites States. This usually requires a sales force of employees and a more burdensome and tangible entity creation, which is why they are less frequent.
How Much Commission can be paid to the IC-DISC?
If the related taxpayer is in a tax loss situation for the year before paying the IC-DISC commission at year end, then the IC-DISC cannot be pay any commission because under Regs. Sec. 1.994-1(e)(1), IC-DISCs cannot cause a taxable loss for the related supplier in any year.
A taxpayer with taxable income, can use either of two primary methods to determine the maximum commission to be paid to the IC-DISC: (1) 4% of the qualified export receipts, or (2) 50% of the combined taxable income of the related supplier and IC-DISC from the sale of qualified export property (i.e. 50% of foreign taxable income). A taxpayer company may select either method of commission calculation most beneficial to it each year. The higher the commission to the IC-DISC, the more taxable income is converted from ordinary income to qualified dividend income. Sec. 994(a)
What is the tax advantage?:
By properly setting up an IC-DISC , and properly filing the related forms, if the second method is selected, 50% of the exports of a businesses can be given a preferential rate, that is, the dividend tax rate of about 15%, rather than the corporate tax rate of about 35%. In other words, the exporter corporation could receive a deduction of 35% on commission payments made to the IC-DISC, and on the other hand, only pay a 15% tax rate on the income eliminated from the IC-DISC.
The bottom line – a permanent tax savings for U.S. exporters and their shareholders of 10% or more: 50% of exports using a corporate rate of 35% could be reduced to 15%, of net export income. This number gets higher when applied to higher tax brackets.
How to File as an IC-DISC?
The company must create a separate entity (or sometimes several entities to maximize the tax benefits) – the “Corporation” part of IC-DISC. The exporter generally pays commissions to the IC-DISC. The commissions are deductible to the exporter, and the deemed or actual dividend payment of the commission income in the IC-DISC is taxed to the exporter’s shareholders/partners at the 15% rate (as opposed to being taxed as ordinary income – ex. 35% rate).
An IC-DISC must make the election using form 4876-A to be treated as such within 90 days of the beginning of the year for a new corporation. For existing corporations, the filing must be made within 90 days of before the election is to be effective. Additionally, all shareholders must consent to the election.
The rules require the IC-DISC to maintain at least $2,500 in capital and keep its own books and records. It must file an annual tax return form 1120-IC-DISC using the same tax years as the principle shareholder.
Assume Exporter Company (EC) has export gross receipts of $1,000,000 and the cost of those operations was $900,000, leaving a net income of $100,000. The owner of this company could be exposed to the top marginal tax rate of 39.6% and the top medicare rate of .9% for a total tax of $40,500.
Let’s say Exporter Company earns the same amount, but pays the maximum 50% commission of $50,000 to the IC-DISC. Even though $50,000 will be subject to the 40.5% (top rate of 38.6% and Medicare tax of .9%), the remaining $50,000 would only be subject to the 20% dividend rate and possibly the 3.8% NII tax, for a total tax liability of $32,150. This $8,350 savings is a 20.6% difference in tax burden which becomes more valuable as the exporting company grows.
U.S. companies engaged in exporting can become IC-DISCS if they meet the gross receipts test and qualified export asset tests. IC-DISCS are tax-exempt entities and can pay dividends to their shareholders, who then are taxed at preferential dividends rates. If you have a business that is involved in exporting goods or services, or provide goods and services to someone who does export abroad, come by our offices to discuss how you can take a slice of this $1 billion pie waiting to be eaten by business owners.