We hear often we live in a global economy. Many U.S. companies have taken advantage of the new markets for sales of their products. Many small- and medium-sized companies have benefited from these new opportunities in foreign countries. This trend is likely to continue as new free trade agreements are negotiated between the U.S. and its trading partners.
A recent check on the U.S. Department of Commerce’s International Trade Administration Web site indicates the U.S had 12 agreements covering 17 countries before the most recently ratified free-trade agreements with South Korea, Columbia and Panama.
The reduction in trade barriers for products made in the U.S. offers opportunities for U.S. manufacturers. Additionally, there may be U.S. tax benefits for closely held U.S. businesses that export goods. Many businesses are taking advantage of these benefits. In 2010 and 2011, the Internal Revenue Service released statistics that support this activity. Tax benefits may be available for U.S. businesses (typically closely-held) by using an Interest Charge-Domestic International Sales Corporation to help export transactions of a U.S. manufacturer or a provider of certain services.
The IRS statistics indicate between 2004 and 2008 (the latest year which data has been released), the number of IC-DISCs increased from 428 to 1,917. This is more than a fourfold increase in just four years. A recent review of the Michigan Corporation Division database indicates many companies in West Michigan have IC-DISCs. The actual export activity reported by IC-DISCs on tax returns was $5.27 billion in 2004 and $36.52 billion in 2008, a nearly sevenfold increase. The reported net income of the IC-DISCs increased from $448 million in 2004 to $3.17 billion in 2008, also a nearly sevenfold increase.
Statistics have not been released by the IRS for any tax years after 2008, but based on anecdotal information, the growth in the number of IC-DISCs and income generated by them has likely continued since 2008.
The IC-DISC entity is a successor to the Domestic International Sales Corporation. The DISC was used by many large U.S. businesses from 1971 to 1984. Many of the court cases that involved DISC entities for this period are names we would recognize as blue chip U.S. companies. Because of complaints by U.S. trading partners, the U.S. revamped the DISC into the IC-DISC in 1984. Many of the operating rules of an IC-DISC have their origin in the DISC operating rules.
An IC-DISC has several requirements: being organized or incorporated under the laws of a state or the District of Columbia, having all shareholders consent to the IC-DISC status, having at least $2,500 in capital, one class of shares and maintaining separate books and records, among other requirements. The IC-DISC also must meet specific requirements for its operations. These requirements include at least 95 percent of the IC-DISC’s total receipts being qualified export receipts and 95 percent of the adjusted basis of the IC-DISC’s assets being qualified assets.
The IRS statistics indicate in 2008, 86 percent of the IC-DISCs were majority owned by individuals, partnerships, trusts, estates or S corporations, all of which are generally taxed at individual income tax rates. This is important as dividends from an IC-DISC generally are eligible for the qualified dividend rate, which is tied to the long-term capital gains tax rate, since the IC-DISC is a domestic corporation. The IC-DISC pays no federal corporate income tax on the corporate net income, rather its shareholders pay income tax on the income of the IC-DISC distributed or deemed distributed under the operating rules for an IC-DISC.
The IC-DISC, in addition to the qualified dividend treatment on the income, has a deferral element for which there is an interest charge on the deferred tax, so it is possible to defer recognition of some of the income (and current taxation) earned by the IC-DISC and its shareholders. Because of the interest charge possibility, the term “interest charge” is included in the description of the entity.
Most IC-DISCs operate as a commission based entity. The IC-DISC receives a commission on the export transactions of its related business operating entity often referred to as the related supplier. The commission can be simple, or it can be complex depending on the commission method used under the regulations. Many IC-DISCs actually use the 4 percent commission method which results (as long as the net income is 4 percent or higher on the export sale), in 4 percent of the export gross receipts being paid by the exporter (the related business that has manufactured the export property) to the IC-DISC.
Many businesses that operate as an S corporation, limited liability company (LLC) or partnership actually have the business entity own the IC-DISC directly. In closely held C corporation situations, the shareholders generally own the IC-DISC directly.
As export transactions continue to grow as the world economy grows, the use of an IC-DISC for the closely held business will remain attractive if the IC-DISC distributions are taxed at the qualified dividend rate. This rate is set to sunset for tax years after Dec. 31, 2012, when the Bush era tax cuts expire. Thus, the opportunity may be limited unless the preferential rate for qualified dividends is extended. In the meantime, many businesses using the IC-DISC in their business structures may want to consider whether a different permitted commission method results in a higher potential taxable income in the IC-DISC and the distributions from the IC-DISC.
The actual operating rules are complex and intricate in many situations. The IRS recently issued its audit guide for IC-DISCs, which may be helpful in understanding the various requirements and rules and how the IRS is actually instructing its examination agents in their audits of IC-DISCs. The audit guide can be found on the IRS Web site at http://www.irs.gov/businesses/international/article/0,,id=255309,00.html
Reviewing the specific statutory and regulatory requirements for operating an IC-DISC should be done with the assistance of a professional tax adviser. As mentioned earlier, the strong growth in the use of IC-DISCs has allowed many closely held and smaller businesses to take advantage of this long dated provision of the Internal Revenue Code.
The views expressed above are those of the author and not necessarily those of BDO USA, LLP. The comments expressed above are general in nature and not to be considered as any specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult with their professional advisers before acting on any items discussed herein.
William F. Roth III is a tax partner with the local office of international accounting firm BDO LLP.