More U.S. companies across an expansive range of industries are becoming increasingly involved in foreign transactions, including exporting. In 2019 alone, total U.S. trade with foreign countries added up to $5.6 trillion. Of that total, $2.5 trillion came from the exportation of various goods and services. However, not many of those exporters are aware that they can improve their cash flow and reduce their U.S. tax liability through the use of an Interest-Charge Domestic International Sales Corporation (IC-DISC).
Can an IC-DISC structure help your business? And if you are using an IC-DISC structure, are you taking full advantage of the benefits?
What’s in this article?
- What is an IC-DISC?
- Who can benefit from an IC-DISC?
- What are the tax benefits of an IC-DISC structure post-tax reform?
- How does an IC-DISC work?
- What is the ownership and organizational structure of an IC-DISC?
- What are the other benefits of an IC-DISC?
- Are there any other matters for consideration?
- How can Squar Milner help?
What is an IC-DISC?
An Interest-Charge Domestic International Sales Corporation is a domestic C corporation, which primarily engages in facilitating foreign sales, leases or rental of export property.
With certain exceptions, export property entails property manufactured, produced, grown, or extracted in the U.S. and held primarily for sale, lease, or rental in the ordinary course of business for direct use, consumption, or disposition outside of the United States.
An IC-DISC is a federal tax incentive specifically provided by the tax code that reduces federal tax liabilities and concurrently increases the ability of U.S. exporters to compete on the global stage.
To qualify as an IC-DISC, a corporation must apply for and receive approval from the Internal Revenue Service (IRS), as well as meet other criteria. Corporations file Form 4876-A to elect IC-DISC treatment. The election applies to each shareholder who owns stock in the corporation.
Who can benefit from an IC-DISC?
IC-DISC structures benefit qualified producers or distributors that are either directly export property or sell products to distributors or wholesalers who then resell those products for use outside of the U.S.
This typically includes traditional manufacturers as well as those who grow agriculture products, extract minerals, distribute U.S.-made goods, and develop software.
The list above, though, is not all-encompassing. Exportation is an activity that affects a vast number of industries throughout the U.S. In 2019, one-third of exported goods were capital goods, mainly commercial aircraft, industrial machines, semiconductors, telecommunications, electric apparatus, and medical equipment. Another third of exported goods were industrial supplies. This includes petroleum products, chemical products, fuel oil, and plastic. Of that total 2019 exportation number, 12% of products were consumer goods, meaning pharmaceutical preparations, cell phones and gem diamonds. Automobiles made up 10% of all exported goods, and 8% was food, feeds and beverages.
IC-DISC tax benefits are also available for certain other types of income, including gross receipts for engineering or architectural services attributable to construction projects located (or proposed for location) outside the U.S.
What are the tax benefits of an IC-DISC structure post-tax reform?
If your company earns taxable profits from exporting products which are manufactured, produced, grown or extracted in the United States, or from providing engineering or architectural services on foreign construction projects, an IC-DISC may offer significant and permanent tax benefits.
An IC-DISC is relatively inexpensive to set up and operate, and it can reduce the federal tax rate imposed on a portion of export taxable income by over 13 percentage points. Reducing the rate from 37% (the top tax rate) to 23.8% leads to about a 38% reduction in tax expense attributable to sales, leases or rental of qualified export property.
IC-DISCs are not subject to federal income tax on qualifying export income. Qualified export income is income derived from the sale of qualified export property.
Instead, the IC-DISC’s shareholders are subject to tax when they receive dividends that are paid or deemed paid to them. If the shareholders are ultimately individuals, trusts or trust beneficiaries (i.e., not a C corporation), then corporate level tax may be avoided altogether, and the resulting taxable income would consist solely of those dividends.
C corporation shareholders can defer this dividend income (and double layer of tax) by issuing producer loans or factoring foreign trade receivables. Factoring receivables is the process of purchasing account receivables at a discounted price and later collecting the full amount of the receivables at a profit.
In addition, a closely held C corporation that distributes dividends to its shareholders is eligible for a federal tax deduction for a portion of those dividends in the form of a commission deduction when utilizing an IC-DISC owned by those same shareholders.
A “commission” IC-DISC provides sales and export related services to a related party supplier and receives a commission for those services. The commission is the greater of two scenarios: 1) 4% of qualified export gross receipts, or 2) 50% on the net income from the sale of export property. The related supplier can also claim a tax deduction for the commission paid. On the other hand, a “buy/sell” IC-DISC purchases export property for resale outside of the U.S. As a result, 100% of the net income qualifies for benefits.
IC-DISC tax benefits are not retroactive. Therefore, you should establish the IC-DISC as soon as possible in order to maximize your tax benefits.
How does an IC-DISC work?
In general the IC-DISC allows certain U.S. exporters to reduce their overall tax liability through a commission mechanism. The exporter pays a tax deductible commission, based on qualified export sales, leases or rentals, to a newly created corporation with an IC-DISC election.
However, by design, the IC-DISC structure is exempt from federal tax and does not need to pay tax on the commission received. The IC-DISC then distributes commission income to its shareholders as a qualified dividends which are subject to tax at reduced capital gains tax rates.
A brief overview of IC-DISC activities are as follows:
- The IC-DISC is established.
- The exporter pays the IC-DISC a commission for facilitating sales, leases or rental of export property.
- The exporter deducts the commission owed to the IC-DISC from its ordinary income.
- The IC-DISC is not subject to federal income tax on the commission income received from the exporting company.
- Shareholders of the IC-DISC, which are trusts or individuals, are subject to federal income tax on dividends received from an IC-DISC at a maximum of 23.8%.
Income of an IC-DISC
The income of an IC-DISC from the sale of export property is in an amount constituting the greater of:
- 4% of its qualified export receipts, subject to export profit limitations;
- 50% of its combined taxable income from qualified export receipts; or
- The arm’s length amount determined under the transfer pricing principles outlined in Sec. 482.
These methods apply regardless of whether the IC-DISC is a “commission” IC-DISC or a “buy-sell” IC-DISC. Any of these transfer pricing methods for the IC-DISC combined with the 20% tax rate on qualified dividends by U.S. corporations to U.S. individual shareholders, creates income tax savings.
Taxpayers rarely rely on the Sec. 482 transfer pricing method to determine the arm’s length amount of income for the IC-DISC because the IC-DISC performs minimal functions and assumes minimal risks.
What is the ownership and organizational structure of an IC-DISC?
An IC-DISC is form over substance. It does not require employees or office space, and it does not have to perform any services or participate in sales to earn a commission.
However, the entity must maintain a separate set of books and records, including an independent bank account. It may have only one class of stock, and it must, at all times, have stock outstanding with a par or stated value of at least $2,500.
Mechanical Structure of an IC-DISC
If the exporting entity is a C corporation, the IC-DISC should generally be set up as a sibling to the exporting entity rather than as a subsidiary, and it should generally be owned by the exporting entity’s individual shareholders.
With IC-DISCs, it’s also important to take into account the new foreign-derived intangible income (“FDII”) deduction for C corporations introduced by the Tax Cuts and Jobs Act (TCJA) starting in 2018.
It’s worth noting that the shareholders of the IC-DISC do not need to be the same as the shareholders of the exporting company. An IC-DISC can provide a benefit to key employees or as a tool in estate and/or succession planning.
Consult with your tax advisor regarding the issues and risks involved with these arrangements before using an IC-DISC for any of these purposes.
An IC-DISC is also allowed to have foreign shareholders as long as the foreign shareholder agrees that any distribution—actual or deemed—is income effectively connected with a U.S.-permanent establishment.
The dividends paid from an IC-DISC to its shareholders are generally considered to be foreign-source income. This makes the use of an IC-DISC particularly valuable to U.S. shareholders with passive foreign tax credit carryovers.
What are the other benefits of an IC-DISC?
Beyond permanent tax savings for exporters, there are a number of other benefits of establishing an IC-DISC structure. These benefits include:
- Closely-held C corporations can obtain permanent tax savings for amounts which would otherwise be paid to their shareholders as dividends.
- A portion of the taxable income of an IC-DISC can be retained within the IC-DISC, thereby deferring tax imposed on the dividends to be paid to the IC-DISC shareholders, and reducing the group’s cost of capital.
- An IC-DISC can be an estate planning vehicle.
- An IC-DISC may be used for executive compensation and succession planning.
- An IC-DISC structure can significantly enhance tax savings of various other tax-advantaged structures, such as IRAs.
- There may be an opportunity for foreign corporations to benefit from establishing an IC-DISC.
Are there any other matters for consideration?
The IC-DISC regime is a U.S. federal income tax incentive. However, not every state adopted the IC-DISC rules.
Many states grant tax-exempt status to IC-DISCs consistent with federal income tax treatment (e.g., Delaware, Michigan, and New York) and other states do not (e.g., Maine and Massachusetts). California, for example, treats an IC-DISC like any other corporation. Therefore, no IC-DISC benefits are available for California state income tax purposes.
How can Squar Milner help?
Admittedly, the TCJA introduced tax-rate reductions and limited the overall benefit an IC-DISC. However, this does not mean that an IC-DISC has completely lost its appeal.
In fact, utilizing an IC-DISC structure can still create significant tax savings. Our International Tax Services (ITS) team is here to help you capitalize on the opportunity.
We can help you implement an IC-DISC, quantify potential annual tax savings, or explore advanced planning opportunities – such as AR factoring or IC-DISC transactional analysis. Our ITS practice has the technical skill and comprehensive experience to help develop the most optimal tax strategies for your business.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.