A Potentially Underutilized Tax Incentive – the IC DISC
Many closely-held businesses that export goods or services overseas are eligible for a permanent tax incentive, called the Interest Charged Domestic International Sales Corporation (IC-DISC). This incentive was established many years ago and has survived several repeals of other export tax incentives over the years. It remains a powerful tax savings technique, even after the tax rate changes that went into effect in 2013. Yet, IC-DISCs are underutilized, perhaps because many businesses are not aware that they qualify, or are not aware of the significant taxes an IC-DISC structure could save.
Who Is Eligible?
Closely-held companies that may be eligible for the IC-DISC tax incentive include, but are not limited to, the following categories of businesses:
- Companies that directly export goods they manufacture;
- Companies that provide architectural or engineering services conducted in the United States for structures built outside the United States; and
- Companies that manufacture goods that are destined for use overseas, in other words, components of another product that is then exported.
How Does It Work?
The IC-DISC works by exploiting the disparate tax rates between ordinary business income and qualified dividend income. The IC-DISC structure essentially converts ordinary business income, taxed at a 39.6% maximum rate, to qualified dividend income, taxed at a combined 23.8% maximum rate.
To set up an IC-DISC, a separate entity from the main manufacturer/exporter must be established (the DISC), with separate books and records, a separate bank account, and separate tax reporting requirements. Also, a formal election must be filed to be treated as an IC-DISC. Proper record-keeping at all stages in the process is important.
In the simplest arrangement, the exporter pays a commission to the DISC for sales of the product overseas. The commission is a deductible business expense to the exporter when paid or accrued, which saves tax of 39.6% (the maximum ordinary income tax rate assuming the exporter is a flow-through entity and the income is taxed to the owners). The DISC is a tax exempt corporate entity and the commission paid to the DISC is treated as an actual or deemed dividend to the owners of the DISC. The dividend is taxed to the owners according to their ownership percentages, at 23.8% (the maximum qualified dividend tax rate of 20% plus 3.8% Medicare tax on investment income). Thus, the structure saves overall tax of 15.8% on the commission paid (39.6% – 23.8%).
Generally, the amount of commission is determined using either 50% of net combined taxable export income or 4% of foreign trading gross receipts, whichever is greater.
What Are The Potential Tax Savings?
As an example, assume that a company has foreign trading gross receipts of $10,000,000 and net export income of $1,000,000. The chart below shows that tax paid without an IC-DISC ($396,000) less tax paid with an IC-DISC ($198,000 + $119,000) produces a difference in tax of $79,000, which can be saved simply by using an IC-DISC to handle foreign sales.
|No IC-DISC||IC-DISC Commission Deduction||IC-DISC Commission Income|
|Foreign Trading Gross Receipts||$10,000,000||$10,000,0000|
|Costs of Goods Sold||($6,000,000)||($6,000,000)|
|Export Net Income||$1,000,000||$1,000,000|
|IC-DISC Commission (50% net export income)||($500,000)||$500,000|
As you can see, utilizing the IC-DISC technique when possible can lead to significant tax savings. In addition to tax savings, IC-DISCs can be used to provide internal pay incentives for employees, company founders, previous owners, or other stakeholders, by shifting income and cash to them from the company. If you are interested in learning more, we have written about some of these possible other objectives and given a more detailed description of IC-DISCs in a previous newsletter article. Please contact Stuart Lyons or your BNN advisor for more information on how an IC-DISC may provide permanent tax savings for your export business.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.