Tapping into Tax Benefits for Export Companies
The American Jobs Creation Act of 2004 dealt a significant blow to U.S. exporters by phasing out the tax benefits available through the "extraterritorial income exclusion" (EIE). Fortunately however, there may be a way to offset the loss of the EIE. It is based on a tax device that's been on the books since 1984 called the Interest Charge Domestic International Sales Corporation -- or IC-DISC, for short.
Corporate Requirements for an IC-DISC
For a corporation to qualify as an IC-DISC, it must:
Caveat: Although the rules for defining "export income" and "export assets" are fairly technical, the practical matter is that the 95% hurdles aren't difficult for most export companies to clear.
As originally enacted, the IC-DISC allowed exporters to defer income tax from profits on the first $10 million of export sales. Prior to the phase-out of the EIE, which was completed after 2006, the IC-DISC received scant attention in the business world. But now it's moving into the spotlight.
Best of all, the benefits of the IC-DISC arrangement are available to a wide range of business entities, including limited liability companies (LLCs), closely held C corporations, S corporations and partnerships.
How it works: The owners of an export company form a new business entity and elect to treat it as an IC-DISC for federal income tax purposes. Usually, the IC-DISC will utilize the same ownership structure as the export company (see right-hand box).
After formation of the IC-DISC, the export company enters into an agreement to pay it commissions based on qualified export sales. The commission may be determined under one of several methods approved by IRS regulations. Two common approaches are:
- A commission equal to 4 percent of the revenue of the qualified export sales; or
- A commission equal to 50 percent of the taxable income of the qualified export sales
- The commissions are deductible by the export company, while income received by the IC-DISC is exempt from tax. Of course, dividends paid out to shareholders are then subject to tax, but the maximum tax rate of 23.8 percent applies (20 percent qualified dividend tax rate plus 3.8 percent Medicare investment tax). Normally, export companies pay tax on business profits on rates up to 35 percent. Thus, IC-DISC shareholders realize benefits from the current preferential tax treatment for qualified dividends.
The IC-DISC does not have any substantive impact on the operations of the export company. It is not required to hire employees or perform any specific functions.
Both distributors and manufacturers may qualify for benefits on export sales. In fact, they can claim an IC-DISC benefit on the same export products. However, the distributor must share copies of its bills of lading with the manufacturer. In addition, the distributor cannot alter the products after completion by the manufacturer.
Obviously, this is an extremely complex area of the law. This is only a brief overview of the IC-DISC arrangement under federal income tax law. State tax consequences must also be considered. If your company might benefit from an IC-DISC, consult with your tax adviser.