In a world of multilateral trade pacts, there are few remaining benefits available for US exporters. The IC-DISC remains as the one, time-tested export tax strategy that offers tax savings for US exporters—even small to mid-market exporters. Because the IC-DISC is endorsed by the Internal Revenue Code and Treasury Regulations, using an IC-DISC should not draw the ire of the IRS the way more aggressive international tax strategies might.
What is an IC-DISC?
An IC-DISC (Interest-Charged Domestic International Sales Corporation) is a tax incentive for U.S. companies that export goods and certain services. It is a frequently overlooked move that a company can make to procure permanent tax benefits and improve cash flow. The benefit comes from the IC-DISC converting ordinary income from foreign sales that is taxed at a high rate, into qualified dividend income that is taxed at a much lower rate and paid directly to the shareholders. The IC-DISC can be set up in various ways depending on the related supplier and that related supplier pays the IC-DISC a tax-deductible commission based on estimated sales for the year. That commission is paid out to shareholders at a lower tax rate in the form of qualified dividends under Section 995(b)(1). Overall, companies that partake in this tax incentive can see anywhere from an 11-20% benefit.
Setting Up Your IC-DISC
To set up the IC-DISC under Regs. Section 1.992-2(a), an election to the IRS by filing Form 4876-A to be treated as an IC-DISC must be made by the IC-DISC within 90 days of the beginning of the tax year. This makes the IC-DISC exempt from federal taxes under Section 991.The IRS regulates how much commission the IC-DISC is allowed to earn, allowing the commission the IC-DISC earns to be calculated in either of two ways via Sec. 994(1):
- 4% of the qualified export receipts, or
- 50% of foreign taxable income
The related supplier may choose whichever method is more beneficial to it every year. Furthermore, a company has to meet certain requirements under Section 992(a)(1) and Regs. Section 14.992-1 which are as follows:
- 95%+ of the gross receipts the IC-DISC receives are qualified export receipts
- The adjusted basis of the qualified export assets meets or exceeds 95% of the total adjusted basis of all assets held by the IC-DISC
- The corporation must maintain only one class of stock
- The par value of the stock is at least $2,500 for each day of the tax year
- The corporation maintains separate books and records, and
- The election to be an IC-DISC is in effect for the tax year
The IC-DISC must meet these requirements every tax year that it wants to maintain its IC-DISC status and take advantage of the tax benefit.
This tax benefit is available to those entities that sell “export property” which is defined by Section 993(c) as:
- The export property must be manufactured, produced, grown, or extracted in the U.S.
- That export property is held for sale, lease, or rental for direct use outside the U.S.
- Less than 50% of the export property’s fair market value is attributable to foreign content
For companies that meet these requirements, there are multiple ways to structure an IC-DISC to best take advantage of the tax benefits. Because the focus of the definition is on source and ultimate use, the benefit can be extended to the exporter in the supply chain as well as the distributor.
Structuring the IC-DISC in a parent-subsidiary or brother-sister structure when the related supplier is a pass-through entity is going to produce a greater tax benefit. S corporations and partnerships are generally the companies that structure this way. The related supplier directly owns the IC-DISC and is able to pass the qualified dividend income directly to its shareholders. The pass-through entity will pay the IC-DISC a qualified dividend then they will receive the dividend back as cash. The real benefit is that once the related supplier has received the cash-back dividend, they can pass it directly to the shareholders instead of having to distribute the cash outside the company to realize a tax benefit. The dividends paid to the shareholders are taxed as qualified dividends at a rate of 23.8%. Ordinarily they would be taxed at the ordinary income tax rate of 39.6%. This move realizes a 15.8% overall benefit. In a company with a cash flow concern, this is going to be a relatively safe way to realize the greatest amount of benefit from an IC-DISC.
Companies set up as C corporations will generally structure by setting up the IC-DISC as a separate corporation. The related supplier pays a tax deductible commission based on exporting sales to the IC-DISC and these sales are distributed to shareholders as qualified dividends. The greatest amount of benefit here will be realized if the IC-DISC is set up in a brother-sister structure; shareholders of the related supplier directly own the IC-DISC stock. This is an effective way to get cash to the shareholders without corporate double tax.
Paying the Commission
The related supplier has to base their commission calculations on what taxable income for the year will be, which makes paying the commission before the tax year-end difficult. To remedy this, under Section 1.994-1(e)(3), a reasonable estimate of the commission may be paid within 60 of the close of the tax year. This estimation does not have to meet the actual amount precisely, however it has to meet or exceed it and the cash does have to flow during those 60 days or the IC-DISC will lose tax benefits because that receivable would not be classified as a qualified export asset.
Consider an IC-DISC
An IC-DISC is not just a tax strategy for Fortune 500 companies. The IC-DISC may make sense for middle market and even lower middle market exporters. IC-DISCS are relatively inexpensive to create an IC-DISC and the corporation doesn’t have to have any other form of income or offer any services. Because a company cannot retroactively apply this benefit and the benefits only start the day the IC-DISC is incorporated, the earlier an exporter explores this option and acts on it, the greater the benefit it will ultimately gain.