An IC-DISC can provide a permanent 20% tax savings (or even more) for qualifying U.S. manufactures and exporters.
For U.S. exporters operating their business via a sole proprietorship or pass-through entity (e.g., limited liability company (LLC), S corporation, limited partnership (LP)), the IC-DISC benefit is essentially tied to the differential between the qualified dividend rates and the ordinary income tax rates. This differential was originally set to expire on December 31, 2010 but Congress extended it in late December of 2010 to December 31, 2012.
Many practitioners strongly believe that this differential will be extended past 2012 even if tax rates on ordinary income increase. In addition to benefiting sole proprietorships and pass-through entities, exporters operating their business via a C corporation can benefit by using the IC-DISC to eliminate double taxation on a majority of their export income, as well as to reduce the need to incur additional payroll taxes on income paid to their shareholders/officers. The IC-DISC is not a tax shelter.
To qualify as an IC-DISC, a domestic corporation must pass two main tests known as the qualified export receipts test and the qualified export assets test. The qualified export receipts test requires that 95% of the gross receipts of the IC-DISC constitute qualified export receipts. The qualified export assets test requires that 95% of the assets of the IC-DISC be qualified export assets. Qualified export assets include accounts receivable, temporary investments, export property, and loans to producers.
Because most of the qualified export receipts categories focus on export property, it is critical that the exporter substantiate that its exports satisfy the definition of export property. Three requirements must be met in order for the IC-DISC to receive income from an export sale. The export property must:
(1) Be manufactured, produced, grown, or extracted in the U.S. by a person other than the IC-DISC.
(2) Be held primarily for sale, lease, or rental for use, consumption, or disposition outside the United States
(3) Have a maximum of 50% foreign content.
Although exporters often think of newly produced property as export property, used equipment and even scrap also qualify.
In its most recent form, the IC-DISC can provide a permanent 20% tax savings (or even more) for qualifying U.S. exporters. In certain cases, it eliminates U.S. tax entirely on the majority of export income. In addition, distributions to individual shareholders are currently taxed at a maximum rate of 15% – providing a way to convert 35% ordinary income to 15% qualified dividend income. Of course, this assumes that the U.S. exporter generates operating profits and is creating taxable income in the U.S.
The IC-DISC is a “paper” entity used as a tax-savings vehicle. It does not require corporate substance or form, office space, employees, or tangible assets. It simply serves as a conduit for export tax savings. An important feature of the IC-DISC is that shareholders can be corporations, individuals, or a combination of these.
This is how an IC-DISC works:
- Owner-managed exporting company forms a special U.S. corporation that elects to be an IC-DISC. The election is made on IRS Form 4876-A, which must be filed within 90 days after the beginning of the tax year.
- Exporting company pays IC-DISC a commission.
- Exporting company deducts commission from ordinary income taxed at up to 35%.
- IC-DISC pays no tax on the commission as long as certain qualification standards are met such as the 95% qualified export assets and the 95% qualified export receipts requirements of Section 992(a)(1).
- Shareholders of an IC-DISC are not taxed until the earnings are distributed as dividends. However, the shareholders must pay annual interest on the tax deferred.
- Shareholders that are individuals pay income tax on qualified dividends at the capital gains rate of 15%. C Corporation shareholders are automatically considered to have received 1/17th of the IC-DISC’s taxable income even if no distributions are made.
- The result may be a 20% or more tax savings on commission.
Permanent Tax Savings on Global Sales
Permanent tax savings begin with the exporting company deducting the commission it pays to the IC-DISC from its ordinary income, which is taxed at up to 35%. Tax law sets the commission rate, which is based on export sales revenue, as the greater of either 50% of net export income or 4% of export sale revenue. Because the IC-DISC is tax exempt, tax is paid only on distributions to shareholders. Individual and pass-through company shareholders pay income tax on qualified dividends at the long-term capital gains rate of 15%.
Ability to Leverage Cost of Capital
An IC-DISC is more than a tax-savings vehicle. It can also be used as a deferral tool to leverage a company’s cost of capital. IC-DISC earnings need not be distributed to shareholders; they can instead be used to perpetuate and grow the deductible dividend tax rate savings. Tax rate savings are perpetuated by lending accumulated IC-DISC earnings back to the exporting company in return for a note and interest. The exporting company can deduct the interest expense, and interest income is considered a dividend to the IC-DISC shareholders. Reinvesting IC-DISC earnings back into the exporting business results in additional tax rate savings and diminishes the group’s cost of capital.
Opportunities to Create Management Incentives
Businesses can also use ownership in the IC-DISC to provide incentives. Exporting company management and other personnel can be named as shareholders, which allows them to benefit from additional cash flow created by increasing global sales.
Means to Facilitate Succession Planning
An IC-DISC offers a number of ways to execute a succession plan. Among these, ownership in the IC-DISC can be used as a means of generating cash, which can be distributed to shareholders in a tax-advantaged manner. IC-DISC shareholders participating in a buyout of current or previous shareholders can leverage these tax-advantaged IC-DISC earnings to pursue the buyout plan.
For U.S. exporters, the IC-DISC is the only remaining tax-saving opportunity. If you are unsure about whether or not an IC-DISC will work, ask the following questions:
- Do you have any transactions outside of the U.S.?
- Do you use overseas distribution?
- Does your product cross any borders?
- Are you generating operating income?
If the answer to any of these questions is yes, an IC-DISC could be a valuable tax-savings vehicle for your business.
On the surface, the rules covering the IC-DISC may seem simple. However, to maximize the tax benefit, a qualified IC-DISC advisor should be engaged. Many times an IC-DISC expert can double if not triple the tax benefit the IC-DISC provides by applying their in-depth understanding of how to structure the IC-DISC and using the complex advance pricing rules that the Internal Revenue Code allows for determining the tax benefit. A firm that has proven IC-DISC expertise, offers fixed fees, and optimizes the IC-DISC on a transactional basis (which almost always provides the best result) should be chosen.