Editor: Mark Heroux, J.D.
In recent years, the IC-DISC, or interest charge domestic international sales corporation, has been considered the last tax incentive available to U.S. exporters and has generated significant federal tax benefits to IC-DISC shareholders.
An IC-DISC is a legal entity organized as a C corporation that, in most cases, is deemed to act as a sales commission agent for a U.S. manufacturer or distributor that exports U.S.-made products. For an entity to be treated as an IC-DISC for federal income tax purposes, IRS approval is required. An IC-DISC must also maintain a bank account, keep separate accounting records, and file federal (and possibly state) income tax returns. On the other hand, an IC-DISC needs no employees or offices and does not physically perform any services or participate in export sales even though it is entitled to a commission. Effectively, an IC-DISC is a shell company that creates permanent tax savings for its owners by virtue of the Internal Revenue Code and related Treasury regulations.
The allowable IC-DISC commission is generally determined by reference to qualifying export sales on a transaction-by-transaction basis, although some grouping of transactions is permitted. The amount of the commission that can be paid to the IC-DISC is calculated using one of three pricing methods:
- 4% of qualified gross export receipts (QER), plus 10% of the IC-DISC's export promotional expenses attributable to those receipts;
- 50% of the combined taxable income (CTI) generated by qualified exports, plus 10% of the IC-DISC's export promotional expenses attributable to that income; or
- Taxable income based upon the sale price actually charged but subject to the Sec. 482 transfer-pricing rules.
The federal tax benefits generated by the IC-DISC structure are recognized in the following manner:
- The U.S. exporter is permitted to calculate and pay a commission to the related IC-DISC and claim an ordinary deduction for the commission expense.
- The IC-DISC receives the commission income, which is not subject to federal tax because IC-DISCs are statutorily tax-exempt.
- The IC-DISC dividends paid to an IC-DISC shareholder (a U.S. individual taxpayer or a flowthrough entity owned by U.S. individual taxpayer(s)) are subject to federal taxation at the preferential capital gains rates.
- The difference between the tax rate benefit allowed for the ordinary deduction for the commission expense and the capital gains rate applied to the IC-DISC dividend generates a permanent federal tax rate arbitrage opportunity.
The key to maximizing IC-DISC-related tax benefits is proper structuring of the legal entities involving the export sales activity and the receipt of IC-DISC dividends by U.S. individual taxpayers. Common structures involve flowthrough entities such as partnerships, limited liability companies, and S corporations that are owned by U.S. individuals and export U.S.-made products. Because the preferential rate on IC-DISC dividends is limited to individuals, C corporations are taxed at regular rates on IC-DISC dividends. Therefore, a C corporation-owned IC-DISC offers no permanent tax rate arbitrage opportunity.
A flowthrough exporter can establish an IC-DISC that it owns directly. The commission the exporter pays to the related IC-DISC is deductible as an expense and yields a federal tax benefit to the exporter's individual owners at their applicable ordinary income tax rates. The commission income of the tax-exemptIC-DISC is treated as accumulated earnings eligible for distribution to its shareholders. The IC-DISC dividends paid to the exporter (the only shareholder of the IC-DISC) retain their character as dividends qualifying for the preferential capital gains rates and flow through to the individual owners of the exporter. Therein lies the federal tax rate arbitrage opportunity: The commission expense creates a tax benefit at ordinary income tax rates while the dividend income is taxed at the qualifying dividend income tax rate. Before 2018, that rate differential was as high as 15.8% (i.e., a 39.6% tax rate benefit for commission expense less 23.8% tax on the IC-DISC dividend income).
As a result of P.L. 115-97, the law known as the Tax Cuts and Jobs Act (TCJA), effective for 2018, the highest U.S. individual tax rate was reduced to 37% or, in certain instances, 29.6% for those receiving the new Sec. 199A qualified business income deduction; the 23.8% highest U.S. individual tax rate on qualifying dividend income remains unchanged. Note here that the rate differential could shrink to as low as 5.8%, as shown in the example.
Example: Assume the following: (1) a 4% of export sales commission rate; (2) the highest applicable individual tax rates including the net investment income tax of 3.8%; and (3) the flowthrough entity that owns the IC-DISC claims the full 20% Sec. 199A qualified business income deduction. The federal tax rate benefit for IC-DISC structures owned by S corporations in 2018 and beyond can be calculated as follows:
- S corporation shareholder tax benefit rate for commission deduction = 37% × 80% = 29.6%.
- S corporation shareholder tax rate on IC-DISC dividends received = 20% + 3.8% net investment income tax = 23.8%.
- Permanent tax rate differential = 29.6% - 23.8% = 5.8%.
This represents a significant reduction in the federal tax benefit associated with this type of IC-DISC structure and should prompt reconsideration of the continued viability of some IC-DISCs, in particular when export sales are less than $2 million. That is, the costs associated with tax compliance and maintenance of the IC-DISC might outweigh the tax benefits, which in the case of $2 million in export sales could be lower than $5,000. Affected taxpayers should reconsider whether the ongoing tax benefits of their IC-DISC will continue to exceed the costs of the structure and, if not, liquidate the IC-DISC or allow it to remain unused and dormant.
Further, another common structure involving a closely held C corporation with a sister IC-DISC may no longer provide a favorable rate differential due to the reduced corporate tax rate of 21% introduced by the TCJA. That is, the tax benefit of the IC-DISC commission deduction will be only 21%, whereas the tax rate on the IC-DISC dividend could be as high as 23.8%. In those cases, taxpayers should explore a new structure with a new IC-DISC and either liquidate the old IC-DISC or allow the old IC-DISC to remain dormant if the taxpayer believes that federal tax rates may change again in the future. The authors also expect an increased frequency of conversions of S corporations to C corporations because of the TCJA rate changes. Here again, the viability of any existing IC-DISC should be revisited.
Taxpayers are encouraged to reassess the ongoing tax benefits of their IC-DISCs due to tax rate differential changes as a result of the TCJA. Because of these changes, taxpayers may find that the tax benefits of using an IC-DISC no longer outweigh the compliance and maintenance costs associated with one.
EditorNotes
Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.
