Did you know there is an underutilized tax incentive that can reap federal tax savings for manufacturers?
One middle-market manufacturer recently saved approximately $300,000 in current year federal taxes by implementing this tax incentive, which promotes exporting goods manufactured in the United States that have an ultimate destination outside of the U. S. The federal tax savings will continue to increase as this client expands its export operations. The tax saving strategy was executed by forming an interest charge-domestic international sales corporation (“IC-DISC”).
To determine if an IC-DISC might be beneficial for your client, all of the following should apply:
- Does the company sell or lease export property or provide services that are related to any exchange of property outside the United States?
- Is the company generating taxable profits?
- Is the company closely held?
An IC-DISC is typically formed as a wholly-owned U. S. corporate subsidiary of a domestic exporting company. The IC-DISC serves as the exporting company’s foreign sales agent (not to be confused with a Foreign Sales Corporation, which was discontinued in 2000).
After the IC-DISC is incorporated, it must file an election with the Internal Revenue Service to be treated as an IC-DISC, which is not subject to federal income tax and certain state income taxes. The election must be made within 90 days of incorporation and is made on Form 4876-A, Election To Be Treated as an Interest Charge DISC. All of the corporation’s shareholders must consent to this election.
Qualifying as an IC-DISC
To qualify as an IC-DISC, a corporation must maintain the following requirements:
- Be incorporated in one of the 50 states or District of Columbia
- File an election with the IRS to be treated as an IC-DISC for federal tax purposes
- Maintain a minimum capitalization of $2,500
- Have a single class of stock
- Meet a qualified exports receipts test and a qualified export assets test.
To expand on the last requirement, at least 95 percent of an IC-DISC’s gross receipts and assets must be related to the export of property whose value is at least 50 percent attributable to U.S. produced content.
The newly formed IC-DISC enters into a commission agreement with the seller of export goods. By virtue of the C corporation meeting all of the IC-DISC qualifications, it is presumed to have participated in the export sales activity, and due to that participation, is entitled to earn a commission.
The related exporter is allowed to pay a tax-deductible commission to the IC-DISC, which is the greater of 4 percent of the company’s gross receipts from qualified exports, or 50 percent of the company’s net income from qualified exports. The IC-DISC commission is a current deduction to the U.S. exporter at ordinary income rates (currently a maximum of 39.6 percent).
The IC-DISC, as a tax-exempt entity, pays no federal tax on the commission income. When the IC-DISC distributes its income to its shareholders, it becomes qualified dividend income taxed at the qualified dividend rate of 23.8 percent when including the new 3.8 percent tax on net investment income.
If the company is a pass-through entity, such as a partnership, S corporation, or LLC, you can form an IC-DISC as a subsidiary. Dividends the IC-DISC distributes will retain their character and be passed through to individual shareholders and qualify for the 23.8 percent qualified dividends rate (20 percent qualified dividends rate plus 3.8 percent tax on net investment income).
If your company is a C corporation however, you will need to have the corporation’s individual shareholders form the IC-DISC as a sister corporation to obtain the lower tax rate on dividends.
Tax Benefits for Shareholders
Assume an S corporation has $20 million in qualifying export sales and $5 million in net export income on those sales. If the company has an IC-DISC subsidiary, it can pay a deductible commission to the IC-DISC equal to the greater of 50 percent of its export net income ($2.5 million) or 4 percent of its export gross receipts ($800,000). In this case, the maximum commission is 50 percent of net income or $2.5 million.
The IC-DISC distributes the full $2.5 million of commission income as a dividend to its S corporation shareholder. The S corporation receives a $2.5 million dividend, which retains its character and passes through to the S corporation’s individual shareholders. The S corporation shareholders pay 23.8 percent federal income tax on the IC-DISC qualified dividend income. If the commission had not been paid, the S corporation individual shareholders would have additional ordinary income passed through to them taxable at a maximum 39.6 percent federal tax rate.
Federal Tax Savings:
Tax on $2.5 Million at 39.6% rate $990,000
Tax on $2.5 Million at 23.8% rate $595,000
Federal income tax benefit to shareholders $395,000
Taxpayers can also use IC-DISCs to defer the recognition of income related to foreign sales, however the discussion above focused primarily on using an IC-DISC to convert ordinary income into qualified dividend income, reducing the income tax liability of a corporation’s shareholders.
We’ve got your back
It is important for practitioners and advisers to be aware of tax incentives available to their manufacturing and export clients that are producing goods in the United States and shipping them overseas. For help establishing an IC-DISC, contact me at [email protected] or 908.655.7411.
References Trea. Reg. 1.992-2(b).  IRC Sec. 992(a)(1) and Treas. Reg. 1.992-1.  IRC Sec. 994.