Taking advantage of IC-DISC: How manufacturing exporters can significantly reduce their tax bill

Income tax incentives for export manufacturers have largely disappeared, but one remains in the form of the interest charge domestic international sales corporation (IC-DISC) incentive. While every other export income tax incentive has been ruled a subsidy by the World Trade Organization (WTO), and subsequently disallowed, the IC-DISC has remained. Yet many companies overlook this potentially significant source of tax savings.

How it works

The IC-DISC benefit starts with a new company set up as a C corporation that elects to be treated as an IC-DISC, a tax-exempt entity. It can have the same ownership as the export company, resulting in income tax savings for the owners. Alternatively, it can have different owners, such as the owners' children or company executives, for estate planning or bonus allocation purposes.

The operating company (the "exporter") pays a commission to the IC-DISC, computed under one of several methods based on qualified export sales. The exporter will receive an ordinary deduction for commission expense, resulting in a deduction at the highest tax rate (35 pefcent plus state tax for a corporate exporter or 39.6 percent plus state tax for a pass-through entity exporter). The IC-DISC, which does not pay income tax, will pass the commission income to its owners as a qualified dividend, taxed at a preferential maximum 23.8 percent (including the Net Investment Income Tax). The tax rate difference between the deduction claimed by the exporter and the income claimed by the IC-DISC owners results in permanent tax savings within the structure. Additionally, the IC-DISC will provide a one-year deferral of taxation on commissions derived from up to $10 million in export sales.

Who should use it

To set up an IC-DISC, a company must meet certain criteria:

• Domestically produce or assemble tangible property or resell property to others.
• Property must be exported or sold to another U.S. customer that exports it.
• More than 50 percent of product fair market value must be created in the U.S.

IC-DISCs may be available to companies that provide software, engineering, and architectural services in the U.S. as long as those services are performed for foreign projects. Many manufacturers offer services in support of their products that would qualify for this deduction.

While any size of company may set up an IC-DISC, the structure is most beneficial for closely held companies with few owners. Public companies are permitted to use them, but, given ownership and decision-making structures, it's typically not worthwhile.

Any company that sets up an IC-DISC should be sure that the expected tax savings will exceed related preparer's fees.

Making the most of IC-DISC

A recent analysis from the Journal of Accountancy estimated that nearly 12,000 manufacturing exporters had not formed an IC-DISC but could. The extra taxes paid by those companies amounts to $1 billion in foregone annual tax savings. The biggest obstacles to its use are the lack of awareness of benefits and how it works as well as the fact that many accounting firms fail to suggest it.

Two "safe harbor" methods are typically used to determine savings: 4 percent of export sales or 50 percent of net income associated with export sales. Exporters of tangible property can benefit further by optimizing the commission computation on a transaction-by-transaction basis by utilizing IC-DISC optimization software with the exporter's sales transaction data. Optimizing the commission by claiming the most favorable commission for each transaction can add hundreds of thousands of dollars in tax savings over a "safe harbor" commission calculation.

Administrative requirements

Although the potential tax savings from an IC-DISC are substantial, administrative requirements are minimal. Companies must complete the following actions:

• Create a new corporation and file an IC-DISC election. The election must be done in a timely manner because benefits only apply to sales that occur after the date filed.
• Maintain separate books and records, which can be done by the export company, its employees, and accounting firm.
• File an annual 1120 IC-DISC tax return.
• Maintain a separate bank account with $2,500 in common stock.
• There is no requirement for separate officers, location, or staff.

Given the variability in how IC-DISCs are treated under state law, companies often incorporate in Delaware even if the associated exporter is located elsewhere.

Conclusion

As the last remaining income tax incentive available to export manufacturers, an IC-DISC is an attractive tool for achieving substantial savings without substantial requirements. For eligible closely held companies, it can provide tax rate arbitrage, income tax deferral, and/or wealth transfer.

This column was co-written by Sandy Shoemaker.

EKS&H has more than 200 manufacturing clients in craft brewing, distilling, biotech, outdoor gear, and other industries. To learn how EKS&H can help your export manufacturing company achieve substantial tax savings with an IC-DISC, please contact Sandy Shoemaker at sshoemaker@eksh.com, in the EKS&H San Francisco office.