U.S. businesses whose goods are exported can significantly reduce their taxes through use of a long-standing U.S. tax incentive known as the "Interest Charge-Domestic International Sales Corporation" or "IC-DISC." This frequently overlooked export tax incentive has been in the U.S. tax code since the 1970s and can reduce the U.S. tax cost of exporting companies by more than 50 percent, says Douglas W. Wright, shareholder, International Tax and Transfer Pricing Services, BPM.
Smart Business spoke with Wright about how to take advantage of IC-DISC.
What products qualify for the IC-DISC tax incentive?
A company that manufactures, produces or grows products in the U.S. may qualify for IC-DISC benefits, provided that the products are destined for ultimate use or consumption outside the U.S. The primary requirements for the goods to qualify for IC-DISC benefits are that they must have been at least partly produced in the U.S. and consist of at least 50 percent U.S. content. This means that exported goods can qualify for IC-DISC even if they consist partly of imported components. You simply need to ensure that the customs duty value of the imported components is less than 50 percent of the ultimate sales price of the finished exported goods.
The U.S. company producing the goods does not need to be the actual exporter of the goods to qualify for IC-DISC benefits. In other words, a U.S. producer can sell its goods to a distributor or OEM in the U.S. that is the actual exporter and the U.S. producer can still qualify for IC-DISC benefits. Moreover, a company that exports U.S.-produced goods can qualify for IC-DISC benefits on its export sales even if it is merely a distributor and not the actual manufacturer of the goods.
Can services companies qualify for the IC-DISC tax incentive?
Companies providing architectural or engineering services related to non-U.S. construction projects can also qualify for IC-DISC benefits. These architectural and engineering services provisions are frequently overlooked, but are very broadly defined so that many companies and firms providing such services are likely to qualify. For this purpose, the qualifying services can be provided either within or outside the U.S., so long as they are provided with respect to a planned or existing construction project outside the U.S.
If a company qualifies, how does it establish an IC-DISC?
To take advantage of the IC-DISC provisions you must establish a separate IC-DISC company, but the IC-DISC company is a paper entity, without any actual operations, employees or tangible assets. It is virtually invisible to employees and customers, serving solely as a Congressionally mandated vehicle needed to qualify for IC-DISC tax benefits. The IC-DISC entity is required to be a C corporation and is generally newly formed to take advantage of the IC-DISC incentive. Once formed, the corporation makes an election to be treated as an IC-DISC within 90 days, effectively making it a nontaxable entity for federal tax purposes.
The ownership structure for the IC-DISC entity will be dependent upon the specific facts and circumstances of each client situation. An IC-DISC can be established either as a subsidiary owned by the client company or as a brother-sister corporation owned by the client company's shareholders or owners. To ensure that IC-DISC benefits are obtained and maximized, we strongly recommend that companies interested in the IC-DISC opportunity obtain advice in structuring their IC-DISC arrangements from a qualified firm with IC-DISC expertise.
What are the tax benefits of the IC-DISC?
Significant and often permanent tax savings can be achieved through implementation of an IC-DISC. The tax code permits qualifying U.S. taxpayers to effectively exclude at least 50 percent, and often considerably more, of their export-related income from U.S. tax. For these purposes, since this is an export incentive regime, there are fairly generous rules for determining and maximizing the amount of export-related income eligible for IC-DISC benefits. In some cases current federal tax liability can be completely eliminated on qualifying export income.
A couple of primary vehicles are used for tax savings with the IC-DISC. One is the payment of a tax-deductible commission to the IC-DISC equal to 50 percent of the qualifying export income of the taxpayer. This effectively eliminates current federal tax on the commission income earned by the IC-DISC, which is a tax-exempt entity. It's like moving export income into a tax-exempt IRA or 401(k).
A second vehicle used to further increase tax benefits is IC-DISC factoring. The IRS recognizes use of an IC-DISC to ‘factor' qualifying export receivables of its related company. With IC-DISC factoring, the IC-DISC purchases export receivables from its related operating company at an arm's length discount, and then earns factoring income upon collection of the receivables. Similar to the commission vehicle, the factoring vehicle is virtually invisible to customers.
The commission and factoring income paid to the IC-DISC is accomplished entirely through bookkeeping entries and no cash is moved out of the operating company. It's important to be careful to use the IC-DISC so as to not adversely impact the company's working capital. However, the company's operating capital can be increased capital by reducing the federal tax burden on their export-related income.
IC-DISC tax benefits can be permanent. This permanent tax savings arises from the current 15% federal tax rate applicable to qualified dividend income, which can include dividends received from an IC-DISC. Through use of an IC-DISC, export income which would have been taxed at normal federal tax rates in the mid-to upper-30 percent range, can effectively be converted into qualifying IC-DISC dividend income, taxable at a 15 percent federal rate. The result is permanent tax savings equal to 20 percentage points on IC-DISC income paid as dividends to shareholders that are individuals or pass-through entities such as subchapter S corporation.
In addition, a U.S. exporter that is a closely held C corporation can use an IC-DISC to obtain a permanent tax benefit in the form of a tax deduction for the U.S. exporter's commission payments to the IC-DISC. Those commissions can then be distributed by the IC-DISC to its shareholders as a dividend - effectively creating an opportunity for a closely held C corporation to pay a tax deductible dividend to its individual shareholders. As such, an IC-DISC can be an effective vehicle for getting cash to the shareholders of a closely held C corporation free from the corporate double tax, augmenting or potentially replacing nondeductible C corporation distributions.
Businesses can also use an IC-DISC as a way to provide incentives, naming management as shareholders, allowing them to benefit from the additional cash flow being created by an increase in global sales.