Interest Charge Domestic Sales Corporation ("IC-DISC") Basics
The IC-DISC (“Interest Charge Domestic International Sales Corporation”) has been a powerful tax incentive supporting US businesses who sell products which are ultimately exported. As the fiscal cliff drama unfolded toward the end of 2012, many international tax practictioners and IC-DISC attorneys wondered whether IC-DISC benefits remain. Thankfully, the solution reached by Congress in the American Taxpayer Relief Act of 2012 has largely left this important planning opportunity intact.
An Interest Charge Domestic International Sales Corporation (IC-DISC) is a qualifying US corporation which elects to be taxed under the special IC-DISC regime at §§ 991-997 of the Code. The United States enacted the legislation for the DISC (without the “IC”) program in 1971 in order to provide an export subsidy. The legislation allowed taxpayers to channel a portion of the income that they earned from selling US made goods bound for ultimate consumption outside of the US (or for performing certain services outside of the US) into a DISC, typically by paying a deductible “commission” to the DISC. Because a DISC is not subject to tax on its earnings (until those earnings are distributed to shareholders), the tax on the portion of the taxpayer’s income sheltered by the commission could be deferred indefinitely. However, due to conflicts with U.S. trading partners who claimed that the program provided an illegal export subsidy, the DISC program was revised in 1984 to impose an interest charge on the deferred tax liability (thereafter, the “DISC” became the “IC-DISC”).
IC-DISC’s are typically paper corporations, and most IC-DISCs are structured to simply earn a commission (which is deductible by the related taxpayer), equal to a portion of the taxpayer’s gross receipts or taxable income. It is generally unnecessary for an IC-DISC to perform any functions in exchange for earning a commission. IC-DISC earnings are generally exempt from US federal income taxation at the IC-DISC level, and taxable to the IC-DISC shareholders when distributed to them.
In sum, taxpayers are permitted to deduct the commission paid to the IC-DISC against their ordinary income, and the IC-DISC is not subject to US federal income taxation on its earnings.
Tax Deferral: An IC-DISC is permitted to retain an amount of earnings each year attributable to the first $10,000,000 of gross export receipts, thus deferring taxation of these amounts. The deferred amounts are subject to an interest charge, calculated based upon the “base period T-bill rate.” This amounts to a low interest loan from the government in the amount of the deferred tax liability, and may be an attractive option to many companies in the current low-interest rate environment.
Qualified Dividend Income: IC-DISC shareholders incur tax on IC-DISC earnings when those earnings are distributed. Any earnings of an IC-DISC in excess of those attributable to the first $10,000,000 of gross receipts are deemed to be distributed by the IC-DISC in the year that they are earned. An IC-DISC can also choose to distribute its accumulated deferred earnings at any time. Businesses which operate in flow-through (partnership) form generally realize income at ordinary rates (currently up to 39.6%). Businesses which operate in corporate form pay corporate income tax at rates up to 35%. A commission paid to an IC-DISC represents a deduction to the taxpayer against this ordinary income. The commission earnings are not taxed in the hands of the IC-DISC. Then, when earnings are distributed (deemed or actually) from the IC-DISC to the taxpayer, they are characterized as dividends, which may be taxable at qualified rates (currently 15-20%).
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 US and ultimately consumed outside of the US may qualify. US 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.
IC-DISC Tax Rate Benefit in 2013 and Beyond
Although a complete repeal of the IC-DISC regime was not expected by practitioners, one significant point of contention in the fiscal cliff negotiations was the preferential rate applied to dividend income. As the differential between ordinary income rates (individual and corporate), and the individual qualified dividend rate represents one of the most significant tax advantages offered by an IC-DISC structure, companies utilizing IC-DISC structures watched the resolution of the dividend rate issue closely. Thankfully, the solution reached by Congress leaves this IC-DISC benefit largely intact.
In 2012 and prior, the highest corporate and marginal income tax rate were each 35%. The qualified dividend rate was 15%. Thus, it was fairly easy to estimate the IC-DISC rate benefit to be approximately 20%. The American Taxpayer Relief Act of 2012 left intact the preferential rate for dividend income, but raised the rate to 20% in the case of individuals with taxable income over $400,000 ($450,000 for married couples filing a joint return). However, the highest marginal ordinary income rate was also raised to 39.6% for these taxpayers, preserving an approximate 20% differential for owners of businesses operating in flow through form.
Two other important tax changes also take effect in 2013. The first is the new 0.9% Additional Medicare Tax on wage and self-employment income of taxpayers in excess of $200,000 ($250,000 for married couples filing a joint return). Thus, the effective ordinary marginal rate for many taxpayers in the highest brackets is likely at least 40.5%. The new legislation also resurrects the phase out of itemized deductions and personal exemptions for high income taxpayers, likely increasing the overall effective taxation of high income earners.
On the dividend side, in addition to the higher 20% rate for those in the top tax bracket, the new 3.8% Medicare contribution tax on excess passive income raises the effective marginal rate on dividends (including dividends from an IC-DISC) to as high as 23.8% for some taxpayers.
Although the new Medicare surtax looks to both “net investment income” as well as “modified adjusted gross income” in its calculation, taxpayers in the highest marginal bracket are likely to be subject to this tax to the extent of any dividend income.
In sum, most taxpayers in the highest brackets are likely to see a net rate benefit of approximately 16.7% (40.5% - 23.8%) on IC-DISC commissions through the use of an IC-DISC structure. However, this benefit is now more widely variable depending on individual taxpayer circumstances.
IC-DISC Tax Deferral Benefits
IC-DISC structures continue to offer the benefit of deferral. In prior years, many taxpayers caused their IC-DISCs to distribute all of their earnings in order to take advantage of the lower rates before their possible expiration. Now, with the new rate structure having no formal expiration date, many taxpayers may wish to consider retaining earnings within an IC-DISC to defer shareholder level taxation. Although deferred taxable amounts are subject to an interest charge, the interest rate charged is equal to the “base period T-bill rate,” which is an annualized rate equal to the average yield of one year constant maturity T-bills. As these rates are near historic lows (the rate for the period ending September 30, 2012 was 0.16%), the deferral benefit to an IC-DISC structure amounts to an extremely low interest loan from the government. Deferred amounts can generally be reinvested into the related operating business (subject to careful monitoring).
IC-DISC tax attorneys
IC-DISC tax attorneys at Harlowe & Falk can help you determine whether you qualify for IC-DISC tax benefits, and assist your company in the implementation and maintenance of the IC-DISC structure.
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