Many taxpayers with foreign sales are missing out on a significant tax planning opportunity.
If your closely held company earns income from exporting U.S.-made products, or from engineering or architectural services on foreign construction products, consider forming an interest charge domestic international sales corporation (IC-DISC).
An IC-DISC is relatively inexpensive to set up and operate, and it can reduce your federal tax burden. The IC-DISC rules were enacted by Congress to encourage tax benefits for those who export some or all their products. To benefit from an IC-DISC, all that is needed is to follow the format outlined in the regulations that promulgate this tax savings strategy.
An IC-DISC is a C corporation that requests and receives IRS approval to be treated as an IC-DISC for federal tax purposes. It must maintain its own bank account, keep separate accounting records, and file U.S. tax returns. But, it need not have an office, employees or tangible assets, nor is it required to perform any invoicing or provide services. Again, the purpose of the IC-DISC is to satisfy Internal Revenue Code regulations that provide this tax relief.
Due to its status as an IC-DISC, the company pays no federal income taxes and reduces the exporter's tax liability by effectively converting a portion of net export income, which is taxable at ordinary income rates as high as 39.6 percent, into qualified dividends taxed at 23.8 percent or less.
To qualify as an IC-DISC, a corporation must:
- Be incorporated in one of the 50 states or in the District of Columbia;
- File an election with and receive approval from the IRS to be treated as an IC-DISC for federal tax purposes;
- Maintain a minimum capitalization of $2,500 of authorized and issued shares;
- Have only a single class of stock;
- Meet an annual qualified export receipts test and a qualified export assets test.
The last requirement is included to permit only exports of property with at least 50 percent U.S.-produced content. In addition, engineering and architectural services related to construction projects outside the U.S. may also generate qualified export receipts.
Here’s how the tax savings work:
The IC-DISC is "presumed" to participate in export sales for which it receives a commission. Your operating company pays a tax-deductible commission to the IC-DISC equal to the greater of: 4 percent of your company's gross receipts from qualified exports, or 50 percent of its net income from qualified exports. Your company's taxable income is reduced by the amount of the commissions paid to the IC-DISC as such commissions are deductible as ordinary income tax deductions.
The IC-DISC is a tax-exempt entity and pays no tax on the commission income. When the IC-DISC distributes its income to its shareholders, the dividend income is taxed at the qualified dividend rate of 23.8 percent or less.
The tax benefits available from an IC-DISC can be demonstrated by the following.
Assume an S corporation has $5 million in qualifying export sales and $1 million in net export income on those sales. If the company utilizes an IC-DISC, it can pay the IC-DISC commissions up to the greater of 50 percent of its export net income or 4 percent of its export gross receipts. In this case, the maximum commission is 50 percent of the net income, or $500,000. The owners in this situation can save $80,000 in federal income taxes ($500,000 commission multiplied by the difference in the ordinary and dividend tax rates 39.6%-23.8%=15.8%).
Remember, these tax benefits result from simply following the requirements previously summarized. The IC-DISC typically has no employees and performs no services. There is no change in the transactions between your operating company and customers. The few mechanics that need followed are solely between your operating company and your IC-DISC.
Estate tax savings can be another benefit of an IC-DISC. The IC-DISC owners can be different from the owners of the operating business. Thus, with capitalization of only $2,500 required, the taxpayer can significantly reduce their estate with proper planning.
Taxpayers with foreign sales of U.S.-produced content or qualifying engineering and architectural firms should consider the benefits of an IC-DISC immediately. Considering the potential savings, it will likely be your most profitable decision of the day!