Understanding the IC-DISC
How This Tax-saving Vehicle Can Work for Your Company
Kristina Drzal-Houghton
Although exporters often think of newly produced property as export property, used equipment and even scrap also qualify.
In its most recent form, the IC-DISC can provide a permanent 20% tax savings (or even more) for qualifying U.S. exporters. In certain cases, it eliminates U.S. tax entirely on the majority of export income. In addition, distributions to individual shareholders are currently taxed at a maximum rate of 15% — providing a way to convert 35% ordinary income to 15% qualified dividend income. Of course, this assumes that the U.S. exporter generates operating profits and is creating taxable income in the U.S.
To make the most of this strategy, it’s a good idea to act soon. An IC-DISC is relatively inexpensive to set up and operate, and it can reduce your federal tax rate on a portion of net export income by up to 20 percentage points. This differential was originally set to expire on Dec. 31, 2010, but Congress extended it in late December 2010 to Dec. 31, 2012.
Many practitioners strongly believe that this differential will be extended past 2012 even if tax rates on ordinary income increase. In addition to benefiting sole proprietorships and pass-through entities, exporters operating their business via a C corporation can benefit by using the IC-DISC to eliminate double taxation on a majority of their export income, as well as to reduce the need to incur additional payroll taxes on income paid to their shareholders or officers. The IC-DISC is not a tax shelter.
What Is an IC-DISC?
An IC-DISC is a ‘paper’ entity used as a tax-savings vehicle. It is a domestic C corporation, but must request and receive IRS approval to be treated as an IC-DISC for federal tax purposes. It also must maintain its own bank account, keep separate accounting records, and file U.S. tax returns. It does not require corporate substance or form, office space, employees, or tangible assets. It simply serves as a conduit for export tax savings. An important feature of the IC-DISC is that shareholders can be corporations, individuals, or a combination of these. The IC-DISC can be incorporated in one of the 50 states or in the District of Columbia.
How Does It Work?
The owner-managed exporting company forms a special U.S. corporation that elects to be an IC-DISC. The election is made on IRS Form 4876-A, which must be filed within 90 days after the beginning of the tax year. Here are more specifications:
• The exporting company pays the IC-DISC a commission;
• The exporting company deducts the commission from ordinary income taxed at up to 35%;
• The IC-DISC pays no tax on the commission as long it passes two main tests known as the qualified export receipts test and the qualified export assets test. The qualified export receipts test requires that 95% of the gross receipts of the IC-DISC constitute qualified export receipts. The qualified export assets test requires that 95% of the assets of the IC-DISC be qualified export assets. Qualified export assets include accounts receivable, temporary investments, export property, and loans to producers.
• Shareholders of an IC-DISC are not taxed until the earnings are distributed as dividends. However, the shareholders must pay annual interest on the tax deferred. Shareholders that are individuals pay income tax on qualified dividends at the capital-gains rate of 15%. The result may be a 20% or more tax savings on the commission.
The following calculation shows how the owners can save a combined $500,000 in federal income taxes. Let’s assume an S corporation has $20 million in qualifying export sales and $5 million in net export income on those sales. If the company has an IC-DISC subsidiary, it can pay the IC-DISC commissions up to the greater of 50% of its export net income or 4% of its export gross receipts. In this case, the maximum commission is 50% of net income, or $2.5 million. The S corporation shareholder has reduced pass-through income by the $2.5 million commissions expense. At 35%, this is a reduction of $875,000.
Assuming the IC-DISC fully distributes the commission as a dividend, the shareholder will have $2.5 million of qualifying dividend income taxed at 15% or $375,000. The net of these two items is the $500,000 tax savings.
For U.S. exporters, the IC-DISC is the only remaining tax-saving opportunity. If you are unsure about whether or not an IC-DISC will work, ask the following questions:
• Do you have any transactions outside of the U.S.?
• Do you use overseas distribution?
• Does your product cross any borders?
• Are you generating operating income?
If the answer to any of these questions is yes, an IC-DISC could be a valuable tax-savings vehicle for your business.
On the surface, the rules covering the IC-DISC may seem simple. However, to maximize the tax benefit, a qualified IC-DISC advisor should be engaged. Many times an IC-DISC expert can double if not triple the tax benefit the IC-DISC provides by applying their indepth understanding of how to structure the IC-DISC and using the complex advance pricing rules that the Internal Revenue Code allows for determining the tax benefit. A firm that has proven IC-DISC expertise, offers fixed fees, and optimizes the IC-DISC on a transactional basis (which almost always provides the best result) should be chosen.
Kristina Drzal-Houghton, CPA, MST, is the partner in charge of Taxation at Holyoke-based Meyers Brothers Kalicka, P.C.; (413) 536-8510.
