IC-DISCs: The Impact of Pending Legislation?
Interest charge domestic international sales corporations (IC-DISCs) have gained popularity in recent years among closely held businesses due to the elimination of other export incentives and the enactment of favorable tax rates.
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRA), non-corporate shareholders of IC-DISCs are eligible for a 15 percent tax rate on qualified dividends while commisssions paid to the IC-DISC by the related exporter, and which are the source of the dividends, generate an ordinary income deduction at a 35 percent tax rate.
IC-DISCs now face an uncertain future. The favorable tax rates under JGTRA sunset for tax years beginning in 2011. Consequently, non-corporate shareholders will be subject to tax at ordinary income rates and the benefits of an IC-DISC will largely be eliminated. However, proposed legislation may give the IC-DISC a new life. The Obama Administration’s fiscal year 2010 budget proposals would continue this benefit to IC-DISC non-corporate shareholders with a preferential 20 percent tax rate on dividends . With the uncertainty of future tax legislation, taxpayers with IC-DISC structures should continue to monitor these developments and be prepared to act defensively in the event that rates are allowed to increase. Specifically, IC-DISC distributions should be considered to lock-in the preferential dividend rate on accumulated IC-DISC earnings in advance of a possible increase in tax rates. The formation of a new IC-DISC may still be warranted to take advantage of the current low tax rates.
Background
The United States and its trading partners have enacted a variety of export tax incentives that have fallen victim to attacks as illegal export subsidies. IC-DISCs came into existence in 1984 and have survived largely unscathed. The benefits of IC-DISCs are subject to an annual ceiling tied to $10 million of qualified export receipts. Until the favorable rates were enacted in 1993, the only benefit of an IC-DISC was tax deferral. Despite the benefits, the IC-DISC structure is not widely used. Specifically, public companies and widely-held private corporations (usually taxable as C corporations) are not eligible for the preferential rate on dividends from IC-DISC subsidiaries and it is impractical for them to have shareholder-owned IC-DISCs. Thus, the primary benefits currently accrue to closely held businesses engaged in exporting qualifying property. The aggregate subsidy to this group of businesses is not large enough to have attracted the attention of U.S. trading partners.
How Does It Work?
IC-DISCs are domestic corporations that are typically formed by a related party manufacturer (which can be a regular corporation or a pass-through entity) or its shareholders or partners. The IC-DISC is not required to have employees, maintain an office or have tangible assets, but must satisfy a number of technical requirements such as an asset test and a gross receipts test. In addition, the property of the related party supplier must satisfy a U.S. content requirement to be considered qualified exporting property. The IC-DISC receives a commission on qualified export receipts of a related party manufacturer, which in turn claims a deduction for the commission paid. IC-DISCs are not taxed on the commission income received, but instead their shareholders are taxed as they receive or are deemed to receive distributions. Distributions to an individual shareholder of the IC-DISC are generally taxed at the preferential rate for qualified dividends. An interest charge (at a very low rate) on deferred IC-DISC income is imputed to the extent that distributions are below the deferred income attributable to $10 million of qualified export receipts. The concept of tax deferral is a key component of the tax policy objectives behind the development of the IC-DISC provisions.
Example
U.S. Corporation X, an S corporation is engaged in the manufacture of qualified export property. The shareholders of X own 100 percent of an IC-DISC. In 2009, X generated $1,000 of qualified export receipts, paid the IC-DISC a $100 commission calculated under the IC-DISC rules, and the IC-DISC distributed $80 to its shareholders, retaining $20 for IC-DISC expenses such as advertising and export promotion. As a result, X shareholders’ recognize a federal tax benefit of $35 relating to X’s commission expense deduction and pay $12 tax on the qualified dividend from the IC-DISC. An interest charge (at a very low rate) would be imposed on the undistributed $20 of IC-DISC earnings that were not distributed, but retained for future IC-DISC business requirements.
Considering that IC-DISCs are relatively simple to form and administer, they can be an attractive option for any closely held business that generates qualified export receipts. The primary caveats are that the IC-DISC must be properly maintained under the IC-DISC technical tax provisions and that the uncertain tax legislature environment must be carefully monitored. Further, taxpayers should consider the interplay of relevant state income tax provisions before creating an IC-DISC.
As indicated, both the JGTRA sunset and the Administration’s budget proposal would increase the tax rate on IC-DISC dividends. Independent legislation has also previously been introduced to eliminate the preferential tax rate on IC-DISC dividends. These various proposals create an uncertain legislative environment that necessitates careful planning. As a consequence, Taxpayers with IC-DISCs should consider making distributions, as otherwise appropriate, from the IC-DISC in the event legislation is not enacted to preserve the current favorable tax rate enjoyed by non-corporate IC-DISC shareholders.
