Many closely-held companies have customers located outside the U.S., whether they solicit sales directly or use an intermediary to do so. In competing for these customers, U.S. companies are often at an economic disadvantage because they are up against competitors who are based in the local market and are therefore subject to lower taxes on their profits.
One solution is to create an interest charge domestic sales corporation, more commonly known as an IC-DISC. It is an often-overlooked tax savings opportunity which can level out the playing field to some degree by lowering the U.S. tax paid by a U.S.-based company.
The concept of an IC-DISC is fairly simple. A U.S. corporation is formed which meets basic structural requirements to act as intermediary from a tax reporting standpoint in connection with export sales of the U.S. closely-held company. It can be owned by the U.S. company, or by the company’s owners or other parties (e.g., children or key employees in combination with the company’s owners).
The IC-DISC earns a commission on its sales, which the U.S. company can take as a deduction to lower its U.S. income tax, regardless of whether the commission is paid at the entity level or at the owner level (in the case of a pass-through entity for tax purposes). The commission is generally equal to the greater of four percent of the foreign sales or one-half of the taxable profit on such sales.
The IC-DISC pays no Federal income tax nor, in many cases, state income tax on its commission income. It distributes its earnings to its owners, creating a taxable dividend which subjects the recipients to income tax, albeit typically at a substantially lower rate than the savings realized from the commission-related deduction.
In effect, the U.S. tax on the foreign sales works out to the spread on tax rates applicable to the deduction as opposed to the dividend income. In addition, there is often a deferral on the ultimate payments of tax; i.e., there are savings in year one on the commission deduction and partial repayment of the savings in year two when the related dividend is paid.
From an estate planning perspective, when some level ownership in an IC-DISC is held by children, net cash in the form of the dividend less the lower tax rate paid on such income can pass from the older to the younger generation with no estate tax consequence.
From a compensation planning perspective, when some ownership in the IC-DISC is held by key employees, the same scenarios can result in materially greater net economic reward that would arise from a bonus or other compensation payment.
Companies with foreign customers for their products should take a closer look at an IC-DISC and with their tax advisor and assess the potential opportunity.
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