Export tax incentives after the Tax Cuts and Jobs Act

By Raymond M. Polantz, CPA, MT, Cleveland

Editor: Anthony S. Bakale, CPA

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, has caused many businesses to consider whether organizing as a C corporation is more tax-efficient than organizing as a passthrough entity, such as an S corporation or a partnership — and for good reason. Among other things, the TCJA lowered the corporate-level tax while allowing certain passthrough owners the ability to take advantage of the new 20% qualified business income (QBI) deduction.

For U.S. exporters, another critical issue is how their business structure affects their ability to benefit from certain export incentives. For many years, the primary export tax benefit available to taxpayers was through an interest charge domestic international sales corporation (IC-DISC). The TCJA, however, introduced a new export tax incentive — the Sec. 250 deduction for foreign-derived intangible income (FDII) — that is available only to domestic C corporations. Because of this, certain U.S. exporters now have an additional factor to consider in deciding which business structure is the most tax-efficient.

This discussion compares the IC-DISC and FDII regimes.

IC-DISC regime

An IC-DISC is a domestic corporation that can act as a sales commission agent for a U.S. exporter (a manufacturer or distributor) that exports certain U.S. property. The exporter creates the IC-DISC to obtain a tax incentive on certain export sales. Once the structure is in place, the exporter pays the IC-DISC a commission that is calculated based on the export sales or export taxable income for the year. The exporter is entitled to deduct the commission payment. The IC-DISC uses the commission to pay dividends to its shareholders.

While exporters can use IC-DISCs to defer the recognition of income from export sales, many exporters primarily use IC-DISCs to convert a portion of ordinary income into qualified dividend income, thereby reducing their effective tax rate on certain export income and lowering the owners' related income tax liability.

For exporters that are structured as passthrough entities, this conversion to qualified dividend income provides a tax benefit equal to the difference between ordinary tax rates and qualified dividend tax rates. Before 2018, this rate differential for passthrough entity owners was as high as 15.8 percentage points — the top individual rate of 39.6% versus 23.8% (the 20% top marginal tax rate on qualified dividends plus the 3.8% net investment income tax). The TCJA tax rate changes reduced this differential for many taxpayers to 5.8 percentage points — 29.6% effective rate after the QBI deduction (top individual rate of 37% × 80%) versus the 23.8% top rate on qualified dividends.

For exporters that are structured as C corporations, the IC-DISC benefit stems from the ability to create a C corporation deduction for income that will ultimately be taxed as qualified dividend income, thereby generating deductible dividends for a portion of the company's income. Before 2018, the benefit for C corporation owners was approximately 26% of the IC-DISC commission amount. However, the TCJA has lowered that benefit to approximately 16% of the IC-DISC commission amount.

FDII deduction

As noted above, the TCJA introduced a new export tax break, the FDII deduction. The purpose is to give U.S. corporations an incentive to export goods and services and locate intangible assets such as patents, trademarks, and copyrights in the United States. The deduction is available only to C corporations.

Computing the deduction is rather complex. Under Sec. 250, a domestic corporation can take a 37.5% deduction for its FDII, which is the foreign portion of its deemed intangible income (DII).

DII take several steps to compute: It is the excess (if any) of the corporation's deduction-eligible income (DEI) over its deemed tangible income return (DTIR). A domestic corporation's DTIR is equal to 10% of the corporation's qualified business asset investment (QBAI) (Secs. 250(b)(2)(A) and (B)). A domestic corporation's QBAI for the tax year is the average of the aggregate of its adjusted bases in depreciable tangible property as of the close of each quarter, with the adjusted basis determined using the alternative depreciation system.

To calculate FDII, the corporation multiplies DII by the ratio of FDDEI (discussed next) to DEI. FDDEI is the foreign-derived portion of DEI, consisting of any income (other than certain excluded income) that the corporation derives in connection with: (1) property sold to any non-U.S. person that the domestic corporation establishes is for foreign use (including a lease, license, exchange, or other disposition); or (2) services the domestic corporation establishes it provided to a person or with respect to property located outside of the United States. Foreign use means any use, consumption, or disposition outside the United States.

As noted, the corporation's FDII deduction is 37.5% of its FDII. The deduction generally yields a 13.125% effective C corporation tax rate on that particular income. For tax years beginning after Dec. 31, 2025, the deduction is 21.875%, yielding an effective tax rate of approximately 16.4% on that income.

Comparison

So, which export tax incentive provides taxpayers with a greater benefit, the IC-DISC or FDII deduction? What business structure is best from this perspective? These are complicated questions because there are commonalities and differences between the two regimes. Each is meant to reward U.S. taxpayers that derive income from foreign sales of a product that has a connection to the United States. However, each has its own set of rules, meaning a taxpayer's answer depends on the taxpayer's unique circumstances. As discussed below, a taxpayer seeking to maximize its benefit from export tax incentives must evaluate the following items: (1) the specific type of export income; (2) whether the property is sold through a U.S. intermediary such as a distributor; and (3) whether the threshold for the benefit is exceeded.

Specific type of export income

Whether an export tax break applies to a transaction depends partly on the specific type of export income.

Sale of property: One major difference between the IC-DISC and FDII export tax incentives is that the IC-DISC benefit covers goods only if they are produced in the United States from primarily U.S. materials.

Taking a step back, one requirement for qualifying as an IC-DISC is that at least 95% of its gross receipts are "qualified export receipts" (Sec. 992(a)(1)(A)). In the case of commission IC-DISCs, the commissions earned by the IC-DISC are generally the gross receipts derived by the principal from the underlying transaction on which the commission is based, where the underlying transaction is the sale or lease of property or the furnishing of services by the principal (Regs. Sec. 1.993-6(e)(1)). These receipts consist principally of revenues on sales and leases of "export property."

For these purposes, export property is property: (1) that is manufactured, produced, grown, or extracted in the United States; (2) that is held primarily for sale, lease, or rental, in the ordinary course of trade or business, by, or to, an IC-DISC, for direct use, consumption, or disposition outside the United States; and (3) for which not more than 50% of the fair market value is attributable to materials imported into the United States (Sec. 993(c)(1)). In other words, this benefit is available for the sale of goods manufactured in the United States from primarily U.S. materials, ultimately destined for foreign use.

In contrast, the Sec. 250 FDII provisions contain no such requirement for U.S. content or U.S. manufacturing. For sales of tangible products, the rules only require a sale of property to a foreign person for foreign use. The absence of the domestic content and manufacturing requirements means a much broader group of products are potentially eligible for FDII benefits, including those of corporations that either manufacture outside the United States or that distribute foreign-manufactured products. Neither of these export sales would qualify for IC-DISC benefits due to the requirements surrounding the U.S. manufacturing of U.S. goods.

Example 1: A C corporation that manufactures automobile parts in the United States and sells them to foreign customers is potentially eligible for both (or either) the FDII and IC-DISC benefits. However, if instead of manufacturing those parts in the United States, it manufactured the parts through its foreign branch, the taxpayer would be potentially eligible for only the FDII benefits. These sales would not be eligible for IC-DISC benefits because the U.S. manufacturing requirement would not be met.

Services: Another key difference between the two export tax incentives is that the FDII regime also covers a much wider range of eligible services.

Under the IC-DISC regime, only a narrow group of services qualifies for the benefit. The definition of qualified export receipts in Sec. 993(a) includes the following categories of service revenue:

  • Gross receipts from services that are related and subsidiary to any qualified sale, exchange, lease, rental, or other disposition of export property;
  • Gross receipts from the performance of engineering or architectural services for construction projects located (or proposed for location) outside the United States; and
  • Gross receipts for the performance of managerial services in furtherance of the production of other qualified export receipts of an IC-DISC.

A service is related to a sale or lease of export property under Regs. Sec. 1.993-1(d)(3) if:

  • The service is customarily and usually furnished with the type of transaction in the trade or business in which the sale or lease arose; and
  • The contract to furnish the service (1) is expressly provided for in, or is provided for by implied warranty under, the contract of sale or lease; (2) is entered into within two years after the date of the sale or lease contract; or (3) is a renewal of the services contract described in (1) or (2) above.

In contrast, the FDII regime covers a wider variety of services because the calculation of the deduction takes into account services the corporation provides to any person, or with respect to property, located outside the United States (Sec. 250(b)(4), discussing FDDEI). FDDEI services are divided into one of four mutually exclusive categories (Prop. Regs. Sec. 1.250(b)-5):

  • Proximate services: Services where substantially all the service is performed in the physical presence of the recipient or its employees (other than property and transportation services). The recipient of a proximate service is treated as being located where the services are performed.
  • Property services: Services provided with respect to tangible property (other than transportation services). Substantially all of the services must be performed at the location of the property and must result in physical manipulation of the property (such as through assembly, maintenance, or repair).
  • Transportation services: A service to transport a person or property using aircraft, railroad, vessel, motor vehicle, or any similar mode of transportation is considered a transportation service.
  • General services: Services that do not fall within one of the other three categories. These are distinguished further between services to a consumer and services to a business.

The FDII-eligible services described above represent a much broader array of services as compared with those eligible for benefits under the IC-DISC regime. As a result, many corporate service providers that cannot qualify for IC-DISC benefits may be eligible for the FDII deduction.

Use of intermediaries

Another important difference between IC-DISC and FDII involves the use of U.S. intermediaries such as distributors in the exporting process. Under the IC-DISC regime's "destination test," property cannot qualify as export property unless it is sold (or leased) for direct use, consumption, or disposition outside the United States. This test is met if the export property is delivered within or outside the United States to a purchaser or lessee and the property is ultimately delivered, directly used, or directly consumed outside the United States by the purchaser or lessee within one year after the sale or lease (Regs. Sec. 1.993-3(d)). In other words, IC-DISC benefits can be derived from sales to U.S. distributors that, in turn, export the property outside the United States within the prescribed time frame.

In contrast, the Sec. 250 rules provide that the FDII deduction is calculated based on FDDEI, which is any deduction-eligible income derived in connection with property that is sold to any non-U.S. person and for a foreign use (Sec. 250(b)(4)). As such, eligible sales include only direct sales from U.S. taxpayers to foreign persons (for foreign use) and do not include sales to any U.S. persons, even if the ultimate destination is outside the United States. This definition excludes taxpayers that sell U.S.-manufactured products to a U.S. distributor that then exports the products.

Example 2: A C corporation manufactures automobile parts and sells them to a U.S. distributor, which in turn resells them to foreign customers. The C corporation is eligible for IC-DISC benefits (provided the other requirements of the destination test are met) but not FDII benefits because of the requirement that the property be sold to a foreign person for a foreign use. (The U.S. distributor in this example is potentially eligible for both FDII and IC-DISC benefits.)

Threshold for benefit

When comparing the two export tax incentives, also keep in mind the threshold for the benefit. Under the IC-DISC regime, a manufacturer or distributor (i.e., the exporter) can use one of two primary methods to determine the commission to be paid to the IC-DISC: (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 (Sec. 994(a)). Both special rules can be used on the same tax return; that is, a 4% gross receipts method can be used on one transaction, and a 50% method can be used on another transaction. Furthermore, certain groupings of transactions are allowed (Regs. Sec. 1.994-1(c)(7)). Taxpayers have the ability to carefully select the method(s) and grouping(s) that will allocate the greatest amount of profits to the IC-DISC to ensure the maximum tax benefits can be derived. Although exporters do not have a specific threshold to surpass, using an IC-DISC structure requires a certain level of setup costs — namely the professional fees to create the IC-DISC, make the proper election, maintain the IC-DISC's status, and compute the proper commission amount.

By comparison, in the Sec. 250 regime the algebraic, residual formula that calculates FDII may limit some corporations' ability to derive a benefit. Even if a corporation has DEI, this income must still exceed its DTIR to generate a potential FDII deduction. As such, capital-intensive businesses and/or taxpayers that have a relatively small amount of export income may find it challenging to claim an FDII deduction.

Tax structure considerations

Because of the changes brought about by the TCJA, many exporters continue to evaluate the tax efficiency of their business structure. With potentially more taxpayers choosing to organize in corporate form, the IC-DISC regime continues to be a viable tax strategy to avoid double taxation on certain profits. While C corporations can use an IC-DISC in conjunction with the FDII benefit, the IC-DISC benefit will be more important when the corporation is unable to take advantage of the FDII deduction — either because DEI does not exceed DTIR or because the corporation's sales are not made directly to a foreign customer.

Passthrough entity owners can lower their effective tax rate through an IC-DISC structure. Certain passthrough entities may find that their exports can derive FDII benefits if they become C corporations.

To perform a complete business structure analysis, taxpayers should consider the availability of IC-DISC and FDII benefits. Each is a powerful tool for optimizing a tax structure, but which incentive is most beneficial depends on several factors, including the type of export revenue, the use of intermediaries, and the mechanics of the calculations.

EditorNotes

Anthony Bakale, CPA, is with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at tbakale@cohencpa.com.

Contributors are members of or associated with Cohen & Company Ltd.

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