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 export sales based on the greater of 1) 50% of net income on sales of qualified export property or 2) 4% of gross receipts from sales of qualified export property. A properly executed IC-DISC is not a separate taxable entity but the operating company still receives a deduction for the commissions paid to the IC-DISC. The impact of the operating company’s deductions can be measured using their ordinary tax rate. The commissions paid to the IC-DISC are not subject to any income taxes at the entity level.
The IC-DISC distributes all of its profits as qualified dividends, and the owners pay tax on the dividends at more favorable capital gains tax rates. Depending on the owners’ personal income levels, federal capital gains tax rates could be as low as zero or 15% — or as high as 23.8% (the highest federal capital gains rate of 20% plus an additional 3.8% of net investment income tax).
How Much Federal Tax Can It Save?
To illustrate, let us 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%, 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%.
The net savings is $12,640 ($31,680 – $19,040), or 15.8% of the commission charge. The tax savings can be further increased if it is possible to pay a higher commission using the 50% of net export income calculation.
What Steps are Required?
A properly executed IC-DISC strategy follows these procedures:
- Form the new IC-DISC entity under the appropriate 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.
For further tax savings, taxpayers also can establish the IC-DISC in a state without 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 a significant amount of products, discuss this strategy with your tax advisor today. For questions, contact Amy Jackson at 312.670.7444. Visit orba.com to learn more about our Manufacturing and Distribution Group.