What is an IC-DISC?
An Interest Charge Domestic International Sales Corporation, or IC-DISC, is one of the last tax incentives available for U.S. exporters structured as a pass-through entity. This incentive is specifically provided by the tax code to allow U.S. exporters to reduce their tax burden to be globally competitive. An IC-DISC is effectively a shell company that creates a permanent tax benefit for its owners. To setup an IC-DISC, you need to create a new entity structured as a C Corporation and request IRS permission by filing an IC-DISC election within 90 days of formation. The IC-DISC will need to maintain its own bank account and books and records. The final requirement is that there may only be one class of stock with a par or stated value of at least $2,500. It is important to note that the formation of an IC-DISC does not change the operations of the original business and is not required to be disclosed to customers.
How does an IC-DISC Create a Benefit?
The benefit of creating an IC-DISC comes from the availability to pay the IC-DISC a commission based on the operating company’s export sales. The commission is based on the greater of either 50% of net income on sales of qualified export property or 4% of gross receipts from sales of qualified export property. The commission paid by the operating company is allowed as an ordinary deduction. The IC-DISC reports commission income and related expenses which are all tax-exempt. The IC-DISC then issues a dividend to its owners which is taxed at the qualified dividend rates. Depending on the individual owners’ personal tax situation the qualified dividend can be taxed at zero, 15, or 20%.
What is the Current Benefit of an IC-DISC
Based on the current tax legislation, the maximum benefit of using an IC-DISC is a 5.8% benefit on income converted from ordinary income to qualified dividend income. This is based on the current highest marginal rate of 37% discounted by 20% for the Qualified Business Income Deduction (QBID) to create a tax burden of 29.6% on ordinary income compared to the 20% maximum qualified dividend income rate and including the 3.8% Net Investment Income Tax to create a 23.8% tax burden on the converted dividend income. With the QBID set to expire after 2025, the benefit will increase to a 13.2% benefit based on the current tax rates.
What does the future hold for IC-DISC?
The first proposed change is the increase of the top marginal tax bracket to 39.6%. With this change, there would be an increase in the tax benefit of using an IC-DISC as each dollar of commission expense converted to dividend income would create an additional 2.6% tax savings. For taxpayers not currently in the top marginal rate, there would not be a material change to the tax benefit of using an IC-DISC.
The next proposed change revolves around the elimination of the QBID for taxpayers earning more than $400,000. For these taxpayers, there would be an increased benefit from an IC-DISC of 7.4%. This is because the tax benefit from the commission expense provides a 37% benefit instead of the 29.6% benefit for taxpayers that can benefit from the full 20% QBID currently. While there is an increased benefit from the IC-DISC, it comes at the cost of losing out on a 20% tax deduction.
The final proposed change is the proposed removal of capital gain and qualified dividend rate for taxpayers earning over $1 Million. For these taxpayers, the dividend income received from the IC-DISC will no longer have an advantageous tax rate. For taxpayers earning less than $1 Million a year, there will still be a benefit based on the other changes above. It will require careful consideration of the ownership structure to determine if the cost and maintaining the IC-DISC outweighs the benefit received by the owners.
While the IC-DISC does not create the same significant tax savings of years gone by, there remains a valuable tax benefit to squeeze out. For taxpayers with income under $400,000, there is no expected change, for taxpayers earning between $400,000 and $1 Million there is an expected increase benefit, and for taxpayers, over $1 Million there is an expected full loss of benefit. With the Biden administration working to update tax policy to meet their objectives, it remains to be seen what the future holds for the IC-DISC. Determining whether the benefit will vanish, increase, or remain stagnant will require a watchful eye on the changes to the tax policy. As always, if you have any questions or would like to learn more, please consult with your HBK tax advisor.