Export from the U.S.? Consider an IC-DISC to take advantage of the capital gains tax rate

Many exporters miss out on a lucrative tax incentive: an Interest Charge Domestic International Sales Corporation (IC-DISC). This tax strategy offers federal income tax savings for businesses that make or distribute U.S. products for export.

Could it benefit your business? Read on to learn more.

What is an IC-DISC?

An IC-DISC is a separate corporation that earns a “commission" from an operating company's export sales. The IC-DISC allows U.S. exporters to reduce their tax liability by transferring income from the operating company to the IC-DISC. The operating company pays a commission to the IC-DISC. The IC-DISC generally pays no tax on this commission income, while the operating company can claim a deduction on its books. The higher the commission, the greater the tax savings.

The commission is capped at the greater of:

•  4% of gross receipts from exports, or
•  50% of net income from exports
   

The exporter receives a deduction for the commission paid, reducing its taxable income. 

The IC-DISC is able to defer tax on up to $10 million of qualified export revenue per year. and distributes all profits to shareholders as qualified dividends. The owners of the IC-DISC pay tax on those dividends at more favorable long-term capital gains tax rates.

Depending on the individual owner's personal tax situation, their qualified dividends may be taxed at 0%, 15%, or 20%, plus a potential 3.8% net investment income tax (NIIT).
 

How to form an IC-DISC

To create an IC-DISC, you first need to form a corporation and get IRS approval to be treated as an IC-DISC. To qualify, the IC-DISC must:

• Be incorporated in one of the 50 U.S. states or the District of Columbia (Note: establishing the IC-DISC in a state without a state income tax eliminates the need to file a state income tax return)
• File an election on Form 4876-A, Election to Be Treated as an Interest Charge DISC within 90 days of forming the company
• Maintain a separate bank account and keep accounting records separate from the operating company
• Have only a single class of stock with par or stated value of at least $2,500
• Export products that are manufactured in the U.S., with less than 50% of the product's sales price attributable to imported materials
• Have at least 95% of its gross receipts be qualified export receipts
• Have at least 95% of its total assets be qualified export assets at the end of the year
   

Note that the IC-DISC does not have to have a separate office, employees, or assets. Also note that once you make an IC-DISC election, it remains in effect for future tax years until you revoke the election.

Cost vs. benefits of forming an IC-DISC

There are costs associated with creating and administering an IC-DISC, including legal fees, filing fees, and the cost of filing a separate corporate tax return. However, the benefits can quickly outweigh the costs in the right situation.

Example: International Home Decor, Inc. (an S Corporation with one owner, Jana) has net income of $1 million from its international exports. It pays a commission of $500,000 (50% of export net income) to an IC-DISC.

As a result of this commission payment, Home Decor’s net income is reduced from $1 million to $500,000. Jana reports this $500,000 taxable income on her individual tax return. Assuming Jana is in the top tax bracket and taxed at 29.6% (the top rate of 37% times 80% for the qualified business income deduction), she will pay $148,000 on this income.

However, the $500,000 of commissions paid to the IC-DISC also gets paid out to Jana, but as a qualified dividend taxed at only 23.8% (the top 20% qualified dividend tax rate plus the 3.8% NIIT). This results in an additional tax of $119,000.

While Jana would normally have paid $296,000 of federal tax on $1 million at 29.6%, she ended up paying just $267,000 by transferring half of Home Decor’s profit to the IC-DISC and paying the lower 23.8% dividend rate instead, resulting in savings of $500,000 times the 5.8% difference, or $29,000.

When used effectively, an IC-DISC can create significant tax savings and free up operating cash flow for exporters nationwide. However, navigating the complexities involved, including filing for the IC-DISC election and calculating your qualified export receipts, can be complex. For this reason, it's a good idea to discuss your potential tax savings with a qualified tax adviser.