Tax Benefits for U.S. Exporters
On December 17, 2010 President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act) extending the Bush-era tax cuts, including 15 percent qualified dividend income rate, for two years. With the extension of the reduced qualified dividend rate qualifying U.S. export companies can continue to take advantage of an interest-charge domestic international sales corporation (IC-DISC) to reduce overall taxes.
Tax Benefits for U.S. Exporters
The IC-DISC tax regime gives U.S. exporters the ability to defer up to $10,000,000 dollars of income per year almost entirely tax-free. And from now through 2012, exporters that operate as S-Corporations, LLCs or closely-held C-Corporations can elect to tax this income at the 15% dividend rate – effectively converting 35% ordinary income to 15% dividend income. Basic IC-DISC benefits are easily accessed by forming a domestic C-Corporation, filing an IC-DISC election and periodically monitoring asset and income levels for compliance with export activity requirements. U.S. exporters wanting to increase the IC-DISC deferral (and dividend) benefits above the $10,000,000 level have an option of adding factoring and export outsourcing service functions to their IC-DISC.
As a threshold, to qualify for an IC-DISC the U.S. exporter must have U.S. export property, produced or manufactured in the U.S., with 50% U.S. content, that is sold to offshore customers. Setting-up an IC-DISC is designed to be very simple. It must be a C-Corporation organized under the laws of any state or the District of Columbia with only one class of stock that has a par value of at least $2,500. Shareholders file a Form 4876-A, "Election to Be Treated as an Interest-Charge DISC," with the IRS within 90 days after the beginning of the tax year. IC-DISCs do not need the typical corporate "substance" requirements – most IC-DISCs are "paper" entities and are not required to perform substantial economic functions nor have employees and office space. The IC-DISC must only maintain its own books and records separate from the export company. Despite lacking the typical substance one would expect from a corporate entity, the IC-DISC is treated as a viable entity for legal and tax purposes.
When set-up as a direct subsidiary of a U.S. S-Corporation or U.S. LLC, the IC-DISC will be able to dividend its deferred income back at 15%, thus converting 35% ordinary income to 15% dividend income. If owned through a closely-held C-Corporation, the IC-DISC should be formed under the C-Corporation’s individual shareholder to take advantage of the 15% dividend regime. Publicly-held U.S. C-Corporations will hold their IC-DISC directly and do not qualify for the 15% dividend benefits. Similarly, shareholder IRAs can hold IC-DISCs but will not qualify for the 15% dividend benefit.
The IC-DISC tax benefit comes by way of a commission payment from the exporter to the IC-DISC. The commission payment is an actual payment from the U.S. Exporter to the IC-DISC and is determined as either 4% of the U.S. exporter’s qualified export receipts or 50% of the exporter’s export taxable income (whichever is greater). The commission payment to the IC-DISC is fully deductible for the U.S. exporter and is only minimally taxable on either a deferral basis or at favorable dividend rates.
Generally, shareholders may defer up to $10,000,000 of annual commission income in the IC-DISC. If the IC-DISC defers this income, there is a shareholder level tax on the deferred tax. The tax is the interest charge—hence the term "Interest-Charge DISC"—on the deferred tax liability at the base period T-bill rate. Again, this tax is not assessed to the IC-DISC but is rather born at the shareholder level.
If the shareholders decide not to defer, the IC-DISC commission income is taxable currently to the shareholders as a dividend. Note, any commission income that exceeds the $10,000,000 annual limit is automatically taxable to shareholders as a deemed dividend. The favorable dividend rates enacted by The Jobs and Growth Tax Relief Reconciliation Act of 2003 (15% through the end of 2010) give IC-DISC individual shareholders a significant benefit—converting all commission income (whether below or in excess of the $10,000,000 limit) from 35% ordinary income to 15% dividend income.
In addition to commission income, the IC-DISC may earn other types of export-related income to increase deferral above the $10,000,000 limit. For example, U.S. exporters with up to $300,000 of export sales may sell receivables to the IC-DISC at a discount and allow the IC-DISC to earn factoring income that is deferred from U.S. tax. Similarly, the IC-DISC may perform promotion activities for the U.S. exporter and earn revenue on a cost-plus 10% basis that is also eligible for U.S. tax deferral. In addition to deferral benefits, these other types of income can be distributed back to qualified shareholders at the reduced dividend rates.
For an IC-DISC election to remain in effect, the IC-DISC must comply each year with both an Income and an Asset Management Test to assure that its activities are exclusively export-focused. Both the income of the IC-DISC and the assets on the last business day of the calendar or fiscal year must be 95% within qualified export income and qualified export asset category types. These tests must be met annually in order to maintain deferral on the IC-DISC income.
The major tax benefits of the IC-DISC to U.S. exporters are deferral of U.S. tax on up to $10,000,000 of annual commission income and on additional export-related services. This deferral can be indefinite and is only minimally taxed as an interest charge to the U.S. shareholder on the deferred tax liability. In addition to deferral, distributions from the IC-DISC are currently taxable under favorable 15% dividend rates to individual shareholders – providing a way to convert 35% ordinary income to 15% dividend income. The steps required to obtain these significant benefits are straightforward: domestic entity set-up, IC-DISC election and annual monitoring of Income and Asset levels. The IC-DISC regime’s substantial tax benefits and modest administrative costs warrant its consideration by all U.S. exporters.