A powerful tax savings opportunity for export companies
IC-DISCs (interest-charge domestic international sales corporations) were once thought of as uninspiring, and not particularly efficient, tax deferral vehicles. They were originally created by the government as a way to assist US-based corporations that focused on foreign sales and exports. Nothing more.
In fact, regulators at the time even conceded that IC-DISCs were not really tax shelters at all. Nor were they considered as listed or reportable transactions. As a result, IC-DISCs were largely marginalized as a tax savings tool; overlooked at best and, if noticed at all, regarded as ineffective and not worth the attention of serious investors.
But times have changed. IC-DISCs are back (they were never really gone), and are now regarded as effective tax-savings tool for companies exporting products. As an added bonus, companies can take advantage of IC-DISC tax benefits without having to make any changes to the way they conduct business.
So why the resurgence of interest in IC-DISCs?
Two things mainly: First, the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003 ― and its extension via the American Taxpayer Relief Act of 2012― which introduced reduced tax rates for exporters possessing qualified dividends.
Second, the impact of the ever-growing global economy, which in combination with these legislative initiatives, transformed IC-DISCs into tax saving instruments that actually did what they were originally intended to do: encourage US businesses to expand into more promising international markets.
IC-DISCs ― the smart choice for US exporters
For qualified US exporters IC-DISCs offer federal income tax savings of nearly 16 percent. What’s more, some of those savings can be further parlayed via deferment structures that have been at the core of the IC-DISC rules since they were first enacted by Congress in 1971.
As they currently stand, some of the many advantages and benefits of IC-DISC include:
In retrospect it would seem that IC-DISCs have greater resilience than many other export-related tax schemes. In fact, when the first DISC policy was introduced it immediately brought condemnation from a variety of European countries; they alleged that it was a proscribed export subsidy and therefore contravened the General Agreement on Tariffs and Trade (GATT).
However, in 1985, the DISC legislation was amended to add an interest charge on shareholders for taxes deferred under the original DISC provisions. The result was that Congress enacted a new export tax incentive — the Foreign Sales Corporation ― which has yet to be contested.
How IC-DISCs are structured
A conventional arrangement of an IC-DISC requires a variety of internal calculations and a certain degree of support, but these have no effect whatsoever on the ways in which the exporting company interacts, or otherwise manages its relations with clients or vendors.
From a management point of view the actual creation requires very little in the way of governance arrangements. All it entails is the establishment of an on-shore corporation, legal agreements that formalize the relationship of the IC-DISC to the exporter, and submission to the IRS of the organization’s tax election and all of its yearly tax returns.
Not only is an IC-DISC easy to set up, but it is not required to produce customer invoices, employ any staff, or even lease office space. Not only that, IC-DISC arrangements are undetectable to all but the principals of a company, and yet can legally save that company substantial amounts of money.
Finally, there are no restrictions on who can own an IC-DISC. In fact, IC-DISC shareholders can be partnerships, limited liability companies, individuals C corporations, S corporations, trusts, or any permutation of the former. An added plus is that foreign individuals and non-US companies can be IC-DISC shareholders, although the taxation of IC-DISC dividends paid to foreign owners is subject to different rules than those that apply to US citizens and business entities.
How IC-DISCs function
Again the operations of IC-DISCs are relatively straightforward. First an exporting company ― or its shareholders ― create a domestic corporation that will ultimately become the IC-DISC.
Once it’s operating the exporting company pays the IC-DISC a commission based on the profits of the export sales. (It’s worth noting here that size of the commission is governed by precise legal regulations). The exporting company is then free to deduct the commissions payable to the IC-DISC from its regular income, which is then taxed at the maximum federal rate of 39.6 percent.
However, not all the types of export sales are eligible for inclusion in a DISC arrangement.
In order to qualify exports must be:
The eligibility requirements of a DISC are actually more extensive than is commonly assumed and can include direct and indirect exporters, software licensing companies, even architectural and engineering design companies. In fact, many of these sorts of companies are simply not aware that they are eligible for DISC status ― and unable to take advantage of the many tax advantages they offer.
In some instances an IC-DISC can even be used as a tool for estate planning or as an incentive to employees.
However, because IC-DISCs constitute a special class of tax-exempt organization it doesn’t pay any federal income tax on the commissions it accepts from the exporting company, and, individual shareholders or trusts only pay federal income tax on dividends at a maximum rate of 23.8 percent (15-20% capital gains rate + 3.8% Medicare tax).
Note: For more details please consult the tables featured at the end of this article.
Is an IC-DISC right for your business?
Depending on your business objectives, IC-DISCs can be utilized in a variety of different ways to help you realize those goals.
Deployed correctly, an IC-DISC can:
Produce ongoing tax savings
Generally speaking an exporting company will pay taxes of 39.6 percent on its ordinary income ― but not on the commission it pays to the IC-DISC. Current tax regulations have the commission rate at the greater of either 4 percent of gross receipts (which is restricted to 100 percent of net income from the export sale), or 50 percent of taxable income from export sales.
And, since IC-DISCs are tax-exempt, only distributions to shareholders are actually taxed ― at a maximum rate of 23.8 percent (federal).
Provide C corporations with tax-deductible dividends
C corporations can also benefit from IC-DISC arrangements since they are eligible for long-term tax savings for disbursements that might otherwise be categorized as dividends. Plus, if a C Corporation can generate adequate profits from its exports, a sister IC-DISC can earn a commission equal to the payments otherwise set aside as dividends.
This means that what would normally be regarded as a nondeductible dividend payment can be turned into to a commission expense, which is tax-deductible. Also keep in mind that shareholders who receive dividend payments are taxed at the same rate, regardless of whether the disbursement is issued by an IC-DISC or a C corporation.
Make capital costs lower
One little-known advantage to an IC-DISC arrangement is that an exporting company can leverage its capital costs by using it as a deferral tool. The fact is that all of an IC-DISC’s earnings do not necessarily have to be dispersed to shareholders only; they can be transferred to the company via the savings generated by the lower tax rate that is applied to qualified dividends.
The method used is simplicity itself: An exporting firm is entitled to lend its accumulated IC-DISC earnings back to itself, for which it receives a note and interest in the form of a producer’s loan. The company can then deduct the interest expense. Again, permissible because interest income is regarded as a dividend to the IC-DISC shareholders.
So, by ploughing its IC-DISC earnings back into the business the company secures additional tax savings and effectively lowers its capital costs. However, a company taking this route would be wise to consult their accountants and legal counsel first, since there are restrictions governing the size of a producer’s loan and the uses to which it can be put.
If the company ― or an individual shareholder ― wants to adjust or realign the degree of investment risk they are willing to tolerate, they can leverage their IC-DISC holdings to secure added liquidity. Cash obtained in this tax-advantaged way allows either the company or the shareholder to relocate their resources to better manage their investment risk profiles.
An added tax savings bonus
Finally, there is actually no bar to a company that wants to operate an IC-DISC and also claim the DPAD (Domestic Production Activities Deduction), which can potentially reduce a company’s effective federal tax rate (by up to three percent ) by claiming certain US-based production endeavors (under Section 199 of the Internal Revenue Code).
A final point
Before embarking on the creation of an IC-DISC it would be best to call in knowledgeable third-party advisors ― accountants experienced in the area and legal counsel with a proven track record in IC-DISC formation ― to help oversee the process. It is vital that you get this right ― from the very beginning. Ask the experts.
About the Author
Curtis Best, CPA, is a Partner in the Tax Group at Marks Paneth. He is an international tax specialist with more than 20 years of public accounting experience who has served as a partner and tax manager in global professional services firms. Mr. Best specializes in global tax structures and optimization. Before joining Marks Paneth, Mr. Best was a partner in international tax and leader of his previous firm’s US Base Erosion and Profit Sharing (BEPS) team. His clients have included multinational companies, closely-held corporations with up to $1 billion in annual revenues, other middle-market business entities and related individuals.
Marks Paneth LLP has been ranked among the top three providers of forensic accounting services in the New York metropolitan area by readers of the New York Law Journal (NYLJ). Marks Paneth is the only firm to be voted among the top three in this category for all six years since the NYLJ’s 2010 inaugural survey.
2016 Tax Deadline Calendar
We've developed a useful summary of various tax deadlines occurring in calendar year 2016. Please review and let us know if you have any questions or, if you have missed a deadline, whether you would like to discuss late filing procedures and options.