The American Jobs Creation Act of 2004 dealt a significant blow to U.S. exporters by phasing out the tax benefits available through the “extraterritorial income exclusion” (EIE). Fortunately however, there is a way to offset the loss of the EIE. It is based on a tax device that’s been on the books since 1984 called the Interest Charge Domestic International Sales Corporation — or IC-DISC, for short. Prior to the phase-out of the EIE, which was completed after 2006, the IC-DISC received scant attention in the business world. But now it’s in the spotlight. Best of all, the benefits of the IC-DISC arrangement are available to a wide range of business entities, including limited liability companies (LLCs), closely held C corporations, S corporations and partnerships.
How it works:
The owners of an export company form a new business entity and elect to treat it as an IC- DISC for federal income tax purposes. Usually, the IC-DISC will utilize the same ownership structure as the export company. However, the ownership may be different as well.
After formation of the IC-DISC, the export company enters into an agreement to pay the IC-DISC commissions based on qualified export sales. The commission may be determined under one of several methods approved by IRS regulations. Two common approaches are:
- A commission equal to 4 percent of the revenue of the qualified export sales; or
- A commission equal to 50 percent of the taxable income of the qualified export sales.
The commissions are deductible by the export company, while income received by the IC-DISC is exempt from tax. Of course, dividends paid out to shareholders are then subject to tax, but the maximum tax rate of 23.8 percent applies. Normally, export companies pay tax on business profits at rates up to 40.5 percent. Thus, IC-DISC shareholders realize tax savings by converting export income, which is taxable at ordinary income rates as high as 40.5 percent, into qualified dividends generally taxed at 23.8 percent.
The IC-DISC does not have any substantive impact on the operations of the export company. It is not required to hire employees or perform any specific functions.
Distributors, software developers, and manufacturers can qualify for benefits on export sales. In fact, they can claim an IC-DISC benefit on the same export products. However, the distributor must share copies of its bills of lading with the manufacturer. In addition, the distributor cannot materially alter the products after completion by the manufacturer.
The IC-DISC is a complex area of the tax law. This is only a brief overview of the IC-DISC arrangement under federal income tax law, and state tax consequences must also be considered. The experts at Clarke, Snow & Riley, LLP can assist you to easily navigate the process. If your company might benefit from an IC-DISC, please contact Thomas Clarke at firstname.lastname@example.org.