Act Now: IC-DISC Rate Arbitrage Opportunity Scheduled to Expire
The Interest Charge Domestic International Sales Corporation (IC-DISC) is a federal tax incentive that may generate significant benefits for closely held companies. IC-DISC was originally created by Congress to promote export sales by allowing companies to defer up to $10 million of annual income with interest charged on the deferred tax—hence the term Interest Charge DISC.
The enactment of the Bush-era tax cuts created another substantial IC-DISC benefit realized by the tax rate differential between qualified dividend tax rates and ordinary income tax rates. This rate arbitrage benefit provides a permanent tax savings for the owners of closely held companies using an IC-DISC structure. If Congress allows the Bush-era tax cuts to sunset without modification, the rate arbitrage opportunity gained from an IC-DISC will expire at the end of 2012. Therefore, it is imperative to act now to take advantage of this permanent tax savings opportunity.
How It Works
The federal government allows U.S. companies—typically S corporations, closely held C corporations, partnerships and limited liability companies taxed as partnerships—with export sales to set up a corporation and designate it as an IC-DISC. The IC-DISC is typically a subsidiary or brother-sister corporation to the U.S. related supplier company. Most IC-DISCs are structured as a commission arrangement. Under this strategy, the U.S. related supplier company pays commission to the IC-DISC that generates an ordinary tax deduction at federal rates as high as 35 percent. The IC-DISC pays no U.S. corporate tax on the commission income. Many states also exempt IC-DISCs from taxation as well. The commissions are then distributed to owner(s) of the IC-DISC through a qualified dividend, which is taxed at rates as high as 15 percent. The end result is that the owner(s) of a U.S. related supplier company, which is treated as a pass-through entity for income tax purposes, may convert income taxed as high as 35 percent to income taxed as high as 15 percent, yielding a potential 20 percent federal rate arbitrage on IC-DISC commissions. The savings are even greater when the related supplier company is treated as a C corporation for income tax purposes.
While there are numerous nuances to the administrative pricing rules under the Internal Revenue Code and U.S. Treasury regulations, in general, the commissions may be the greater of the following:
- 4 percent of the IC-DISC’s qualified export receipts, not to exceed 100 percent of export profits
- 50 percent of the combined taxable income arising from export sales
Requirements of an IC-DISC
The IC-DISC must meet several requirements, including the following:
- The IC-DISC must be incorporated in the U.S. and have only one class of stock of at least $2,500 of par or stated value.
- The U.S. corporation must elect to be treated as an IC-DISC within 90 days of incorporation by filing IRS Form 4876-A. For any tax year other than the corporation’s first tax year, the election must be made during the 90-day period immediately preceding the first day of that tax year.
- At least 95 percent of both gross receipts and assets of the IC-DISC must be qualified export receipts/assets.
- The export goods must be manufactured, produced, grown or extracted in the U.S., and no more than 50 percent of the fair market value of the export property can be attributed to goods imported into the U.S.
- The export property must be sold or leased for direct use, consumption or disposition outside of the U.S.
Who Is a Good Candidate for an IC-DISC Structure?
There are likely a large number of U.S. companies missing out on permanent tax savings by not using the IC-DISC structure. A common misconception is that IC-DISC benefits are only available to U.S. manufacturers. While U.S. manufacturers with export sales are great candidates for an IC-DISC structure, here are a few commonly overlooked scenarios:
- Agricultural and Mineral Products – Products that are grown or extracted in the U.S. generally qualify if the products are exported.
- Distributors of U.S.-Made Goods – Distributors of exported U.S.-made goods also may qualify.
- Product Components – Components shipped out of the U.S. for further manufacturing generally qualify. This is true even if the final product returns to the U.S. under certain conditions.
- Software – Computer software licensed for reproduction outside the U.S. generally qualifies.
The IC-DISC structure offers a variety of tax planning opportunities for owners of closely held U.S. exporting companies. As mentioned above, one of the most significant IC-DISC benefits results from the tax rate arbitrage between ordinary income tax rates and qualified dividend tax rates. As the current preferential dividend rate of 15 percent is scheduled to expire at the end of 2012, it is important to act now. It should be noted that the IC-DISC must be organized before export sales can qualify for this export incentive. This increases the urgency of evaluating the IC-DISC opportunity immediately. The IC-DISC tax benefits compared to administrative costs warrant its consideration by all U.S. companies with export sale transactions.
For more information on how your company might benefit from an IC-DISC, contact your BKD advisor.