Benefits of Interest Charge Domestic International Sales Corporations

By Samuel Buck, CPA, AKT LLP, Lake Oswego, Ore.

Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA

Corporations & Shareholders

Taxpayers can use an interest charge domestic international sales corporation (IC-DISC) to obtain a tax incentive available to manufacturers, producers, resellers, and exporters of goods that are produced in the United States with an ultimate destination outside the United States. Taxpayers can also use IC-DISCs to defer the recognition of income related to foreign sales; however, this item focuses primarily on using IC-DISCs to reduce the income tax liability of a corporation's shareholders by converting ordinary income into qualified dividend income.

The number of IC-DISCs has seen a resurgence for a couple of key reasons. The repeal of the foreign sales corporation provisions 14 years ago and the extraterritorial income exclusion in 2005—both of which generally provided larger tax benefits—have made the IC-DISC an attractive tax incentive once again. The "fiscal cliff" in 2012 and the American Taxpayer Relief Act of 2012, P.L. 112-240, that followed it also held the qualified dividend tax rates well below the ordinary income tax rates, meaning that IC-DISCs could still be used effectively to reduce income taxes. Therefore, tax professionals will likely come across more of these when working with manufacturers or producers.

An IC-DISC reduces its shareholders' income tax liability by converting ordinary income from sales to foreign unrelated parties into qualified dividend income. An IC-DISC must be set up as a corporate entity (exempt from federal income tax under Sec. 991) separate from the related producer, manufacturer, reseller, or exporter.

Once the IC-DISC structure is in place, the related supplier can pay the IC-DISC a tax-deductible commission that is calculated based on the related supplier's foreign sales or foreign taxable income for the year. The IC-DISC then can distribute that commission to its shareholders in the form of qualified dividends under Sec. 995(b)(1). These calculations and payments are generally made once the tax year is complete and the related supplier's taxable income can be accurately determined or estimated. In this situation, the IC-DISC entity exists solely on paper and does not actually act as an intermediary between the related supplier and customer. This setup is common; however "buy/sell" IC-DISCs operate much like a distributor of goods in foreign countries. This item focuses on the former type of IC-DISC.

Who Can Benefit From an IC-DISC?

Entities that sell "export property" and are profitable can benefit from using an IC-DISC to reduce their income tax liability. Sec. 993(c) defines export property as property:

  • That is manufactured, produced, grown, or extracted in the United States;
  • That is then held for sale, lease, or rental for direct use, consumption, or disposition outside the United States; and
  • The fair market value of which is not more than 50% attributable to articles imported into the United States.

The definition focuses on the source and ultimate use of the products and not their producer. Therefore, the benefits of an IC-DISC can be extended to the exporter in the supply chain as well. For example, brewers that produce beer that is sold and ultimately consumed outside the United States can use IC-DISCs to reduce their tax burdens because they are selling export property. In addition to the brewers, the distributors that sell the beer to bars and retailers outside the United States also would be able to use an IC-DISC to reduce their tax burden because they, too, are selling export property.

Determining the Commission

Many requirements need to be followed to obtain the tax benefits of an IC-DISC. One of the first obstacles is the taxable income hurdle. If the related supplier is in a tax loss situation for the year before paying the IC-DISC commission at year end, then the IC-DISC cannot be used in this capacity because, under Regs. Sec. 1.994-1(e)(1), IC-DISCs cannot cause a taxable loss for the related supplier in any year.

Assuming that the related supplier has taxable income for the year, it can use either of two primary methods to determine the commission to be paid to the IC-DISC under Sec. 994(a): (1) 4% of the qualified export receipts, or (2) 50% of the combined taxable income of the related supplier and IC-DISC from the sale of qualified export property (generally, this would be 50% of foreign taxable income). The higher the commission to the IC-DISC, the more taxable income is converted from ordinary income to qualified dividend income. This is why there is a limit on how much commission the related supplier can pay in a given year. However, the related supplier may select the method of commission calculation that is most beneficial to it each year.

The 4%-of-gross-receipts method is less complicated since it is a straight 4% of the qualified export receipts generated by the related supplier during the tax year. Qualified export receipts as defined under Sec. 993(a)(1) include:

  • Gross receipts from the sale, exchange, or other disposition of export property;
  • Gross receipts from the lease or rental of export property used by the lessee outside the United States;
  • Gross receipts for services related to any qualified sale, exchange, lease, rental, or other disposition of export property;
  • Gross receipts for engineering or architectural services for construction projects located outside the United States; and
  • Interest on any obligation that is a qualified export asset (defined later).

This calculation method generally is used when the related supplier is selling a high volume of items with low profit margins.

The 50%-of-combined-taxable-income method requires more calculations and looks at both the related supplier's income and expenses and the IC-DISC's income and expenses, if any. To determine the combined taxable income attributable to the qualified export receipts (i.e., foreign taxable income), the principles of Sec. 861 are used to determine the source of the income and expense items for both the IC-DISC and the related supplier. The goal behind this calculation is to determine the taxable income from U.S. operations and from foreign operations. Fifty percent of the taxable income related to qualified export receipts (i.e., foreign operations) can then be used to determine the commission paid to the IC-DISC.

Under Regs. Secs. 1.994-1(c)(6)(iii) and 1.861-8, costs directly related to a specific class of income (in this case, foreign income vs. domestic income) are considered to be allocable to that class of income. Next, selling, general, and administrative (SG&A) costs that are directly related to either class or that support deductions related to either class are specifically allocated to that class. Lastly, items that cannot be directly allocated to either class are apportioned to each class based on the ratio of class receipts to the total gross receipts of the related supplier and IC-DISC. Once the domestic- and foreign-source taxable incomes are determined, the related supplier can pay 50% of the foreign-source income to the IC-DISC in the form of a tax-deductible commission. This method of determining the commission generally is used when the related supplier has a high profit margin on foreign sales.

Example. Commission expense calculation: Company A is a manufacturer of widgets in the United States and sells a portion of the widgets produced to Company C based in Canada for use in Company C's business in Canada. Company A decides to set up an IC-DISC to take advantage of the tax savings, and, after it sets up the IC-DISC, it has taxable income for the year of $100,000. The IC-DISC has no activity other than the commission received from Company A. The calculation of Company A's income is shown in Exhibit 1.


Of the $500,000 of sales, $250,000 comes from qualified export receipts. Of the $350,000 of cost of goods sold, $125,000 is directly related to qualified export receipts. The tax-deductible commission to the IC-DISC calculated under the 4%-of-qualified-export-receipts method would be $10,000 ($250,000 × 4%). Based on the information outlined above, the tax-deductible commission under the 50%-of-combined-taxable-income method would be $50,000. See the calculation in Exhibit 2.


Because the SG&A expenses are not related to either the foreign or domestic revenue, they are apportioned to each class of income based on the ratio of the specific class of sales to total sales.

Paying the Commission

Both calculation methods require the related supplier to have an idea of what taxable income for the year may be before it can calculate a commission. This makes actually paying the commission to the IC-DISC prior to the tax year end difficult. Thus, under Regs. Sec. 1.994-1(e)(3), the commission, or a reasonable estimate of the commission, can be paid to the IC-DISC within 60 days after the close of the tax year. The estimated payment does not have to equal the final commission amount once all returns are finalized, but the cash does have to move in that time frame to take advantage of the benefits and generally would have to meet or exceed the final commission amount. If the related supplier does not make the payment within the 60-day window, the IC-DISC may lose the tax benefits associated with being an IC-DISC because that receivable is not a qualified export asset, which may cause the company to not meet the qualified export asset test to be treated as an IC-DISC.

Assuming that the commission is calculated as described above and the commissions and dividends are paid out every year, there is no statutory limit on how much income can be pushed through the IC-DISC annually, aside from the taxable income limitation and the limitations inherent in the commission calculations.

Structuring the IC-DISC

To derive a tax benefit from an IC-DISC, the ownership of both the related supplier and the IC-DISC entity must be carefully structured.

IC-DISCs that are owned directly by the related supplier and structured as passthrough entities (partnerships and S corporations) are able to pass through the qualified dividend income directly to their individual partners or shareholders. Parent-subsidiary or brother-sister entity structures both work well when the related supplier is a passthrough entity. Related suppliers structured as passthrough entities, coupled with the parent-subsidiary ownership structure of the IC-DISC, work well when cash flow is a concern, because the passthrough entity pays the dividend to the IC-DISC and then receives the cash dividend back from the IC-DISC. The passthrough entity is then able to pass the character of the qualified dividend income it received from the IC-DISC up to the shareholders or partners without having to actually distribute the cash out of the company to realize the tax savings.

Related suppliers that are structured as C corporations and own IC-DISCs in a parent-subsidiary structure do not benefit from an IC-DISC in this way because those dividends do not qualify for the dividend-received deduction under Sec. 246(d). In this structure, the commission paid to the IC-DISC, and the dividend received back from it, create a tax deduction and corresponding dividend income in equal offsetting amounts.

To effectively derive a benefit from an IC-DISC in conjunction with a related supplier structured as a C corporation, the shareholders of the C corporation must also own the IC-DISC stock directly (a brother-sister entity structure). This works best when the C corporation is a closely held entity with only a few shareholders. This entity type and structure work best when cash flow is not a problem for the company or the shareholders. Since a C corporation is not a passthrough entity, the cash has to move from the C corporation to the IC-DISC and back up to the IC-DISC shareholders for them to realize the tax savings. This could potentially strip the operating company of vital capital. However, the shareholders could also turn around and loan the money back to the operating entity to remedy that problem temporarily.

Ownership Diagram

The two diagrams in Exhibit 3 show two examples of how IC-DISCs can be set up in conjunction with a related supplier that is a C corporation (left diagram) and a passthrough entity such as a partnership or S corporation (right diagram). The red arrows show the flow of the commission payments from the related supplier to the IC-DISC, and the green arrows show the flow of dividends from the IC-DISC to the related supplier/shareholders.


Setup of an IC-DISC

IC-DISCs are incorporated as C corporations and set up at the state level. An election is made to treat the entity as an IC-DISC, similar to how an S election is made. Under Regs. Sec. 1.992-2(a), the election to be treated as an IC-DISC is made on Form 4876-A, Election to Be Treated as an Interest Charge DISC, and must be filed within 90 days of the beginning of the tax year in which the election will take effect.

Once the corporation has been set up and the election has been made, assuming the entity meets the requirements to maintain IC-DISC status, all foreign sales from that point on can be used to calculate the commission payment from the related supplier to the IC-DISC. If an election is not made within 90 days, the regulations do not provide for late-filing relief, and it may be necessary to start over with a new corporate entity. However, the IRS has granted extensions of time to file the election under Regs. Secs. 301.9100-1 and -3 in private letter rulings (see Letter Rulings 201221003 and 201025043).

Requirements to Maintain IC-DISC Status

To qualify as an IC-DISC under Sec. 992(a)(1) and Regs. Sec. 1.992-1, the entity must maintain the following requirements annually:

  • 95% or more of the gross receipts the IC-DISC receives are qualified export receipts;
  • The adjusted basis of the qualified export assets meets or exceeds 95% of the total adjusted basis of all assets held by the IC-DISC;
  • The corporation maintains only one class of stock;
  • The par value of the stock is at least $2,500 for each day of the tax year;
  • The corporation maintains separate books and records; and
  • The election to be an IC-DISC described above is in effect for the tax year.

Qualified export assets under Sec. 993(b) include:

  • Export property;
  • Assets used primarily in connection with the sale, lease, or other specified activities relating to qualified export property, and in connection with performing certain services;
  • Sufficient cash required to meet the working capital requirements; and
  • Amounts on deposit in the United States used to acquire other qualified export assets, subject to the limitations of Regs. Sec. 1.993-2(j).

If an IC-DISC does not meet and maintain these requirements each year, it could lose IC-DISC status and the associated tax savings.

Planning With IC-DISCs

The IC-DISC is an often overlooked structure that can generate significant tax savings for a wide variety of taxpayers. As long as the entity has been set up according to the IRS regulations and is operated within the requirements of Secs. 991—997, there is very little risk associated with using an IC-DISC to reduce tax. Determining who or what qualifies, how to set up the entity, and how to report activity correctly is a complex task and far more detailed than can be described in this item. However, as the economy continues to pick up and manufacturers continue to sell products to foreign companies and "re-shore" their operations to the United States, the IC-DISC is a tax incentive that is likely to see more use in the future.

Editor Notes

Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or

Unless otherwise noted, contributors are members of or associated with CPAmerica International.

Tax Insider Articles


Business meal deductions after the TCJA

This article discusses the history of the deduction of business meal expenses and the new rules under the TCJA and the regulations and provides a framework for documenting and substantiating the deduction.


Quirks spurred by COVID-19 tax relief

This article discusses some procedural and administrative quirks that have emerged with the new tax legislative, regulatory, and procedural guidance related to COVID-19.