For U.S. exporters operating their business via a sole proprietorship or pass-through entity (LLC, S corporation, LP), the available Interest Charge – Domestic International Sales Corporation tax planning benefit can provide a permanent 20 percent federal income tax savings for qualifying exports. In certain cases, it eliminates U.S. tax entirely on the majority of export income.
Distributions to individual shareholders are currently taxed at the qualified dividend rate of 20 percent — providing a way to convert 39.6 percent rate ordinary income. C corporations can use 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/officers.
For an IC-DISC election to remain in effect, you must pass two main annual tests: qualified export receipts test and qualified export assets test. The qualified export receipts test requires that 95 percent of the gross receipts of the IC-DISC constitute qualified export receipts. The qualified export assets test requires that 95 percent of the assets of the IC-DISC be qualified export assets.
Three requirements must be met in order for the IC-DISC to receive income from an export sale. The export property must:
(1) Be manufactured, produced, grown or extracted in the U.S. Used equipment and scrap also qualify;
(2) Be held primarily for sale, lease or rental for use, consumption or disposition outside the U.S.; and
(3) Have a maximum of 50 percent foreign content.
The IC-DISC is a separate domestic entity whose shareholders may be corporations, individuals, or any combination thereof which then makes an initial election to be treated as an IC-DISC. The election is made on IRS Form 4876-A, which must be filed within 90 days after the beginning of the initial tax year. Exporting company pays IC-DISC a commission. Exporting company deducts commission from ordinary income taxed at rates up to 39.6%.
The IC-DISC pays no tax on the commission income as long as the above-referenced qualification tests are met. Shareholders of an IC-DISC are not taxed until the earnings are distributed as qualified dividends. In lieu of current distributions, 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 20 percent.
C Corporation shareholders are automatically considered to have received 1/17th of the IC-DISC’s taxable income even if no distributions are made. The commission payment is an actual payment from the U.S. exporter to the IC-DISC and is determined as either 4 percent of the U.S. exporter’s qualified export receipts or 50 percent of the exporter’s taxable income (whichever is greater).
Generally, shareholders may defer up to $10 million of annual commission income in the IC-DISC. If the IC-DISC defers this income, there is a shareholder level tax on the deferred tax. The tax is the interest charge — hence the term “Interest-Charge DISC” — on the deferred tax liability at the base period T-bill rate.
If the shareholders decide not to defer, the IC-DISC commission income is taxable currently to the shareholders as a qualified dividend. Note, any commission income that exceeds the $10 million annual limit is automatically taxable to shareholders as a deemed dividend.
Ability to leverage capital
An IC-DISC is more than a tax-savings vehicle. It can also be used as a deferral tool to leverage a company’s cost of capital. Because IC-DISC current earnings need not be distributed to shareholders, they can instead be used to perpetuate and grow the deductible dividend tax rate savings.
Tax rate savings are perpetuated by lending accumulated IC-DISC earnings back to the exporting company in return for a note and interest. The exporting company can deduct the interest expense, and interest income is considered a dividend to the IC-DISC shareholders. Reinvesting IC-DISC earnings back into the exporting business results in additional tax rate savings and diminishes the group’s cost of capital.
Any small- or medium-sized businesses who are currently exporting at least $300,000 per year should take a hard look at this IRS approved planning technique, designed by Congress to incentivize overseas shipments of U.S. manufactured goods.
James P. Schnell, CPA/ABV, CVA, is a partner and the tax and business valuation director at Mengel, Metzger, Barr & Co LLP. He can be reached at (585) 423-1860 or JSchnell@mmb-co.com.