If your business operates outside of the United States, it’s possible that utilizing an IC-DISC could deliver significant tax savings. When a business has what are considered “qualified export sales”, an IC-DISC enables businesses to transform income taxed at potentially the highest ordinary income tax rates into that taxed at the lower capital gains rate, realizing a permanent rate savings on normal operations.
For businesses with sizable export operations, this can easily represent hundreds of thousands of dollars in permanent tax savings each year. Despite this, the IC-DISC is often an under-utilized tax strategy.
When a business expands internationally, leaders and tax advisors have a wide variety of considerations: income tax nexus, employee vs. contractor issues, VAT taxes, selecting the appropriate entity structure – the list is endless. These concerns, paired with the fact that an IC-DISC isn’t the easiest tax strategy to grasp, mean that many businesses neglect to establish an IC-DISC. In doing so, they’re potentially losing out in large amounts of tax savings.
In this overview, we will share a high-level overview of the IC-DISC and the role it plays in a broader international tax strategy. Read on to learn exactly what an IC-DISC is, whether your business may be eligible to use one, and how Smith + Howard can help you realize the tax savings this strategy may offer.
For many business leaders, an IC-DISC is not necessarily an intuitive concept to understand. Before exploring whether an IC-DISC might be a good fit for your business, it’s important to understand the basics of what an IC-DISC actually is and how it is typically used.
An Interest Charge Domestic International Sales Corporation, more commonly known as an IC-DISC, is a tax-exempt entity that functions as a sales commission agent for U.S. businesses that export goods and services internationally.
IC-DISCs are designed to function as an export incentive, enabling U.S. businesses to recognize significant tax savings on sales to international markets. The IC-DISC was created by Congress in 1984 and is enshrined in the Internal Revenue Code.
An IC-DISC essentially offers corporations with a significant export business the ability to arbitrage tax rates.
When an exporting business uses an IC-DISC, it pays the IC-DISC a commission on its export sales. This commission is recognized as an expense that can be used to reduce the exporting business’s ordinary income. The IC-DISC returns this commission to its shareholders as a cash dividend, which is taxed at a lower rate than ordinary income.
An IC-DISC is a paper entity. It is not required to own any assets other than a nominal amount of cash or have any employees: it exists solely to allow exporters of American products to achieve favorable tax treatment. This is one of the few areas of the tax code where the IRS permits this type of strategy to incentivize US companies to keep their operations mainland instead of moving overseas.
The key benefit of using an IC-DISC is that it allows shareholders of businesses to have a certain amount of their income be taxed as a qualified dividend, rather than as ordinary income.
This can offer significant tax savings. Today, the highest marginal tax rate for ordinary income is 37%, whereas dividends are taxed at a maximum of 20%: a huge delta for successful businesses with substantial levels of income flowing through to partners and shareholders.
Unlike many tax strategies, the tax benefits offered by an IC-DISC are not a timing difference, they are a permanent tax reduction that can be taken every year.
Used correctly, it’s clear an IC-DISC can be extremely valuable. That prompts the question: in what scenarios is it appropriate for a business to use an IC-DISC?
Traditionally, IC-DISCs have been used most extensively by businesses in the manufacturing and distribution industries. But the reality is that businesses in many industries are eligible to use an IC-DISC, provided certain criteria are met. This includes professional services businesses that do not export physical products.
To be an IC-DISC, 95% of an entity’s gross receipts must be qualified export receipts i.e. revenue sourced from a country outside of the United States. Additionally, over half of the final value of the exported goods or services must be attributable to U.S. activity. In practice, this means that businesses are permitted to import raw materials and components from international markets, but 50% of the fair market value of the finished product must be attributable to activities undertaken in the United States, such as manufacturing and assembly.
Related: 10 Tax Opportunities for Manufacturers
As a paper-based entity, the process of setting up an IC-DISC is relatively straightforward. The exporting business must create a new C Corporation and fund a $2,500 capital account in this new entity. This entity must register with the state, keep certain records, and file IRS Form 1120 IC-DISC each year. This return is purely informational: the IC-DISC itself does not pay any tax.
The setup process is relatively straightforward. Complexities primarily arise when it comes to calculating the commissions the IC-DISC charges the exporting business. There are multiple ways to calculate this commission: 4% of gross receipts, 50% of taxable income, or an arm’s length amount calculated using Section 482.
Businesses are permitted to use a combination of these methods. At Smith + Howard, we use sophisticated scenario analysis frameworks to analyze which method is most effective for every unique product a business exports, often analyzing tens of thousands of transactions. While this adds complexity, it often delivers incremental tax savings well in excess of any associated costs.
An IC-DISC is just one element of a sophisticated international tax strategy. There are many other components, from inbound and outbound planning to ensuring your business remains in compliance with tax laws in every country it operates.
Designing and executing a truly effective strategy to maximize shareholder returns is no light undertaking. It’s the role of tax advisors to stitch together multiple strategies and often, an IC-DISC serves as the icing on top of the cake.
At Smith + Howard, our international tax practice has significant experience advising businesses on all elements of global tax strategy, including establishing an IC-DISC. If you’re interested in learning more about utilizing an IC-DISC to optimize your business’s tax strategy, contact tax partner Chris Conrad or an advisor today.
If you have any questions and would like to connect with a team member please call 404-874-6244 or contact an advisor below.CONTACT AN ADVISOR