Shareholders of businesses that sell “export property” can benefit from establishing an Interest Charge Domestic International Sales Corporation (IC-DISC) to ultimately reduce their income tax liability. “Export property” consists of property meeting the following criteria:
These criteria indicate that the tax benefit associated with establishing an IC-DISC is targeted towards exporters of property that is comprised of at least a majority of U.S.-sourced materials, and that is manufactured or produced within the U.S. before being sold abroad.
The tax benefit which an IC-DISC can yield is the conversion of ordinary income, which may be taxed at an individual’s highest marginal tax rate, into qualified dividend income, which is preferentially taxed. To take advantage of this benefit, three related entities are involved: one that manufactures or produces the export property, one that sells or distributes the export property abroad and the IC-DISC itself. Note that the IC-DISC is a corporate entity which must be incorporated at the state level. After establishing the IC-DISC within this structure, the seller/distributor of the export property pays the IC-DISC a tax-deductible commission (the computation of which is discussed below). Upon receiving the commission, the IC-DISC then distributes the commission to its shareholders in the form of qualified dividends. As the shareholders of the manufacturer/producer, seller/distributor and the IC-DISC are one and the same, the conversion of what would have otherwise been ordinary income into qualified dividend income has been achieved.
Certain requirements must be met in order to obtain the tax benefit that an IC-DISC offers. One requirement is that the seller/distributor of the export property must have taxable income for the year before paying the tax-deductible commission to the IC-DISC. This is so as the IC-DISC cannot be utilized to generate a taxable loss for the seller/distributor in any year. If the seller/distributor has taxable income for the year prior to paying the commission to the IC-DISC, the commission can then be computed using one of two methods: (1) 4% of qualified export receipts, or (2) 50% of the combined taxable income of the seller/distributor and the IC-DISC that is attributable to the sale of export property. Note that each year the seller/distributor can select either method when computing the tax-deductible commission to be paid to the IC-DISC. In other words, the most beneficial method can be selected each year in order to ultimately convert as much ordinary income into qualified dividend income as possible. There is no limit placed on the dollar amount of the commission.
Choosing the proper structure to take advantage of the tax benefit that an IC-DISC can yield is very important. If the manufacturer/producer and the seller/distributor are both pass-through entities (S corporations and/or partnerships), the qualified dividend income is directly passed through to the individual shareholders or partners. Put simply, cash is not distributed out of the business until it is distributed to the shareholders. If, on the other hand, the manufacturer/producer and the seller/distributor are C corporations, the tax benefit for the related shareholders can only be achieved by distributing cash from the business in multiple steps. After the seller/distributor pays the commission to the IC-DISC, the IC-DISC then distributes the qualified dividends to its shareholders. This could be problematic if the business is experiencing cash flow issues as the payments do actually have to be made to the IC-DISC, rather than simply being passed through in the case of an S corporation or a partnership. However, with proper planning, either structure can be utilized to yield significant tax savings.
Lastly, there are certain requirements which must be met on an annual basis for the IC-DISC to continue to qualify for treatment as an IC-DISC. These requirements include, but are not limited to, the following:
If the IC-DISC does not meet these requirements each year, it could lose the ability to qualify for treatment as an IC-DISC and the associated tax savings that accompany it.
Disclaimer: Any written tax content, comments, or advice contained in this article is limited to the matters specifically set forth herein. Such content, comments, or advice may be based on tax statues, regulations, and administrative and judicial interpretations thereof and we have no obligation to update any content, comments or advice for retroactive or prospective changes to such authorities. This communication is not intended to address the potential application of penalties and interest, for which the taxpayer is responsible, that may be imposed for non-compliance with tax law.