The United States has continually offered encouragement and support to domestic companies to promote export sales of domestically produced goods. One of the tools it has utilized to accomplish this goal is the Interest Charge Domestic International Sales Corporation (“IC-DISC”).
Created in 1971, the original goal of the IC-DISC was a mere deferral of taxable income: A US exporter would set up a paper export company which it would pay a commission to and receive an income tax deduction. The paper export company could then decide when it wanted to return the funds to the original US exporter. When this occurred, a taxable dividend would be triggered. In 1984, Congress created an interest feature on the deferral of income giving the IC-DISC its current name.
According to the Internal Revenue Service (“IRS”), few IC-DISC returns were filed from 1984 to 2006, as other foreign-friendly tax strategies, such as the extra-territorial income exclusion (“ETI”), were more beneficial. In addition, there was no income tax rate difference between dividends and ordinary income. However, with the repeal of the ETI and the introduction of the preferential qualified dividend rate in 2006 for individuals, the IC-DISC became a powerful tool with the potential to yield substantial tax savings for companies operating as partnerships and S-Corporations.
As of today, for every dollar in commission expense allocated to the IC-DISC, the maximum tax savings could be as a high as 15.8 percent. This assumes a top ordinary income tax rate of 39.6 percent and a top preferential qualified dividend tax rate, including the net investment tax, of 23.8 percent.
Step 1: Determining Export Property
To determine if an IC-DISC is beneficial, the first step is to see if a company has enough “export property” to make the set-up of the IC-DISC entity worthwhile. Export property is defined as goods that:
- Are manufactured, produced, grown, or extracted in the United States.
- Are sold, leased, or rented for direct use outside of the United States.
- Have 50 percent or more of its value derived from items that were domestically produced in the US.
Step 2: Setting Up the Entity
If a company has sufficient export property ($1,000,000 is a good benchmark, but could vary among companies), the next step would be the set-up of the actual entity itself. The set-up is similar to a regular, operating domestic corporation: articles of incorporation are filed with a chosen state and the appropriate tax election is made with the IRS.
It is important to note the IC-DISC entity must be set-up and registered with the IRS before it may begin charging a commission and paying dividends. Any export sales made before this time are ineligible for the generous, preferential tax treatment the IC-DISC offers.
Step 3: Funding and Record Keeping
The next step is the initial funding and record keeping of the IC-DISC entity. The IC-DISC is required to maintain a single class of stock with a par value of at least $2,500, in addition to keeping its own books and records separate from the operating company. It is further recommended that the IC-DISC entity distance itself from the operating entity by establishing a separate bank account.
Step 4: Calculating the Allowing Commission
Once the initial analysis, set-up, and funding of the IC-DISC entity is complete, the next step is the calculation of the allowable commission. There are two primary methods allowable when calculating the IC-DISC commission:
- Four percent of qualified export receipts plus 10 percent of the export promotion expenses, and
- 50 percent of the foreign taxable income related to the qualified export plus 10 percent of the export promotion expense.
It is important to note both of these methods are limited to the total foreign taxable income of the transaction, and are only “safe harbors”; there are other, more detailed calculations that are permissible. It is highly recommended that a professional be involved with the calculation of the commission to ensure compliance and to maximize the commission and associated tax savings.
Step 5: Paying the Commission and Distributing the Dividend
After the allowable commission has been calculated, the final step is the payment of the commission and the distribution of the dividend. Fortunately, the IRS allows the payment of the commission up to 60 days after year-end. Even if the operating company pays the commission and the dividend is treated as being distributed simultaneously, the cash should be “cycled” through the IC-DISC entity’s bank account. This ensures a paper trail that is able to corroborate the funds, albeit briefly, switching possession. There is no specific requirement that the funds be distributed according to any particular time table, but as previously mentioned, interest must be charged by the operating entity to the IC-DISC entity on any undistributed commission payments.
The IC-DISC is a formidable tool for any company with significant export sales. It is highly recommended that companies, especially partnerships and S-Corporations, with at least a moderate amount of export sales, explore the generous, 15.8 percent tax savings the IC-DISC has the potential to offer. If you have any questions, please reach out.