The IC-DISC: How Your Foreign Sales Can Save You Tax

If your business exports goods that are made or grown in the United States or performs services in the U.S. for foreign construction projects, there are special tax incentives available that allow you to defer or reduce your income tax. This is accomplished through a little known yet tried-and-true entity called the “interest-charge domestic international sales corporation,” or IC-DISC for short (pronounced: eye-see-disk).

I’ve included the gory details below. But, in short, with an IC-DISC, exporters of American made goods, including some intangible goods such as films and professional services, can significantly reduce their taxable income without changing the way they do business.

This benefit is available to all exporters, whether they manufactured the goods or not. It also includes those who sell goods to other businesses in the United States which then subsequently export the product. Therefore, many businesses that think they’re not exporting are actually indirectly doing so and may qualify for the benefits of an IC-DISC.

In general, a business with an IC-DISC can defer 50% or more of its net taxable income from selling the exported product. If the taxable income is not deferred, the income is instead taxed at the qualified dividend rate, thereby saving money from converting ordinary income, which is taxed at higher marginal rates, to qualified dividend income, which is taxed at lower rate capital gains rates.

The Details
An IC-DISC is a separately formed corporation that receives a commission on your foreign sales even though it may have had no direct role in those sales. Because IC-DISCs are exempt from federal taxation, they pay no tax on the commission income. Nevertheless, a tax deduction is allowed for your business on the commission paid to the IC-DISC.

The commission income in the IC-DISC is not recognized until it pays a dividend of its retained earnings. When it does, we structure the ownership of the IC-DISC so that it pays a “qualified dividend.” The result is a deduction from your business’s higher-taxed ordinary rate income, with recognition of dividend income from the IC-DISC at the “qualified” lower capital gains rate, all together resulting in a tax savings differential of up to 20% of the commission sent through the IC-DISC. And, due to the “round trip” of cash, this strategy does not tie any of it up for any length of time.

Many of our new clients wonder why they had not heard of this before. Some think it is too good to be true or that it is a possibly illegal tax gimmick. The truth is that they probably haven’t heard of it due to the United States’ sordid history with export tax incentives and how events have quietly come together to create these tax benefits.

In the Beginning
In the early years of the income tax in the United States, large companies often set up offshore foreign subsidiaries in tax havens to be able to shift the profit on foreign sales out of the United States. This allowed companies to defer recognition of the profits until they repatriated them back to the United States, which in some cases never happened.

The Kennedy administration patched many of these loopholes with the so-called “CFC” rules. Nevertheless, large companies were still able to avail themselves of complex international tax planning techniques that allowed them to park income offshore.

In 1971, the domestic international sales corporation (DISC) was born out of Congress’ desire to allow smaller companies to also achieve some of the tax benefits that larger companies were achieving through sophisticated tax planning in an effort to level the playing field somewhat.

Almost immediately other countries objected to the DISC as an unfair export subsidy for U.S. manufacturers. After a long legal process, the DISC was repealed and the IC-DISC (a slightly tweaked variant of the DISC) was instituted in its place in 1984. In that same year, the foreign sales corporation (FSC) was introduced and was also eventually deemed to be an illegal export subsidy and repealed. Almost comically, the extra-territorial income exclusion (EIE) was created subsequent to the FSC and also repealed by objections from U.S. trading partners and organizations. Now, the sole remaining export tax incentive left to taxpayers is the IC-DISC.

Throughout the decades, tax practitioners learned and applied the intricacies of the law for each new export tax incentive only to have them repealed and phased out. Throughout the iterations of these various incentives, the IC-DISC still existed, but it did not produce a tax result that was as beneficial as the latest export tax incentive “du jour.” Once the EIE was repealed and phased out, the lowly IC-DISC was all but forgotten. Queue the qualified dividend…

The Qualified Dividend
Originally, the DISC was meant to offer a deferral of income to small and medium-sized businesses in an effort to mimic the way that larger companies could park profits offshore through foreign subsidiaries. However, the passage of the Jobs Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) breathed new life into the IC-DISC and changed the strategy for their use.

The JGTRRA allowed certain dividends, including those dividends paid from IC-DISCs, to be “qualified” and therefore taxed at the lower capital gains rates. As a result, deferral of IC-DISC income was no longer its biggest benefit. Instead, tax practitioners began to realize that income could be run through the IC-DISC and immediately distributed without the originally intended deferral benefit. This allowed a “rate play” between the ordinary income and capital gains rates, which sweetened the tax incentive pot, thereby achieving a significant and permanent tax savings on IC-DISC income.

During 2003, most taxpayers and their advisors were too busy utilizing the EIE through its last days in 2005 and 2006 to realize that there was a new sheriff in town: the IC-DISC pumped up with qualified dividend power. The latest rise of the IC-DISC has been slow and steady, seeing most of its use by clients of specialty international tax and consulting firms.

The Future of the IC-DISC
It was understood by tax practitioners that this latest golden era of the IC-DISC rested largely on the temporary capital gains rate treatment of qualified dividends. The law granting this “qualified” treatment to dividends was set to expire in 2010, only to get a last minute stay of execution in 2012. Finally, at the end of 2013, the American Taxpayer Relief Act of 2012 (passed by Congress in frenzied action on New Year’s Day 2013) made permanent the capital gains rate treatment of qualified dividends.

The DISC, and now the IC-DISC, was created by Congress to give taxpayers an incentive to export goods and services. Originally, this tax incentive was in the form of a deference of the recognition of profits for years, if not decades. While this particular incentive still exists, the most lucrative incentive of IC-DISCs nowadays is the rate arbitrage that can be achieved through the ordinary rate deduction coupled with qualified dividend income. This IC-DISC strategy is ensured for years to come due to the new law, which permanently enshrines the capital gains treatment for qualified dividends in the tax code.

Creation and Maintenance
There are various requirements to creating and maintaining an IC-DISC. For instance, it is important to note that a business cannot begin taking an IC-DISC commission deduction until the corporation that will become the IC-DISC is formed. After formation, an IC-DISC election must be prepared and filed within 90 days of formation. Nevertheless, IC-DISC benefits may accrue between incorporation and filing of the election.

Once the corporation has been formed and its status as an IC-DISC has been elected, it must be maintained as per the state corporate laws under which it has been created, which generally requires filing of annual reports and keeping corporate formalities. It must also maintain books and records that are “separable” (i.e., not necessarily separate, but can be made separate if needed).

To maintain the corporation’s tax status as an IC-DISC, it must have a certain ratio of “export assets” to total corporate assets at each of its year ends, and it must maintain a capitalization of at least $2,500 at all times. It must also prepare and file its own specialized tax return (i.e., a Form 1120-IC-DISC) on an annual basis.

Commission Calculation
The IC-DISC commission is calculated using the “50/50” method or the “4% of gross receipts” method. (It should be noted that another calculation method is available, but involves using a complex economic analysis, which is beyond the scope of most taxpayers.) To maximize the benefit, the calculation of the commission may be made on a transaction by transaction basis using a combination of these methods.

The IC-DISC commission calculation is limited to a consideration of net profits received from a maximum of $10 million of gross receipts. In other words, if your business netted 5% on its gross receipts, a maximum of $500,000 could be used for IC-DISC calculation purposes (i.e., 5% x $10,000,000 = $500,000). Fifty percent of this, or $250,000, could be used as an IC-DISC commission.

Commission Payment
The business’ payment of the commission to the IC-DISC and the subsequent dividend distribution from the IC-DISC to its shareholders can be accomplished in several ways. Many professionals advise that actual cash payments be made between the entities. While this is the safest method to ensure avoiding IRS scrutiny, it isn’t a necessity. We consider a client’s entity structure, commission calculation, and asset mix when deciding whether to “pass cash” to satisfy the commission and related dividend, or whether “accounting entries” will suffice.

State Tax Treatment
Each state’s tax system is different. Therefore, some states conform to the federal IC-DISC provisions and some do not. Unfortunately, California does not recognize the federal IC-DISC provisions. Therefore, there is no opportunity to defer or reduce California taxation using an IC-DISC, which makes the use of an IC-DISC federal only benefit.

The “Interest Charge” Feature
As previously mentioned, the “IC” in IC-DISC stands for “interest charge.” This comes from the fact that commission income that is retained in the IC-DISC will incur an interest expense if held within it for more than a year. This is the “penalty” for deferring the recognition of the earnings in the IC-DISC.

Very few of our clients incur this charge because most immediately opt to pay out the IC-DISC dividends to lock in the rate play between the ordinary deduction and qualified dividend income. Nevertheless, other clients wish to defer all income, which means they pay this interest charge on the undistributed balance. For calendar year end 2013, the interest rate is 1.400978%, which means that this charge is quite nominal and is well worth the cost for deferring the income for these clients.

Conclusion
From wine to high-tech measurement instruments, to computer hardware and software, to engineering and architectural services, we have found that many of our clients export goods and services to other countries. IC-DISCs have allowed us to achieve significant tax reductions for these clients. As a result, they have been able to be increasingly competitive with their products overseas and have expressed the desire to increase the export side of their businesses. This was exactly Congress’ intent all along when it created the IC-DISC for these businesses.

Here at BPW, we offer complete “turnkey” IC-DISC services, including overseeing formation of the corporation, preparation of the IC-DISC election, calculation of the IC-DISC commission, and the annual maintenance, accounting, and tax return compliance of the IC-DISC.

Each business’ result using an IC-DISC is different. To best evaluate how well an IC-DISC would work for your business, we encourage you to call or meet to discuss its potential. If you have any questions, please contact me at (805) 963-7811 or dclark@bpw.com.