Manufacturers and distributors who export products should consider the use of an interest charge domestic international sales corporation (“IC-DISC”) to reduce their tax burden. Here are some frequently asked questions about this strategy.
How does it work?
An IC-DISC is a separate entity that earns a “commission” on the operating company’s qualified export sales. Qualified export sales include sales made to domestic companies that then ship directly to a foreign customer provided no further manufacturing of the property takes place.
The commission is based on the greater of:
- 50 percent of net income on sales of qualified export property or
- 4 percent of gross receipts from sales of qualified export property.
These thresholds can be applied on a per-item basis or applied to the entire amount of qualified foreign sales. Finally, a properly executed IC-DISC isn’t taxable at the entity level. So, the operating company receives a deduction for the commission paid at ordinary tax rates and the IC-DISC pays no tax.
The IC-DISC then distributes all of its profits as qualified dividends and the owners pay tax on the dividends at the more favorable qualified dividend tax rates. Depending on the owners’ personal income levels, qualified dividend tax rates could be as low as zero or 15 percent—or as high as 23.8 percent (the highest federal capital gains rate of 20 percent plus an additional 3.8 percent of net investment income tax).
How much federal tax can it save?
To illustrate, let’s suppose Widgets, Inc. (a fictional S corporation) ships $2 million internationally and pays $80,000 in commissions to its IC-DISC. Assuming the owners qualify for the highest capital gains tax rate of 23.8 percent, they’ll owe federal tax of $19,040 on qualified distributions from the IC-DISC.
However, the owners also owe less tax on their S corporation earnings. Widgets can deduct $80,000 in commissions paid to the IC-DISC, resulting in a tax savings of $31,680, assuming that the owners are in the highest federal tax bracket of 39.6 percent.
The net savings is $12,640 ($31,680 – $19,040), or 15.8 percent of the commission charge. The savings could be higher using the 50 percent of net export income method if deductions are tracked on a per-item-sold basis.
What steps are required?
A properly executed IC-DISC strategy follows these procedures:
- Form the new IC-DISC entity under state law.
- Make the IC-DISC election within 90 days of formation.
- Offer only one class of stock with par or stated value of stock of at least $2,500.
- Maintain a separate set of books and records for the IC-DISC.
Taxpayers also can establish the IC-DISC in a domicile without state income tax to eliminate the need to file state income tax returns.
Potential for big return on investment
The potential tax savings can outweigh the costs of creating and administering an IC-DISC. If you export products, discuss this strategy with your tax advisor at LGT today to see if it is a cost feasible strategy to implement.
Seek the services of a legal or tax adviser before implementing any ideas contained in this blog.