I’ve great news for privately held companies in Indiana that currently export – resurgence of an export incentive. I recently attended a seminar co-hosted by our own Indiana District Export Council’s Tom Miller, Partner at BKD CPA’s, in downtown Indianapolis. I wanted to share with you what I learned at the seminar and through further conversations with Tom.
The Interest Charge Domestic International Sales Corporation (IC-DISC) is an incentive expanded by the Jobs and Growth Act of 2003, and is intended for small/medium sized companies. By transferring a portion of the export profits to the IC-DISC, the program reduces the taxes on those earnings from the standard individual rate of 39.6%, to a personal income tax rate of 23.8% (the highest rate) for the respective shareholders; yielding at least a 15.8% tax savings. Tax benefit may be greater depending on the income tax bracket of the respective shareholders.
Similar export incentives were discontinued in the early 2000’s as the US lost its battle with the European Union at the World Trade Organization over the Extraterritorial Income Exclusion program. At the time, the ETI program was the successor to the Foreign Sales Corporation, which in turn was a successor to the original Domestic International Sales Corporation, all of which ended largely after being determined an unfair trading practice by the WTO.
By charging interest on the export earnings funneled to the IC-DISC, Congress complies with the WTO’s regulations and rulings, and the program appears to be weathering the test of time. There is even an IRS Audit Guide for IC DISC’s suggesting the US government recognizes the legitimacy and likely longevity of this accounting instrument.
Operation –How it works:
The law allows applicable business entities to establish an IC-DISC, which effectively receives a portion of the firm’s export profits in the form of a commission, or purchase and resell of qualifying exports. There are varied ways to determine the permissible commission, but BKD breaks it down to two simple, safe-harbor methods for ease of analysis:
- Fifty percent of the combined taxable income of the related supplier (often the manufacturer) and the DISC (good if export margins are at or over 8%), or:
- Four percent of the gross receipts from the sale (usually selected when export profit is under 8%).
The above methods may be analyzed on a case-by-case basis to determine which is the more profitable. Uniformity of method used is not an IRS requirement, another selling point of this export incentive.
The benefit: The tax rate on pass-through earnings is usually 39.6% for those at highest tax bracket, and the rate on the earnings from the DISC would be about 23.8%. This makes for a savings of about 15.8%.
Tipping point/Break Even: If over $2 million in exports, 10% profit – that’s $200,000…using 50% safe harbor rule – that’s $100,000 in commission paid to the IC-DISC. So top individual rate of 39.6%, subtract 23.8% capital gain rate on the dividend income, (note the DISC itself pays no tax) for savings of $15,800. If 5% profit, doing the math suggests the harbor rule of 4% of Gross Export Receipts would be the better rule to apply and $80,000 in commission is paid to IC-DISC. Here, doing the same tax rate differential of 15.8% allows $12,640 to be saved. Obviously the higher the profit margin, the lower the break-even level of export.
It may be possible to increase the tax benefit. The above benefits assume the IC-DISC distributes its earnings and the resulting dividend is taxable to the owner at the capital gain tax rate of 20% plus the 3.8% net investment income tax. However, IC-DISCs can retain their profits, up to a point. By retaining the earnings in the DISC, the 23.8% tax is deferred, so the immediate cash benefit to the business is the full 39.6%. However, the owners would then be subject to the interest charge on the tax deferred. But that interest charge is minimal –0.1400978% for earnings deferred as of December 31, 2013. Remember that by charging interest on those export earnings, Congress makes this tax incentive acceptable to the World Trade Organization – that body politic that had determined similar prior US tax incentives as unfair. On $1 million of earnings deferred at December 31, 2013, the interest charged would be $333.
- The IC-DISC should work on the same year as the shareholders – most likely calendar year.
- Must be a US firm – usually an S Corp., LLC, any closely held company that exports, including service such as architectural and engineering firms. Also export houses and distributors may be eligible, and the manufacturer may still use the IC-DISC in these instances with proof of export.
- Exports must be over 50% US content – value of cost of foreign content divided into the total selling price.
- IC-DISC may be a company on paper only, or may be a real operating company with expenses and employee(s).
Establishing an IC-DISC requires a deposit of at least $2,500 to remain in the account. The only other deposits would be from paying the IC-DISC the export commissions based on two formulas mentioned, an estimate of which need to be paid within 60 days of the end of the year. If there are additional commissions permissible once the final tax return calculations are made, the final commission adjustment needs to be paid to the DISC within 90 days of making the final determinations. The IC-DISC needs to be set up prior to the date of any export intending to be part of this program.
Notes: There is a cost to establishing the mechanisms of an IC-DISC, so consult with BKD or your accounting firm to determine the ROI. Privately held C-Corporations may also benefit, however this segment of corporate America is not the target audience of this blog nor the ISBDC, so consult your corporate or personal tax advisors for further analysis. Indiana – allows for the IC DISC – does not tax it. Other states and even counties may treat / tax the IC-DISC differently, so again, consultation with your tax advisor is a must.