I always loved the old Coca Cola commercial sung to the catch jingle “It’s a Small World” demonstrating the appeal of Coca Cola to all people around the globe. I think the same can be said about the idea of having to pay a government anywhere a dollar more in taxes than you have you to pay. The world is smaller and apparently getting smaller as a result of technological innovation and communication. Maybe it is because the world really is flat but not taxed with a flat tax rate.
It is no longer large multi-national corporations that are doing business around the world. Small businesses are exporting products and services and competing for business outside of the United States and around the globe. Maybe this has always been well known but Uncle Sam will reward the business owner with rich tax incentives to export American products and services around the globe. The Interest Charge Domestic International Sales Corporation or IC-DISC is a powerful planning tool for the owner of a closely held business.
If you were wondering if there was a way to convert a substantial portion of your taxable income export sales to tax-exempt income with a minimal amount of current taxation while reinvesting on a tax-free basis with minimal annual tax leakage and taking corporate distributions at a preferential dividend rate, the answer is “Yes”. I also forgot to mention that the business owner might also own the shares outside of his taxable estate.
An interest charge domestic international sales corporation ("IC DISC") is the successor to the Foreign Sales Corporation and extra-territorial income inclusion that Congress had previously authorized to provide export incentives to U.S.-based exporters.
The tax incentives are designed to provide the closely held business owner with the ability to defer tax recognition from export sales that would otherwise be taxable based upon the operation of Sub-Part F - Controlled Foreign Corporation (CFC) rules. The legislative intent with a strong focus on manufacturing companies was that the export tax incentives would assist the parent corporation to maintain manufacturing operations in the U.S.
The CFC rules are generally designed to prevent a U.S. business from using corporations in low tax jurisdictions to defer the recognition of taxable income for U.S. purposes. The CFC rules provide for current taxation of the CFC's earnings and profits as an imputed dividend to shareholders on a pro rata basis, taxed at ordinary income rates. The IC DISC provides an excellent planning mechanism to defer the income from these export services.
Federal taxes on the export-related income are deferred until the income is distributed or deemed distributed. The IC DISC shareholder is required under IRC Sec 995(f) to pay interest at the applicable federal rate, calculated on the amount of tax deferred by the shareholder assuming the export related income would be taxed to the shareholder as ordinary income.
The IC DISC provisions provide that the IC DISC, itself, is not subject to taxes imposed by subtitle A (Income Taxes) at the federal level but is subject to state level corporate taxation based upon the domicile of incorporation. Instead the tax effect of transactions through an IC DISC, generally, would fall on the shareholders of the IC DISC. The IC DISC provides for meaningful long term deferral from foreign export sales.
The IC DISC allows business income that would be treated as CFC dividends taxed at ordinary rates to be recharacterized as qualified dividend income when ultimately distributed to shareholders. The lower individual tax rate on qualified dividend distributions (20 percent) is significantly lower when compared to ordinary income tax rates - 39.6 percent federal plus state level taxation.
Generally two types of IC DISCs are used:
Buy/Sell IC DISC - A buy/sell IC DISC is a corporation that actually takes title to the goods it resold outside the U.S.; and
Commission IC DISC - A commission IC DISC is a corporation that is treated as if it were a commission agent for a principal (Blue Island) who sold outside the U.S. The Commission IC DISC has historically been the more popular vehicle used for export sales.
A single IC DISC can accommodate both buy-sell transactions and commission transactions, although it is rare. Alternatively, an IC-DISC can also act as an active operating company which may provide an ability to capture more income within an IC-DISC.
An IC DISC generally determines its income on a transaction-by-transaction basis or if so elected could determine income on groups of transactions. Transactions can also be tracked on a transaction-by-transaction basis as well as group IC DISC transactions.
The IC DISC’s income is based on one of the following three pricing methods:
Four percent of qualified export receipts (“QER”) plus 10 percent of the IC DISC’s export promotional expenses attributable to such receipts;
50 percent of combined taxable income (“CTI”) plus 10 percent of the IC DISC’s export promotional expenses attributable to such income; or
Taxable income based upon the sale price actually charged but subject to the transfer pricing rules under IRC § 482.
These pricing methods provide caps on the IC DISC tax benefits. The taxpayer is not required to use the method producing the greatest tax benefit. The taxpayer is permitted to claim tax benefits less than the amounts calculated using the four percent QER or 50 percent combined taxable income methods. In addition to a choice of method, the IC DISC also had the option of determining income under each method on a full costing or a marginal costing approach.
Tax Summary of the IC- IC DISC Rules
IRC § 991 provides that an IC DISC is not subject to federal income taxes. Treas. Reg. § 1.991-1(a) reaffirms the non-tax status of the IC DISC for income taxes. An IC DISC may be liable for other taxes that are applicable to a corporation, such as taxes withheld at the source, employment taxes, interest equalization taxes and excise taxes.
Prop. Treas. Reg. § 1.991-1(a) provides that after 1984, the IC DISC shareholders are required to pay an annual interest charge on the shareholders’ IC DISC related deferred tax liability. The interest charge is imposed on the shareholder and not the IC DISC. Treas. Reg. § 1.991-1(b) provides rules for determining the taxable income of the IC DISC, including methods of depreciation, inventory methods, the choice of accounting methods and the choice of the annual accounting period, etc. All taxable income elections for the IC DISC must be made by the IC DISC.
The Form 1120 IC DISC return must be filed on or before the 15th day of the ninth month following the close of the IC DISC taxable year. The Internal Revenue Code and Treasury regulations do not provide for an extension of time to file the return.
When filing its first tax return and all subsequent filings, an IC DISC must use the same annual accounting period of its principal shareholders.
IRC § 992(a) and Treas. Reg. § 1.992-1(a) provide that the term “IC DISC” means, with respect to any taxable year, a corporation which is incorporated under the laws of any State or the District of Columbia, and satisfies the following conditions for the taxable year:
Qualified Export Receipt Test – Ninety-five percent or more of the “gross receipts” (as defined in IRC § 993(f)) must consist of Qualified Export Receipts (QER) as defined in IRC § 993(a).
Qualified Export Asset Test - The adjusted tax basis of the “qualified export assets” as defined in IRC § 993(b) of the corporation at the close of the taxable year must equal or exceed 95 percent of the sum of the adjusted basis of all assets of the corporation at the close of the taxable year.
One Class of Stock Requirement - The IC DISC must have only one class of stock and the par or stated value of its outstanding stock must be at least $2,500 on each day of the taable year.
IC DISC Election - The corporation must have made an election to be treated as an IC DISC and that election must be in effect for the taxable year. The IC DISC election is made using Form 4876A.
IRC § 992(b) and Temp. Treas. Reg. § 1.921-1T(b)(1) provide specific rules for when and where this election is to be filed. Existing corporations may make the election at any time during the 90-day period that immediately precedes the beginning of the taxable year. New corporations must make the election within 90 days after the beginning of the taxable year.
The taxable year of the IC DISC must be the same as the taxable year of the principal shareholder which, at the beginning of the IC DISC taxable year, has the highest percentage of voting power.
If two or more shareholders have the highest percentage of voting power, the IC DISC must have a taxable year that conforms to any one taxable year of the principal shareholders.
All shareholders of the IC DISC must consent to the IC DISC election. Treas. Reg. § 1.992-2(b) provides rules for the proper filing of the consents. Failure to make the election on time will result in the IC DISC not qualifying as an IC DISC and the loss of IC DISC benefits.
If taxpayer failed to make a timely election, please verify if taxpayer has requested or been granted relief for such late filing under Treas. Reg. §§ 301.9100-1 and 301.9100.
The IC DISC must maintain a separate set of books and records.
Economic Substance - Unlike any other corporation, the IC DISC is not concerned with the performance of any activities and, therefore, does not need employees or office space and does not have to actually participate in the soliciting, negotiating or concluding of any sales contract or perform any economic functions to earn a commission.
Treas. Reg. §1.992-1(a) explains that the IC DISC tax rules are intended to relax the rules of corporate economic substance otherwise applicable under the Internal Revenue Code. These rules limit the ability of the IRS to enforce the transfer pricing rules of IRC § 482.
The IC-DISC rules like all of the tax rules are complex. The IC-DISC strategy itself may not be too widely known but from the perspective of the closely held business owner engaged in export sales, it provides extremely strong tax benefits that provide tax reduction and deferral in a manner that far exceeds a qualified retirement plan.
In fact, the tax treatment is arguably better than a qualified retirement plan, i.e. (1) the ability to have the IC-DISC owned outside of the taxable estate of the business owner. (2) Distributions as dividend income at preferential rates versus ordinary income for qualified plans (3) Minimal tax cost or leakage during the accumulation phase.
Like many strategies, the IC-DISC may not be for everyone but it is for someone. My goal is to circulate basic information on the IC-DISC so that advisors and their clients have one more reduction and deferral strategy to consider.
Don’t forget to count your blessings today!