DISCount Your Federal Tax Liability
 
Written by Brian R. Tunis
As published in the Califf & Harper, P.C. August 2013 Newsletter
 
 
 
 
 
 
 
If your company is a U.S. manufacturer or supplier of exported products, an Interest Charge Domestic International Sales Corporation ("IC-DISC") may be able to significantly reduce your federal tax liability.

An IC-DISC is an entity used primarily by U.S. manufacturers and exporters to defer taxation on exported sales.  An IC-DISC is a U.S. corporation formed under the laws of any state which complies with the rules of Sections 991 through 997 of the Internal Revenue Code.  Most DISCs are subsidiaries of a related U.S. manufacturer or exporter because the DISC itself cannot be a manufacturer.

DISCs are able to defer Federal income taxation on offshore profits indefinitely.  Federal income taxes are only paid when (if ever) the earnings are distributed to its shareholders.  The only "fee" for deferring the taxation of earnings is a small "interest charge" (the IC of the IC-DISC) equal to the product of the Treasury Bill rate and the undistributed, untaxed portion of the earnings.

In order to be an IC-DISC, an entity must:

(1) Be a corporation formed under the laws of any state;

(2) Have only a single class of stock with a par or stated value of more than $2,500 on each day of the year;

(3) Not be a tax-exempt organization (section 501), a personal holding company (section 542), a financial institution (section 581), an insurance company (section 801), a regulated investment company (section 851(a), a China Trade Act Corporation (section 941(a)), or an S corporation;

(4) Make an election to be treated as an IC-DISC at least 90 days prior to the corporation's taxable year (or within 90 days of formation for a new corporation).  The election requires the consent of all shareholders of the corporation on the first day of the taxable year;

(5) Ensure 95% or more of the gross receipts of the corporation consist of "qualified export receipts" ("QER"). QER primarily means gross receipts from the sale or lease of export property or property outside the U.S., but includes other receipts such as certain interest and dividend payments stemming from sources outside of the U.S; and

(6) Ensure 95% of the adjusted basis of the corporation's assets at the end of its tax year are "qualified export assets" ("QEA").  QEA are assets that can remain on the entity's balance sheet at the end of the taxable year and includes, among other assets, accounts receivable related to QER, export property and assets, and other assets primarily used in the connection with the sale, lease rental, etc. of export property.

Now that we have gotten through the DISC requirements, it is time to get into why a DISC can be beneficial. Because DISCs are not subject to Federal income taxation, an exporter that is subject to this tax could create a DISC to shift its taxable ordinary income to the DISC to substantially reduce its tax liability.

There are two main ways to shift an entity's income to a DISC:
 
(1) a commission DISC (treated as if it were a commission agent for a principal who sold outside the U.S.); and
 
(2) a buy/sell DISC (that actually takes title to the goods and resells them outside the U.S.). 
If the entity chooses to use the commission DISC, the DISC commissions must be calculated in one of the three commission methods provided in Section 994 of the Internal Revenue Code.  If the entity chooses to use the buy/sell DISC, it must actually purchase and take title to the export property at a fair price.  Based on the requirements of each method, the commission DISC is generally the preferred method of shifting income to a DISC.

Once this income is shifted to the DISC, it remains untaxed until it is distributed to shareholders.  When the earnings are paid to shareholders and become taxable, they are taxed at the dividend tax rate, rather than the ordinary tax rate (in 2013, the highest ordinary income tax rate is 39.6% and the highest qualified dividend tax rate is 20%).  This is where the tax savings occurs. Instead of paying ordinary income rates on the entire taxable income, the DISC shareholders will pay dividend rates only on amounts distributed to them.

As an example, consider ALPHA, Inc., an S-Corporation which sells its flying discs both domestically and internationally. ALPHA, Inc., worried about incurring a large tax liability on this year's exported sales, decides that it would be beneficial for it to create a wholly-owned IC-DISC, Beta Corp.  ALPHA, Inc. will route all international sales through IC-DISC Corp.

In 2013, ALPHA, Inc. and BETA Corp. combine for $2,500,000 in domestic sales and $1,000,000 in exported sales. Using a 50% of combined taxable income commission, the combined export taxable income after commission is $500,000 ($2,500,000 less 50% DISC commission).  When this is distributed to the entity's shareholders, the deducted commission is taxed at a maximum rate of 23.8% for dividends (20% maximum rate plus 3.8% tax on investment income) rather than the maximum 40.5% provided for ordinary income (39.6% maximum plus 0.9% Additional Medicare tax).  As shown in the example below, this results in a substantial savings to the shareholders of $83,500, or approximately 6% of the original tax burden without the IC-DISC.  The greater the value of the exported sales, the greater the tax savings will be through an IC-DISC.

ALPHA, Inc. (w/o IC-DISC) ALPHA, Inc. with BETA Corp.

 

Domestic

Exported

Total

Domestic

Exported

Total

Taxable Income

$2,500,000

$1,000,000

$3,500,000

$2,500,000

$1,000,000

$3,500,000

DISC Commission Deduction

       

($500,000)

($500,000)

Taxable Income less Commission

$2,500,000

$1,000,000

$3,500,000

$2,500,000

$500,000

$3,000,000

Federal Tax at 40.5%

$1,012,500

$405,000

$1,417,500

$1,012,500

$202,500

$1,215,000

Federal Tax at 23.8% for dividends

       

$119,000

$119,000

Total tax burden to ALPHA, Inc. shareholders

   

$1,417,500

   

$1,334,000

After-tax cash available to shareholders

   

$2,082,500

   

$2,166,000

Tax savings with BETA Corp.

         

$83,500

What if instead the entity wants to retain its income rather than distributing it to its shareholders?  As mentioned above, the entity will not pay federal income on the retained income and will only pay a small interest charge.  This interest charge is the product of the Treasury bill rate and the undistributed, untaxed portion of the earnings.

In the case of BETA Corp., assume that in a few years, the year 2015, that its undistributed income is $1,000,000 and the base period T-bill rate is 1%.  As shown in the chart below, the net tax savings (at a 35% tax rate) for ALPHA, Inc. and BETA Corp. by retaining the income amounts to $340,000, approximately a 97% tax savings.

Income Retained by BETA Corp.

$1,000,000

Tax Savings at 35% Tax Rate

$350,000

1% (T-bill) interest charge

$10,000

Net Tax savings

$340,000

 
As evident by the examples above, regardless of whether you distribute income or retain income, an IC-DISC can help drastically reduce your federal tax liability.  The examples above are just some of the many possibilities for tax savings with IC-DISCs.
 
For more information on this topic please contact Califf & Harper, P.C. by calling 309-764-8300 or 1-888-764-4999. This article is intended to provide general information regarding the topic discussed herein but is not intended to constitute individual legal advice.