If your company exports products or provides certain services abroad, you may be able to achieve significant tax savings by establishing an Interest Charge Domestic International Sales Corporation (IC-DISC).
“Despite the name, this tax saving technique is fairly straightforward,” says Mark D. Klimek, chair of the Tax Practice Group at McDonald Hopkins. “It is not aggressive from a tax standpoint or overly complicated from a legal or accounting standpoint. In fact, it’s not very complicated at all. An IC-DISC can be set up for a relatively low cost, which can easily be recovered in the first year of tax savings alone.”
Determining whether an IC-DISC makes sense for your company is as simple as looking at your export sales and profits on them and then comparing the tax savings versus the set-up costs. As for companies that already have an IC-DISC in place, Klimek says there are probably opportunities to achieve even greater tax savings.
Smart Business asked Klimek for more details on this tax saving opportunity.
How is an IC-DISC structured?
An IC-DISC is simply a separate corporation that is formed by the owners of an existing company (the ‘manufacturer’). The new corporation’s shareholders, which can be individuals or other types of business entities, make an election to treat the corporation as an IC-DISC. The IC-DISC is paid a commission on foreign sales by the manufacturer, and the manufacturer can take a deduction for the commission payment. This deduction normally generates a tax benefit of 35 percent to the manufacturer. The IC-DISC itself is a tax exempt entity; tax is paid only by the IC-DISC shareholders on dividends received from the IC-DISC. Currently, these dividends are taxed at the favorable 15 percent rate. Therefore, the tax savings occur because the commission arrangement between the IC-DISC and the manufacturer provides a corporate deduction (usually worth 35 percent) in exchange for the tax cost of a dividend to the IC-DISC shareholders (taxed at only 15 percent), generating a net tax benefit of 20 percent on the allowable commissions paid.
Is the commission limited?
Yes, the commission is limited under the IRS rules to a maximum of the greater of 4 percent of total export sales or 50 percent of profits from export sales. However, this is a very basic analysis and is really the minimum commission. A consultant can study a company’s product lines and gross sales figures and come up with very sophisticated ways to maximize the commission.
What are some of the requirements that must be met in order to qualify as an IC-DISC?
The company has to be a C corporation and can only have one class of stock. There must be an initial capitalization of at least $2,500. There is an election form to be signed by all shareholders and filed with the IRS. The IC-DISC should follow the normal corporate requirements of any other corporation There needs to be a commission agreement between the manufacturer and the IC-DISC. This commission agreement is normally flexible in terms of stating how the commission is to be calculated.
Please provide some estimates of the potential tax savings.
The tax savings depend on the profitability of the company’s export sales. A company taking the 4 percent commission on $5 million in gross export sales would save at least $40,000 of federal income taxes, assuming the tax rates are as discussed earlier. If the same company had $5 million in gross export sales and $1 million in profits and was able to deduct the 50 percent commission, the tax savings would be at least $100,000. Again, these savings are minimums; various techniques exist for increasing the effective commission by, for instance, applying the commission limitation to different product lines.
What types of related planning opportunities are associated with this technique?
You can use the IC-DISC to provide shares to family members or to employees. If it’s a family business, you can give family members shares in the IC-DISC, which will provide them with income every year, but not ownership rights in the primary business. If you’re transitioning a business to the next generation by selling shares to that generation, perhaps you’re wondering how your children will get the money to pay you for the business. You can pay them a higher salary to generate this cash, and the company can take a 35 percent deduction on that payment, but the children have to pay tax on this income at ordinary income rates so there is not much tax efficiency. If you or the children own shares in an IC-DISC, the company still gets to take the 35 percent deduction for the commission, but now your children only have to pay tax on the dividends at 15 percent (versus having to pay the ordinary income rates). You can also use an IC-DISC to provide an equity type of incentive to employees, which can serve as a motivation tool to improve productivity and increase export sales.
Does a company have to be making a certain level of sales for the IC-DISC to make sense?
Again, this depends on a company’s profitability. A company doing $1 million in export sales could save at least $8,000 per year under the 4 percent commission scenario. However, if this same company has $200,000 in profits, the tax savings would be $20,000 — still making the IC-DISC an attractive option. Anything less than $100,000 in profits on $1 million in sales would require a closer look at some of the commission-maximizing strategies to see if the IC-DISC makes sense.
MARK D. KLIMEK is chair of McDonald Hopkins’ Tax Practice Group and is a member of the firm’s mergers and acquisitions practice group. Reach him at (216) 348-5453 or [email protected]