According to the USDA, the international exports of US processed foods and related consumed products have increased more than 61 percent since 2009. While the report includes a diverse array of fresh, prepared, and packaged products, all of them benefit from a common trend: rapid growth in global demand. With all this growth, companies that export are looking for ways to reduce taxable income.
One way to do this is by creating an interest charge domestic international sales corporation (IC-DISC). IC-DISCs were created by Congress in 1971 as a means to subsidize US exports—and the opportunity extends to agribusiness, food, and beverage companies. Prior to 2003 IC-DISCs were rarely used due to their administrative burden and complexity.
Today, for individuals, the top income tax rate on qualified dividends (including the net investment income tax) is 23.8 percent, while for ordinary income the top tax rate is 39.6 percent—not including an individual’s potential Medicare surtax or net investment income tax liability—which means a 15.8 percent rate differential still exists. Unlike many tax planning strategies that result in only a deferred payment of the tax, the use of an IC-DISC results in permanent tax savings—typically to the extent of the spread between the shareholders’ top marginal tax rates and the qualified dividend tax rates.
Ownership and Organizational Structure
An IC-DISC is a separate corporation that acts as a sales commission agent for a US agricultural, food manufacturing, or distributing exporter (the exporting entity).
In a departure from the usual substance-over-form approach to income tax law, the IC-DISC is, by design, form over substance. An IC-DISC doesn’t need employees or office space, and it doesn’t have to perform any services or participate in any sales to earn a commission. The entity is required to maintain a separate set of books and records, including a separate bank account. It may have only one class of stock and must, at all times, have stock outstanding with a par or stated value of at least $2,500.
Any type of entity or individual can own an IC-DISC. In most situations ownership should be held by an individual or flow-through entity (an LLC, partnership, or S corporation) for the greatest tax benefit. If the exporting entity is one of these pass-through entities, the IC-DISC can even be formed as a subsidiary.
However, if the exporting entity is a C corporation, the IC-DISC should be set up as a sibling to the exporting entity rather than a subsidiary, and it should generally be owned by the exporting entity’s individual shareholders.
Note that the shareholders of the IC-DISC don’t need to be the same as the shareholders of the exporting company. An IC-DISC can be used to provide a benefit to key employees or as a tool in estate and or succession planning. Consult with your tax advisor regarding the issues and risks involved with these arrangements before using an IC-DISC for key employees, estate planning, or succession planning.
An IC-DISC is also allowed to have foreign shareholders as long as the foreign shareholder agrees that any distribution (actual or deemed) is income effectively connected with a US permanent establishment.
The dividends paid from an IC-DISC to its shareholders are generally considered to be foreign-source income. This makes the use of an IC-DISC particularly valuable to US shareholders with passive foreign tax credit carryovers.
Taxation of an IC-DISC
An IC-DISC is categorized as a domestic C corporation that is tax-exempt for federal income tax purposes. However, in order to obtain this tax-exempt status, the corporation must file Form 4876-A, Election to Be Treated as a DISC, within 90 days of its first taxable year. If the corporation elects to be treated as an IC-DISC moving forward, then the election must be made within 90 days before the beginning of the first taxable year of the DISC. The election must be signed by all shareholders as of the effective date of the election. Once made, the election is effective for all subsequent years until it is revoked by the corporation.
Based on foreign sales of products manufactured, produced, grown, or extracted in the United States, the exporter pays a commission to the IC-DISC and then deducts the commission from its ordinary business income. This results in a deduction at ordinary tax rates. The IC-DISC receives the commission without having to pay federal tax on the income. In most cases the IC-DISC then distributes this cash as a dividend to its shareholders. As long as the shareholders are individuals or pass-through entities such as S corporations or partnerships, the dividend is taxed at the favorable qualified dividend tax rates.
For example, say an S corporation hops grower has domestic gross receipts of $25 million and foreign gross receipts of $15 million for a total of $40 million. The cost of growing, harvesting, drying, and bailing the hops—which will be sold both domestically and overseas—leaves the gross margin at $8 million. Take out general expenses, and the grower’s net taxable income is now $3.75 million domestically and $2 million internationally.
To determine the permanent federal tax savings using an IC-DISC, start by calculating its commission, which in this case can be either:
- 50 percent of export net income
- 4 percent of export gross receipts (limited to export net income)
We’ll go into these commission calculation methods in further detail below. In this example the first method gives us a commission of $1 million (50 percent of $2 million, the grower’s net taxable international income), and the second gives us a commission of $600,000 (4 percent of $15 million). Generally, you’ll want to choose the larger of the two amounts for the greatest tax benefit. In this case we’d choose the first, which results in a $1 million commission paid by the grower to the IC-DISC. As a result of this commission, the grower’s taxable income is reduced by $1 million. Since the grower is an S corporation, its shareholders report this income (now reduced by $1 million) on their individual income tax returns. Assuming the shareholders are in the top tax bracket (and taxed at 39.6 percent), the commission payout results in a federal tax reduction of $396,000 in total for the shareholders.
The $1 million paid to the IC-DISC is taxed to the IC-DISC’s owners (when paid or deemed paid) as a qualified dividend at the 23.8 percent rate, resulting in tax of $238,000. The difference between the ordinary income tax saved by the individual shareholders and the new qualified dividend tax liability incurred by the IC-DISC results in a tax savings of $158,000.
The IC-DISC may also choose not to pay a dividend to its shareholders. In this case an interest charge would apply to the deferred tax (hence the entity’s name). The interest charges are based on Treasury bill rates, so at this time the potential interest charges are small.
There are also deemed distribution rules related to qualified export receipts that exceed $10 million; these rules can result in shareholders being taxed on the DISC’s earnings without there being an actual distribution.
Several methods may be used to calculate the amount of commission the IC-DISC may receive:
- Four percent of its qualified export receipts, subject to export profit limitations
- Fifty percent of its combined taxable income (its export profits)
- The actual amount earned by a buy-sell IC-DISC that has employees and operations of its own
The table below demonstrates how different methods of calculating the IC-DISC’s commission can have varying tax outcomes:
Annual Maintenance of IC-DISC
Once an IC-DISC is formed, annual requirements must also be met. These requirements include:
- At least 95 percent of the gross receipts must be qualified export receipts (see below).
- A reasonable estimate of the commission must be paid within 60 days of the exporter’s tax year-end.
- An IC-DISC tax return, Form 1120-IC-DISC, must be filed annually by the 15th day of the ninth month following the close of the IC-DISC’s taxable year. (The IC-DISC’s taxable year must be the same as that of its principal shareholder.)
- The IC-DISC must maintain its own separate set of books and records.
- International boycott (Israel) operations must be disclosed.
At least 95 percent of the IC-DISC’s assets must be qualified export assets, which fall into several categories: export property, working capital (only the amount necessary for required working capital), commission receivable, stocks or securities of a related foreign export corporation, and producers’ loans. Qualified export property must be:
- Manufactured, produced, grown, or extracted in the United States
- For use or consumption outside the United States
Up to 50 percent of the fair market value of the export property can be attributable to foreign content.
Qualified export receipts include:
- The sale, exchange, or other disposition of export property
- The lease or rental of export property used outside the United States
- Related and subsidiary services
- Dividends from the related foreign export corporation
- Interest on obligations that are qualified export assets
- Engineering and architectural services for construction projects outside the United States
Sales made to US distributors and sales made to foreign disregarded entities may qualify in some cases.
Use of IC-DISCs by Cooperatives
Many cooperatives, particularly agricultural cooperatives, export their patrons’ products overseas. Cooperatives can also make use of an IC-DISC by creating a sibling entity owned by a pass-through entity (such as a partnership or trust) ultimately owned by the same members as the exporting cooperative. The dividend is paid to this pass-through entity and ultimately to the members. Cooperatives should consult with their tax advisors before setting up an IC-DISC due to the related complexity in determining a cooperative’s taxable income.
IC-DISC Audit Watch
The IRS issued an audit guide for IC-DISCs in 2012 in which it expresses particular interest in:
- Whether the IC-DISC is valid (set up and maintained properly)
- Whether export property is properly qualified
- Whether IC-DISC commissions are properly calculated
- Errors on the IC-DISC return
Until recently, many businesses have reaped the benefits of using an IC-DISC without the proper documentation or support—so beware that is the exact issue the IRS is looking for.
The Future of IC-DISCs
Because the American Taxpayer Relief Act of 2012 permanently extended federal tax rates on qualified dividends to a maximum of 20 percent (plus the 3.8 percent net investment income tax, when applicable), the question of whether IC-DISCs will remain useful appears to be settled: For now, companies selling products for use or consumption outside the United States that do not currently have an IC-DISC should review the potential benefits of using one.
Contact your Moss Adams professional to learn whether setting up an IC-DISC may be beneficial to your organization.