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Law firm of Harlowe & Falk LLP
The IC-DISC - After the Tax Cuts and Jobs Act
The IC-DISC export tax incentive remains intact with the final version of the the Tax Cuts and Jobs Act. While the original Senate proposal would have eliminated the IC-DISC regime, the final version keeps the IC-DISC in its current form. This is a positive for U.S. companies that export. This article reviews the application of the IC-DISC after the Tax Cuts and Jobs Act.
The Interest Charge Domestic Sales Corporation (“IC-DISC”) is a powerful tax incentive used by U.S. exporting companies to reduce overall U.S. tax liability. An IC-DISC is a domestic U.S. corporation, which elects to be taxed under the special IC-DISC regime of the Internal Revenue Code. Once the election is made, the IC-DISC is not subject to U.S. tax. The IC-DISC is typically set up as a mere “paper company”, does not have any employees, nor is the DISC required to perform any functions. Therefore, no operational changes are required order to obtain the IC-DISC tax benefits.
The IC-DISC generates tax savings by allowing the U.S. exporting company to pay a commission to the IC-DISC. The commission paid by the exporting company creates a tax deduction for the export company and its owners. The commission received by the DISC is not taxable to the DISC. When the DISC company pays a dividend to its shareholders, the lower dividend rates apply . Therefore, the DISC allows a U.S. export company to cut its tax liability, based on a portion export sales.
IC-DISC’s can be utilized by many companies beyond traditional exporters. Generally, any company which sells products which are at least partially manufactured in the U.S. and ultimately consumed outside of the U.S. may qualify. U.S. businesses which perform certain services in foreign countries may also be eligible. A company does not need to export directly, so long as there is some mechanism to trace the sales to ultimate export.
Tax Benefits Under the IC-DISC tax incentive.
One thing is clear after the passage of the Tax Cuts and Jobs Act, the IC-DISC will still produce significant tax savings for U.S. companies that export products abroad. What has changed, however, is the potential expected savings that will occur with an IC-DISC structure. After the Tax Cuts and Jobs Act, the tax savings of the IC-DISC will be dependent on whether the operating company of the exporter is setup as a C Corporation or a flow through entity (a type "S" corporation, or a partnership entity taxed under sub-chapter K of the Internal Revenue Code).
IC-DISC Structure for Pass-Through Entities after the Tax Cuts and Jobs Act.
The Tax Cuts and Jobs act provides a potential change in how owners of pass-through entities are taxed. This change comes under new Section 199A of the Internal Revenue Code. Section 199A may or may not effect the overall IC-DISC benefit, depending on the application of the limitations on Section 199A.
Generally, Section 199A allows for a 20% deduction from "Qualified Business Income". If fully applicable, the Section 199A deduction could lead to a tax rate of approximately 30% for owners of the flow through entity (calculated by taking the highest marginal rate (37%), assuming a deduction of income of 20%).
If a full Section 199A deduction is available, the IC-DISC still provides a tax savings of approximately 6%. As provided above, the commission paid to the IC-DISC will create a deduction at the operating company level. This deduction should provide a tax savings of approximately 30%. The commission paid to the DISC company will not be taxable at the DISC entity level. Then, when the dividend is paid from the IC-DISC to the shareholder, the shareholder should be taxable at qualified dividend rate of 23.8% (assuming the shareholder is taxable at the highest rates).
The tax savings should be higher than 6% in many cases however, as the Section 199A limitations likely will not allow many taxpayers to deduct the full 20% from their income. The limitation that will cause the reduction in the Section 199A benefit is likely the "W-2 Limitation". The W-2 limitation generally provides that the Section 199A deduction is limited to 50% of the W-2 wages paid by the Qualified Business, or the sum of 25% of the W-2 wages plus 2.5% times the qualified depreciable property.
In the case of a pass-through entity, tax payers can expect to maintain a minimum of a 6% tax benefit with the use of the IC-DISC. In many cases however, the tax savings is likely to be much higher, as limitations provided above may not allow a full Section 199A deduction.
IC-DISC Structure for C Corporations.
For C Corporations, the Tax Cuts and Jobs Act provided several changes in the international context. One change that potentially affects the IC-DISC benefit calculation is new Section 250. Section 250 effectively creates a new preferential tax rate for income derived by domestic corporations from serving foreign markets. Generally, if applicable, a corporation pays an effective rate of 13.125 percent (rather than 21 percent) on certain income derived from foreign markets. This new deduction is described as a deduction for foreign-derived intangible income, or FDII.
The IC-DISC still provides substantial tax savings to taxpayers, even after new Section 250 and the FDII rules. Th minimum tax savings the taxpayer can expect in the context of a C corporation operating company should be 13.125%. This assumes the FDII deduction is fully allowed, which again will need to be tested an confirmed. To the extent the FDII deduction is reduced, taxpayers can expect an even higher tax savings.
The Tax Cuts and Jobs Act did not change or eliminate the IC-DISC export tax incentive, and should provide a tax savings in all cases. The savings permitted under the Tax Cuts and Jobs Act will different by taxpayer, depending on the limitations provided above. Accordingly, taxpayers should review their structure, to ensure they are able to obtain the maximum deduction under the IC-DISC regime.
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Mehrdad is a partner at the law firm of Harlowe & Falk LLP. Based in the greater Seattle area, but with clients internationally, Mehrdad's practice includes international tax consulting. This includes consulting with clients on inbound transactions, outbound transactions, mergers & acquisitions, and IC-DISC....