The IC-DISC: Forgotten Tool of the U.S. ExporterThursday, January 21, 2010
Kenneth Laks, CPA - During this challenging economic climate, U.S. domestic exporters are looking to leverage any financial advantage available to them. Previously, export incentives such as the Extraterritorial Income exclusion (ETI) and Domestic International Sales Corporation (DISC) were available but these have been gradually eliminated over the years by the IRS. Today, the Interest Charged Domestic International Sales Corporation, otherwise known as the IC-DISC, is the only remaining tax benefit for a U.S. exporter.
The IC-DISC regime has been in existence since 1984 and, probably due to lack of understanding, has been widely underutilized. To be eligible to make an IC-DISC election, an entity must exist as a corporation and be organized under the laws of a state. An IC-DISC is usually established as a subsidiary or as a brother-sister corporation and owned by the exporter’s shareholders or owners.
After its formation, the corporation makes an election (via the Form 4876-A) to be treated as an IC-DISC, which effectively makes it a non-taxable entity. Income is generated by the IC-DISC through a commission paid by the related exporter on the sale of goods outside the U.S. A commission agreement must be put in place before any benefits become available. Such agreements usually state that the commission is to be determined based on 50 percent of net export income or 4 percent of gross export receipts, which is mandated by the IRS. The income that is earned by the IC-DISC can either be distributed down to shareholders as a dividend or it can be held in the IC-DISC (commissions on up to $10 million of export sales) at a small interest charge. The interest charge on income left in the IC-DISC is calculated on Form 8404 and is based on the tax liability being deferred as a result of the shareholders not taking distributions. The base period T-bill rate (defined in IRC 995(f)(4)) is used in calculating the interest amount owed. The rate for 2009 is not yet available, but was 2.5% for 2008. If the shareholders take distributions, they are considered qualified dividend income and taxed accordingly. Under the current tax regime, this IC-DISC creation allows an effective federal tax rate of 15 percent as opposed to a 35 percent effective rate if it was not put into place. Let’s take a look at the following example: Smith Exporters sets up an IC-DISC called Smith IC-DISC. A commission agreement is put into place that states commission income to the IC-DISC will be 50 percent of net export income or 4 percent of gross export receipts, whichever is greater. For the year, net export income is $900,000 which is greater than 4 percent of gross export receipts (gross receipts are $5 million). Commission income of $450,000 would be recorded as income on Smith IC-DISC and expensed on Smith Exporters. Assuming nothing else occurred, Smith Exporters will show as a bottom line $450,000 of net income and Smith IC-DISC will show $450,000 of net income At the end of year, if the full $450,000 was distributed, the federal tax savings would be $90,000 (the difference between the 35 percent and 15 percent rate on $450,000.) See Table 1 for detail of savings No IC-DISC Sales $5,000,000 Taxable income Before Commission 900,000 Net taxable income 900,000 Shareholder level tax-35% 315,000 Total tax 315,000 With IC-DISC Sales 5,000,000 Taxable income Before Commission 900,000 Commission to IC-DISC 450,000 Net taxable income 450,000 Shareholder level tax-35% 157,500 Distribution from IC-DISC 450,000 Tax on IC-DISC distribution 67,500 Total Tax 225,000 Tax Savings using IC-DISC $90,000 For the 2008 tax year, if distributions were not taken by shareholders, the interest charge would be approximately $1,700 (deferred tax of $67,500 multiplied by the T-bill rate factor stated above). This assumes no IRC 995(f)(2) adjustments as described on Form 8404. Other requirements that must be met in order to be eligible for IC-DISC status:
1. At least 95 percent of its gross receipts during the year must be qualified export receipts. These would include gross receipts from: -
selling, exchanging or otherwise disposing of export property or qualified export assets that are not export property, but have realized a gain;
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leasing or renting export property that the lessee uses outside the United States.
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engineering or architectural services for construction projects outside of the United States. 2. At the end of the tax year, the adjusted basis of the IC-DISC’s qualified export assets is at least 95 percent of the sum of the adjusted basis of all assets. An export asset would include export property held for sale, lease or rent in the ordinary course of a trade or business by or to an IC-DISC for direct use, consumption or disposition outside of the United States. 3. The IC-DISC can only have one class of stock and its outstanding stock must have a par or stated value of at least $2,500 each day of the tax year. 4. The IC-DISC maintains separate books and records. 5. The IC-DISC is not a member of any controlled group of which a foreign sales corporation is a member. 6. The tax year of the IC-DISC must conform to the tax year of the principal shareholder who has the highest percentage of voting power. If two or more shareholders have the highest percentage of voting power, the IC-DISC must elect a tax year that conforms to that of any one of the principal shareholders. A company’s election to be treated as an IC-DISC is in effect for the tax year. This election once made is in place until revoked or terminated. The formation of an IC-DISC does not affect an exporter’s qualification for the tax benefits of the Domestic Production Activity Deduction which stands at 6 percent of qualified income for the year ending Dec. 31, 2009. The IC-DISC is an effective tool if used properly and is the sole tax planning technique for those companies selling goods outside the United States.
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