Updated August 2018 to reflect changes to tax legislation.
According to the USDA, food products have been one of the highest-valued exports since 2013—contributing to the strongest five-year period for agricultural exports in US history. In 2017 alone, food exports climbed to more than $138.4 billion.
While the USDA report includes a diverse array of fresh, prepared, and packaged products, all of the products reflect a common trend: continued growth in global demand. With all this growth, companies that export goods are looking for ways to reduce taxable income.
Reducing an Export Company’s Taxable Income
One way export companies can reduce taxable income is by creating an interest charge domestic international sales corporation (IC-DISC).
With this strategy, the exporter—an S corporation, LLC, partnership, or closely held C corporation—pays commissions to the IC-DISC, which is owned by the exporter’s shareholders or partners. The commissions are deductible by the exporter for US federal income tax purposes, and the IC-DISC is treated as a federally exempt entity.
While recent tax reform legislation, often referred to as the Tax Cuts and Jobs Act of 2017 (TCJA), made significant changes to the US tax system, an IC-DISC can still provide tax benefits to US food, beverage, and agribusiness exporters.
The top income tax rate on qualified dividends for individuals, including the net investment income tax, is currently 23.8%. For ordinary income, however, the top tax rate is 37%—not including an individual’s potential Medicare surtax or net investment income tax liability. This means a maximum of 13.2% rate differential still exists.
Unlike many tax-planning strategies that merely result in deferred tax payments, an IC-DISC can provide tax savings that are permanent—typically to the extent of the spread between the shareholders’ top marginal tax rates and the qualified dividend tax rates.
Ownership and Organizational Structure
In a departure from the usual substance-over-form approach to income tax law, the IC-DISC is, by design, form over substance. An IC-DISC doesn’t need employees or office space, and it doesn’t have to perform any services or participate in sales to earn a commission.
However, the entity is required to maintain a separate set of books and records, including a separate bank account. It may have only one class of stock, and it must, at all times, have stock outstanding with a par or stated value of at least $2,500.
Changes Due to the TCJA
Prior to the TCJA, taxpayers could reduce their tax rate by as much as 19.6%. Following the passage of TCJA, the benefit has been limited due to the reduction in tax rates and the potential 20% deduction for pass-through entities—resulting in an effective reduction of only 5.8%.
However, the new potential pass-through income reduction is limited to taxable income of less than $157,500 for individuals and $315,000 for married taxpayers—and it only relates to certain types of income. This means the reduction may not be as significant as first thought.
Mechanics of the IC-DISC
If the exporting entity is a C corporation, the IC-DISC should generally be set up as a sibling to the exporting entity rather than as a subsidiary, and it should generally be owned by the exporting entity’s individual shareholders. With IC-DISCs, it’s also important to take into account the new foreign-derived intangible income deduction for C corporations that was included under the TCJA.
It’s worth noting that the shareholders of the IC-DISC don’t need to be the same as the shareholders of the exporting company. An IC-DISC can be used to provide a benefit to key employees or as a tool in estate and/or succession planning. Consult with your tax advisor regarding the issues and risks involved with these arrangements before using an IC-DISC for any of these purposes.
An IC-DISC is also allowed to have foreign shareholders as long as the foreign shareholder agrees that any distribution—actual or deemed—is income effectively connected with a US-permanent establishment.
The dividends paid from an IC-DISC to its shareholders are generally considered to be foreign-source income. This makes the use of an IC-DISC particularly valuable to US shareholders with passive foreign tax credit carryovers.
Taxation of an IC-DISC
An IC-DISC is categorized as a domestic C corporation that’s tax-exempt for federal income tax purposes. However, in order to obtain tax-exempt status, the corporation must file Form 4876-A, Election to be Treated as an IC-DISC, within 90 days of its first taxable year.
If the corporation elects to be treated as an IC-DISC moving forward, the election must be made within 90 days before the beginning of the first taxable year of the IC-DISC. It must then be signed by all shareholders as of the effective date of the election. Once made, the election is effective for all subsequent years until it’s revoked by the corporation.
Based on foreign sales of products manufactured, produced, grown, or extracted in the United States, the exporter pays a commission to the IC-DISC and then deducts the commission from its ordinary business income. This results in a deduction at ordinary tax rates. The IC-DISC then receives the commission without having to pay federal tax on the income.
In most cases, the IC-DISC then distributes this cash as a dividend to its shareholders. As long as the shareholders are individuals or pass-through entities, such as S corporations or partnerships, the dividend is taxed at the favorable qualified dividend tax rates.
For example, say an S-corporation-hops grower has domestic gross receipts of $25 million and foreign gross receipts of $15 million for a total of $40 million. The cost of growing, harvesting, drying, and bailing the hops—which will be sold both domestically and overseas—leaves the gross margin at $8 million. After general expenses, the grower’s net taxable income is $3.75 million domestically and $2 million internationally.
To determine the permanent federal tax savings using an IC-DISC, start by calculating its commission, which in this case can be either of the following:
- 50% of export net income
- 4% of export gross receipts, limited to export net income
In this example, the first method provides a commission of $1 million (50% of $2 million, the grower’s net taxable international income), and the second gives us a commission of $600,000 (4% of $15 million). Generally, you’ll want to choose the larger of the two amounts for the greatest tax benefit. In this case, we’d choose the first, which results in a $1 million commission paid by the grower to the IC-DISC.
As a result of this commission, the grower’s taxable income is reduced by $1 million. Since the grower is an S corporation, its shareholders report this income (now reduced by $1 million) on their individual income tax returns. Assuming the shareholders are in the top tax bracket—and taxed at 29.6%, which is the top rate of 37% multiplied by 80%**—the commission payout results in a federal tax reduction of $296,000 for the shareholders.
The $1 million paid to the IC-DISC is taxed to the IC-DISC’s owners—when paid or deemed paid—as a qualified dividend at the 23.8% rate, resulting in a tax of $238,000. The difference between the ordinary income tax saved by the individual shareholders and the new qualified dividend tax liability incurred by the IC-DISC results in a tax savings of $58,000.
**This 80% assumes the full benefit for pass-through entities of the newly enacted 20% Quailed Business Income tax deduction (Internal Revenue Code Section 199A).
The IC-DISC may also choose not to pay a dividend to its shareholders. In this case, an interest charge would apply to the deferred tax—hence the entity’s name. The interest charges are based on US Treasury bill rates, so at this time, the potential interest charges are small.
There are also deemed distribution rules related to qualified export receipts that exceed $10 million. These rules can result in shareholders being taxed on the IC-DISC’s earnings without there being an actual distribution.
Several methods may be used to calculate the amount of commission the IC-DISC may receive, including the following:
- 4% of its qualified export receipts, subject to export profit limitations
- 50% of its combined taxable income, or export profits
- The actual amount earned by a buy-sell IC-DISC that has its own employees and operations
The table below demonstrates how using different methods to calculate the IC-DISC’s commission can have varying tax outcomes.
Use of IC-DISCs by Cooperatives
Many cooperatives, particularly agricultural cooperatives, export their patrons’ products overseas. Cooperatives can also make use of an IC-DISC by creating a sibling entity owned by a pass-through entity—such as a partnership or trust—that’s owned by the same members as the exporting cooperative.
The dividend is paid to the pass-through entity and ultimately to the members. Cooperatives should consult with their tax advisors before setting up an IC-DISC due to the complexity in determining a cooperative’s taxable income.
Factor Accounts Receivable
Factoring accounts receivable (AR) through an IC-DISC often results in additional tax savings. It allows a company to increase its qualified export revenue and, as a result, the income it can ultimately pay out as dividends.
Under the tax code, qualified export revenue includes interest on any obligation that’s a qualified export asset. Income earned through a factoring arrangement is treated as interest, and qualified export assets include AR that results from a qualified export sale.
When an exporter and its IC-DISC enter an AR-factoring agreement, the exporter sells its AR at a discount to the IC-DISC. The IC-DISC recognizes the discount as interest income, and the exporter is then able to deduct the loss that results from the sale of its AR.
As a result, the AR-factoring agreement increases the IC-DISC’s qualified export revenue, which isn’t subject to federal tax, and reduces the income of the exporter. It’s worth noting that while this arrangement may seem underhanded, the IRS agrees with the classification of these transactions, and the above positions are supported through a revenue ruling.
IC-DISC Transaction by Transaction Method
Depending on the nature of your business, you could increase your tax savings by reviewing each transaction through a series of computations to determine the transactional data. That data is then run through a series of algorithms that determine the maximum allowable commission, calculating the allowable calculation combinations and selecting the greater option. By looking at each transaction separately, the results may yield a higher commission than what was originally calculated.
We’re Here to Help
Tax-rate reductions introduced by the TCJA have limited the overall benefit IC-DISCs provide to a company. However, they can still create significant tax-savings opportunities.
To learn more about how to implement an IC-DISC, quantify potential annual tax savings, or explore advanced planning opportunities—such as AR factoring or IC-DISC transactional analysis —contact your Moss Adams professional.