U.S. companies that export goods can significantly reduce their taxes through use of a federal tax incentive known as the “Interest Charge — Domestic International Sales Corporation” or “IC-DISC.”
IC-DISC provides an incentive to promote the exporting of U.S.-sourced products to customers outside of the United States, says Henry J. Grzes, CPA, director in tax at SS&G.
“Generally, it provides a tax benefit on export-related income,” says Grzes. “There can be two benefits associated with such an entity, one is a permanent tax savings in the sense that income earned by the IC-DISC can be potentially taxed at a lower federal rate than it would have been had it been earned by the operating company. Or, you can use this as a method to defer the payment of taxes, so you can accumulate income in this separate entity without having to immediately pay the taxes due on this particular income.”
Smart Business spoke with Grzes about how an IC-DISC can significantly reduce the amount of taxes your business pays on income earned from exported products.
What types of companies can create an IC-DISC?
The company has to be selling outside the U.S. It can be a manufacturer of goods in the U.S. that is selling overseas, or a distributor that acquires goods from a third party, then resells them to customers outside the U.S.
To qualify, more than 50 percent of the value of your product has to be from goods sourced to the U.S. For example, if a manufacturer’s product sells for $1,000 outside the U.S., and $300 of the cost is related to products imported from outside the U.S., this sale can qualify for IC-DISC benefits because it’s under the 50 percent threshold. This affords you the opportunity to make qualifying sales using some level of imported products.
However, if you are a U.S. distributor with a wholly owned subsidiary in China, you can’t buy items from that related company, then sell them in other countries and still qualify for IC-DISC treatment on these sales.
Also, if your U.S. company sells to an independent third party that uses your product in its products, which are then resold outside the U.S., you may be able to treat these sales as revenue eligible for IC-DISC benefits.
How does an IC-DISC work?
Ordinarily, there is an expense reported by the operating company that can take the form of a commission or a factoring charge on accounts receivable. That amount of expense is reported by the IC-DISC as revenue.
Say your company is taxed at the 35 percent federal corporate rate. If it generates $200,000 of net taxable income, its tax bill would be $70,000. Ordinarily, if this income is kept in that operating company and reported as income, you’d give up $70,000 in cash for taxes. But with the IC-DISC, you get the benefit of $70,000 in tax savings in the company by paying $200,000 in deductible commissions to the IC-DISC, thereby reducing taxable income to zero and completely eliminating the tax that would be due. Taxes don’t have to be paid on revenue earned by the IC-DISC until it is distributed to its owners. Depending on who owns the IC-DISC (often the same individuals who own the operating company), they may be able to take advantage of the 15 percent rate afforded to recipients of qualified dividend income. Even if the operating entity is in a lower tax bracket, individual owners would only owe taxes on distributions from the IC-DISC at a maximum federal rate of 15 percent. However, state taxes are assessed on this income when received by the IC-DISC as well as when the distributions are received by the owners of the IC-DISC.
So if the operating company owes $70,000 in tax on $200,000 of net taxable income, but that revenue goes into the IC-DISC and is distributed to the owners of the IC-DISC, that income would instead be reported on the individual’s tax return. And because it is qualified dividend income, it would be taxed at a maximum rate of 15 percent, or $30,000. You’ve achieved a $70,000 tax savings in the operating company and it has only cost $30,000 to do so, resulting in a net tax benefit of $40,000.
If you use it as a deferral mechanism and choose to leave profits to accumulate in the IC-DISC, you would compute an interest charge on what the tax would be on this revenue, as if the IC-DISC was a taxable entity.
Current IRS interest rates are very low (less than 1 percent per year), so a 1 percent interest rate on $70,000 would be $700 — a very inexpensive way to keep cash in the business.
You only have to pay the interest charge on profits that are not distributed to owners of the IC-DISC. If the profits are all distributed, you are not going to incur that interest charge.
How can a company establish an IC-DISC?
The owners of an IC-DISC must form a regular (Subchapter C) corporation and that entity must make an election to be treated as an IC-DISC on IRS form 4876-A. Next, set up a bank account with a minimum capitalization of $2,500 and issue stock. It is wise to form the corporation in a state with no state corporate income taxes (i.e., Nevada), to maximize tax savings. However, the corporation must be formed and the IC-DISC election must be made before benefits can begin to accrue in the IC-DISC. So unlike other tax benefits, this one is not retroactive to the beginning of the year the IC-DISC was formed. The benefits only start when the entity is in place and the proper paperwork has been filed.
What is the future of IC-DISCs?
With the current economy, IC-DISCs are an incentive for U.S. taxpayers to export products. Anything the U.S. can do to improve its balance of trade and the trade deficit is a positive result. Under the extension of the Bush tax cuts, the 15 percent rate on qualified dividends will last through 2012. No one knows what will happen with that rate after that, or whether IC-DISC dividends will still be considered qualified dividends.
Most experts think that IC-DISC distributions will continue to be treated as qualified dividend income, but the preferential rate may increase. But even with a reduced benefit, IC-DISC owners would still pay tax at lower than the 35 percent corporate rate.
Henry J. Grzes, CPA, is director in tax at SS&G. Reach him at (330) 668-9696 or HGrzes@SSandG.com.