United States exporters continue to benefit from powerful tax savings through the use of Interest Charge Domestic International Sales Corporations (IC-DISCs). By establishing an IC-DISC, the owners of a US operating company can save tax at the rate of up to 20% on commissions paid to the IC-DISC on qualifying foreign sales. Because Congress extended the preferential capital gains rates to qualifying dividends for another two years, the IC-DISC continues to be a viable tax saving tool.
Here’s How it Works
A United States exporter can pay income tax on ordinary operating profit at a rate as high as 35%. Once an IC-DISC is established, the operating company can pay to the IC-DISC a commission on foreign sales, which is generally equal to 4% of qualified export gross receipts or 50% of taxable income, whichever is greater. The commission is taken as a deduction by the operating company which in turn saves income tax at its bracket rate. The IC-DISC does not pay tax on the income it receives. Rather, the IC-DISC distributes some or all of its profit to its shareholders as qualified dividends taxed to the shareholders at the preferential capital gains rate (as high as 15%). Therefore, by establishing an IC-DISC, the owners of a US exporter may convert income which would normally be taxed at rates as high as 35% into qualified dividends taxed at rates as high as 15% (thus the 20% savings mentioned above). It is important to note that only individuals, including shareholders of pass-through entities such as S corporations and limited liability companies, are entitled to the preferential capital gains rate on qualified dividend income.
The IC-DISC is not required to currently distribute all of its profit. For any amount not distributed, the shareholders will incur a small interest charge on the deferred income tax amount. The IC-DISC tax regime gives U.S. exporters the ability to defer up to $10,000,000 of income per year almost entirely tax-free. Because there are some costs involved in creating and maintaining an IC-DISC, history shows that in order to benefit from the creation of an IC-DISC, the operating company must generally have foreign sales of at least $500,000. And because foreign sales cannot be counted until the IC-DISC is actually established, the sooner one establishes the IC-DISC the better.
Establishing and Operating the Entity
To receive the tax savings of an IC-DISC, it is first necessary to establish the entity. Tax benefits will only be applicable to income transferred to the IC-DISC after the entity is created. The IC-DISC is a domestic corporation that may be established in any state in the United States for which a valid IC-DISC election can be made on Form 4876-A. All shareholders of the IC-DISC must sign form 4876-A. Particular attention needs to be paid to the proper incorporation state, as some states offer additional tax savings over others.
To qualify as an IC-DISC for a taxable year, the IC-DISC must have, on every day of the year, at least $2,500 of capital and only one class of stock. We recommend starting the company with $3,000 so as not to run afoul of this rule.
95% of the gross receipts must be qualified export receipts. This criterion must be satisfied on an annual basis. In addition, 95% of the entity’s assets must be qualified export assets. This test must be satisfied on the last day of the entity’s tax year. Qualified export assets include:
- Customer accounts receivable
- Commissions receivable (if paid within 60 days of year end)
- Stock and securities in related foreign export corporations
- Producer’s loans
- Certain financial assets (PEFCO paper)
- Cash not in excess of excess of working capital needs of the IC-DISC
The entity must not be a member of a controlled group of which a FSC (Foreign Sales Company) is also a member. The entity must also not be an ineligible corporation. Examples include Personal Holding Company, a Financial Institution, and an Insurance Company operating under Subchapter L, Regulated Investment Company, Electing Small Business Corporation and China Trade Act Corporation among others.
Taxpayers should enlist the assistance of Hill, Barth & King LLC’s experienced tax practitioners to ensure that qualification requirements are met and maximum tax savings potential is achieved.
If you have any questions about the content above, please contact the HBK team member with whom you regularly work.
Joe Ledford is a Principal at Hill, Barth & King and leads the firm’s Manufacturing Group. Joe has over 23 years experience serving clients in the manufacturing industry.