Interest Charge Domestic International Sales Corporation - A Tax-Saving Device Available to Closely-Held Exporters
Corporate & Finance Alert
July 7, 2009
Companies and their owners that export manufactured products to overseas customers may realize income tax savings by forming an interest charge domestic international sales corporation (“IC-DISC”). An IC-DISC provides a means of deferring up to $10,000,000 of export income per year almost tax-free and, at least through 2010, the ability to convert ordinary income, otherwise taxed at 35%, to dividend income taxed at 15%.
As a prerequisite, the company must be selling “export property” overseas. Export property means property:
- manufactured, produced, grown or extracted in the United States;
- held for sale, lease or rental, in the ordinary course of business, for use, consumption or disposition outside the United States; and
- not more than 50% of the fair market value of which is attributed to articles imported into the United States.
Few formalities are required in order to take advantage of the IC-DISC tax regime. A corporation must be formed under the laws of any State or the District of Columbia. The corporation must have only one class of stock and minimum capital of $2,500 (for example, 1,000 issued shares with a stated value of $25.00 per share). The owners may be the same as the owners of the exporting company, family members or key employees, depending on the company’s strategic objectives. The owners should be individuals or pass-through entities such as partnerships, limited liability companies or S corporations, so that the IC-DISC income is taxed only once.
The shareholders of the IC-DISC must file an election to be treated as an IC-DISC with the Internal Revenue Service within 90 days after the beginning of the tax year.
There is no requirement that an IC-DISC have substance in terms of assets, office space and employees. However, the company must maintain books and records separate from the exporting company. At least 95% of the IC-DISC’s gross income must consist of “qualified expert receipts.”
How The Benefits Are Realized
The exporting company and the IC-DISC should enter into a sales agent agreement under which the IC-DISC is appointed as the exporter’s agent for sale of export property outside of the United States. The income tax benefits are realized through the mechanism of a commission payable by the exporter to the IC-DISC which is deductible by the exporter and taxable to the IC-DISC owners at favorable dividend rates.
The commission is computed using one of two methods, whichever produces the higher result:
- 4% of the exporter’s qualified export receipts; or
- 50% of the exporter’s taxable income.
The IC-DISC has the option of deferring commission income attributable to qualified export receipts of the exporter of up to $10,000,000 annually. If the deferral option is elected, the IC-DISC shareholders pay a tax which is the interest charge on the tax deferral. This is the source of the name “interest charge” DISC. Currently, the interest charge is less than 1% per annum. The savings realized based upon the difference between value of the deduction of the commission expense and the “interest charge” tax is available for the exporter as working capital.
Commission income to the IC-DISC in excess of the allowed deferral amount will be automatically taxed to the shareholders as dividend income.
The IC-DISC tax regime offers various planning opportunities for the owner of an exporting company. As noted above, the most significant opportunity is the ability to extract cash from the enterprise at tax advantageous rates. While the current favorable dividend rate of 15% is scheduled to expire at the end of 2010, it will likely remain lower than the 35% corporate ordinary income tax rate.
The owner of an exporting company may also opt to incentivize management and other personnel by making them shareholders of the IC-DISC and allowing them to benefit from the additional cash flow attributable to increased export sales. Alternatively, the IC DISC may be utilized to facilitate business succession or estate planning by making family members the shareholders of the IC-DISC and allowing them to benefit from the cash flow attributable to export sales.
Finally, rather than being organized as a mere “paper” entity for receipt of commission income only, an IC-DISC may have more substance and engage in additional export-related activities such as promotional activities, thereby enhancing its income and the benefit of the advantageous tax rates to shareholders.