Export from the U.S.? Consider an IC-DISC to take advantage of the capital gains tax rate

Many exporters miss out on a lucrative tax incentive: an Interest Charge Domestic International Sales Corporation (IC-DISC). This tax strategy offers federal income tax savings for businesses that make or distribute U.S. products for export.

Could it benefit your business? Read on to learn more.

What is an IC-DISC?

An IC-DISC is a separate corporation that earns a “commission" from an operating company's export sales. Paying this commission allows U.S. exporters to reduce their tax liability by transferring income from the exporter to the IC-DISC through an export sales commission.

The commission is based on the greater of:

• 1.50% of export net income, or
• 2.4% of export gross receipts

The exporter receives a deduction for the commission paid, reducing their taxable income. The IC-DISC pays no tax because it is tax-exempt and distributes all profits to shareholders as qualified dividends. The owners of the IC-DISC pay tax on those dividends at more favorable long-term capital gains tax rates. Depending on the individual owner's personal tax situation, their qualified dividends may be taxed at 0%, 15%, or 20%, plus a potential 3.8% net investment income tax (NIIT).

How to form an IC-DISC

To create an IC-DISC, you first need to form a corporation and get IRS approval to be treated as an IC-DISC. To qualify, the IC-DISC must:

• Be incorporated in one of the 50 U.S. states or the District of Columbia (establishing the IC-DISC in a state without a state income tax eliminates the need to file a state income tax return)
• File an election on Form 4876-A, Election to Be Treated as an Interest Charge DISC within 90 days of forming the company
• Maintain a separate bank account and keep accounting records separate from the operating company
• Have only a single class of stock with par or stated value of at least $2,500
• Export products that are manufactured in the U.S., with less than 50% of the product's sales price attributable to imported materials

However, the IC-DISC does not have to have a separate office, employees, or assets.

Once you make an IC-DISC election, it remains in effect for future tax years until you revoke the election.

Cost vs. benefits of forming an IC-DISC

There are costs associated with creating and administering an IC-DISC, including legal fees, filing fees, and the cost of filing a separate corporate tax return. However, the benefits can quickly outweigh the costs in the right situation.

To illustrate, say a home décor company has a net income of $1 million from its international exports. It pays a commission of $500,000 (50% of export net income) to an IC-DISC.

As a result of this commission payment, the exporter's taxable income is reduced by $500,000. Since the company is an S corporation, its sole shareholder reports this income on their individual tax return. Assuming the shareholder is in the top tax bracket and taxed at 29.6% (the top rate of 37% x 80% for the qualified business income deduction), the commission results in a federal tax savings of $148,000 for the shareholder.

The $500,000 paid to the IC-DISC is paid out to the shareholder as a qualified dividend, taxed at 23.8% (the top 20% long-term capital gains rate plus the 3.8% NIIT). This results in a tax of $119,000. As a result, the shareholder receives a tax savings of $29,000 ($148,000 - $119,000).

When used effectively, an IC-DISC can create significant tax savings and free up operating cash flow for exporters. However, navigating the complexities involved, including filing for the IC-DISC election and calculating your qualified export receipts, can be complex. For that reason, it's a good idea to discuss your potential tax savings with a qualified tax adviser.