IC-DISC Offers Permanent Tax Rate Savings for Closely Held Export Companies
This article was originally published in January 2013 and is updated as of December 2016.
Many businesses that are organized as LLCs and S Corporations, pass through the taxation of their income to its owners. The top federal tax rate for businesses that pass through its income to the owners of such businesses are subject to the highest tax rate of 39.6% and the top dividend tax rate from 15% to 20%. Also since 2013, the 3.8% Unearned Income Medicare Contribution Tax, which was created in 2010 to help fund the significant healthcare rules created by that year’s Patient Protection and Affordable Care Act, are applicable to taxpayers who have incomes over certain levels ($250,000 for taxpayers filing a joint return). But in the end, Congress did keep the top dividend tax rate lower than the ordinary tax rate even for the U.S. taxpayers who are considered America’s wealthiest taxpayers (income of $400,000 for single filers, $450,000 for married filers and $425,000 for head of households). For those who exceed those thresholds, dividends will be taxed at no more than 20%. For others, the rate does not exceed 15%.
As a result of this differential in the top U.S. ordinary tax rates and the dividend tax rates, closely held business owners can realize permanent tax rate savings for their business operations related to export sales by organizing what is known as an Interest Charged Domestic International Sales Corporation (IC-DISC). This structure basically converts ordinary business income taxed at the top rate of 39.6% to dividend income taxed at top rate of 23.8%. Thus a permanent tax rate savings of 15.8% can be realized in many situations.
Domestic international sales corporation
An IC-DISC exists as a separate entity apart from the parent company, and it is not required to have the same shareholders as the parent company. Export sales from the parent company flow through the IC-DISC, and the IC-DISC receives a commission based on either 4% of gross receipts or 50% of net foreign sales income.
While tax can be deferred on commissions of up to $10 million per year in export sales conducted by the IC-DISC, many closely held businesses pay out the earnings of the IC-DISC and obtain the more favorable dividend tax rate.
The IC-DISC, then known as the domestic international sales corporation (DISC), was created by Congress in 1971 to help U.S. businesses combat a growing U.S. trade deficit. The DISC was eliminated in 1984 and restructured by Congress as the IC-DISC. The IC-DISC’s income is treated as if it were distributed to its shareholders, and shareholders pay interest on any deferred tax liability from this pass through income (hence, the “interest charge” nomenclature) (Sec. 995(f)). The IC-DISC today is the lone export tax incentive available to U.S. companies.
Operating company tax benefits
A company that establishes an IC-DISC reduces the amount of ordinary income subject to a 39.6% top tax rate.
Example: A Co.has $20 million in annual foreign sales and $5,000,000 in annual taxable income attributable to those export sales. If A Co., its shareholders, or executives form an IC-DISC, the commissions owed to the IC-DISC by the company can then be deducted. The amount of the deductible commissions is the greater of the amount calculated using the gross receipts method, or the combined taxable income (CTI) method.
Based on the gross receipts method, a 4% commission ($800,000) on annual foreign sales would be paid to the IC-DISC. Assuming the shareholders’ (in the case of a passthrough entity) ordinary income is taxed at the maximum 39.6% tax rate, the commission payment would reduce the amount of tax owed by the shareholders by $316,800. The commission paid to the IC-DISC would then be distributed to its shareholders as dividends. Assuming those shareholders are individuals, a 23.8% tax (the current top rate for dividends including the new Medicare tax of 3.8%) would be paid by the IC-DISC shareholders (or $190,400 of tax on an $800,000 distribution), thereby saving $126,400 in tax ([39.6% – 23.8%] × $800,000).
If the company decided to use the CTI method to calculate commissions, the IC-DISC would be paid a commission equal to 50% of the combined taxable income amount, which takes into account applicable expenses. That payment could result in a $395,000 tax savings to the company and its shareholders ([39.6% – 23.8%] × [50% × $5,000,000 of CTI]).
While reducing the amount of income subject to the 39.6% ordinary income tax rate, an IC-DISC also enables a company to channel the commissions in various ways to reward certain individuals. Where the IC-DISC is formed by individuals who are either shareholders of the company, relatives of the shareholders, or executives, the IC-DISC can be a powerful tax planning tool.
Other possible objectives served by IC-DISC commissions
Because an IC-DISC is not required to have the same shareholders as the company, the company owners can determine who will be beneficiaries of the commission payments. Those beneficiaries would be subject to a 23.8% top dividend income tax rate on the distributions received from the IC-DISC.
In some instances, IC-DISC shareholders may be employees of the company. In those scenarios, the IC-DISC commissions could function as a substitute for other components of the employee’s compensation package, such as annual bonuses or commissions paid on export sales. If the DISC shareholders are employees of the parent company, those employees might qualify for a tax rate of only 15%, depending on their levels of income. Thus, this structure could be used to convert employee bonuses from ordinary income to lower taxed dividend income.
IC-DISC shareholders can also be company founders, previous owners, or other stakeholders that no longer have active company roles. In those cases, the IC-DISC payments could be regarded as part of retirement, succession, or deferred payment plans.
While an IC-DISC offers those benefits, there are export sales standards that must be met, as well as requirements for establishing and sustaining the IC-DISC.
Requirements for qualified export sales
For a company to conduct sales through an IC-DISC, the goods being sold must be manufactured, produced, grown, or extracted (MPGE) within the United States.
That requirement accommodates “substantial transformations” of various items. Fish caught in international waters that are processed and canned within the United States qualify as MPGE goods. Transforming wood pulp from another country into paper would likewise meet the MPGE standard. Goods provided by distributors, professional services firms, software developers, or other entities may also qualify.
A content requirement specifies that no more than 50% of the fair market value of the goods being sold can be attributable to foreign materials. This provision may bar a company from qualifying for IC-DISC benefits if it mostly performs simple assemblies of parts produced in other countries and then exports the assembled goods.
A foreign destination test is also used to determine sales eligible for IC-DISC commissions. To meet that destination requirement, goods must be sold or leased for direct use, consumption, or disposition outside the United States. A company can still qualify for IC-DISC commissions if goods are sold to a freight forwarder or distributor or manufacturer in the United States. Those goods, though, must then be resold to a foreign customer within one year.
The commission requirements also include a safe-harbor provision that applies when conversion costs (direct labor and factory burden, including packaging or assembly) account for 20% of the cost of goods sold or inventory costs.
IC-DISC entity requirements
In addition to having at least $2,500 in capitalization, an IC-DISC must be a U.S. entity, and it must have made a timely election to be treated as an IC-DISC. At least 95% of gross receipts must be qualified export receipts, and at least 95% of total assets must be qualified export assets on the close of each tax year.
Remaining in compliance with those provisions requires maintaining accurate documentation to support the validity of commission-based sales.
Final considerations for creating an IC-DISC
Forming an IC-DISC requires careful evaluation of a company’s products and sales, comparisons of various commission methodologies, and detailed documentation of sales and commission activities. The considerable potential tax incentives and the ability to pass through income to individuals, though, make it worthwhile for a company that exports goods to consider whether it can benefit from establishing and sustaining an IC-DISC.
If you would like to discuss further, please call Stuart Lyons at 1.800.244.7444.
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.