Are you a manufacturer who exports products abroad? Are you a distributor who exports products made in the USA? Do you manufacture or sell products to other U.S. companies that export your products?
If your answer is “yes” to any of those questions, you might qualify for an IC-DISC and not even realize it. The IC-DISC is an overlooked federal income tax incentive which can provide significant tax savings to small business owners. In March 2011, Forbes reported that, “while over 6000 small and medium businesses take advantage of the tax incentives of the IC-DISC, thousands more that are eligible are failing to do so.” (Read the article here.)
What is an IC-DISC?
An “Interest Charge Domestic International Sales Corporation”, or “IC-DISC” for short, is a domestic corporation which is a separate entity from the exporter of products manufactured in the U.S. It is a federal-only tax incentive that can be utilized by individually owned manufacturers, producers, resellers or exporters of goods produced in the U.S. which are ultimately used or consumed outside of the U.S. The IC-DISC can be set up as a brother-sister entity to the exporter, where both would have common shareholder ownership. Alternatively, the IC-DISC can also be a subsidiary of the exporter.
Within 90 days of incorporation, a federal tax election is typically filed with the IRS to treat the new domestic corporation as an IC-DISC effective upon the incorporation date. The timely filing of the election on Form 4876-A makes an IC-DISC a tax-exempt entity for federal income tax purposes only.
How does the IC-DISC work?
Once implemented, an IC-DISC is deemed under U.S. federal tax rules to facilitate export sales on behalf of its related exporter, which can be an S-Corporation, a partnership or a closely-held C-Corporation. The exporter pays a sales commission to the IC-DISC for “facilitating” export sales, which is considered an ordinary expense deduction for the exporter. The IC-DISC does not have to have employees or other business activity in order to claim the tax benefits. In fact, most IC-DISCs do not have employees or business activities.
As long as the commission is paid by the exporter to the IC-DISC within 60 days of the exporter’s current year-end, the exporter can claim the commission expense deduction on that year’s tax return. For example, an S-Corporation with a calendar year-end would have to pay the commission to the IC-DISC within 60 days after December 31, 2017 in order to deduct the commission expense on its Form 1120S for 2017.
The IC-DISC subsequently records the commission income it receives from the exporter on its separate books and records, and it is not subject to U.S. corporate taxation on the income received. When the IC-DISC pays out dividends to its shareholders, they are considered qualified dividends which are taxed at the long-term capital gains rate of 20 percent (plus the 3.8 percent net investment income tax if it applies at the shareholder level).
While dividend payments can be deferred from an IC-DISC to its shareholders, this is usually not the preferred option because the tax savings potential of an IC-DISC is in the arbitrage between the tax rates on ordinary income and qualified dividends – not in the deferral of dividends. The chart below illustrates a hypothetical scenario of an exporter with $1M net profit on $5M of export sales, and assumes a commission expense of $500,000 can be paid to an IC-DISC:
As illustrated by the chart, the $79,000 in permanent tax savings results from the $500k commission being taxed to IC-DISC shareholders at a lower 23.8% tax rate rather than at the highest 39.6% individual tax rate.