Export Incentives for Small Companies
Over the past decade, Congress has repealed many of the tax incentives designed to encourage exports. The latest casualty was the Extraterritorial Income Exclusion (“ETI”), which was repealed in 2006. However, the Interest Charge Domestic International Sales Corporation (“IC-DISC”) remains a viable export tax incentive that allows small and mid-sized exporters to drastically reduce the rate at which their income is taxed. Over the past two years, Congressional initiatives to amend or abolish the IC-DISC have failed, and it appears that it will continue to exist as one of the few remaining incentives designed to stimulate domestic export growth. It is essential that export companies be aware of the IC-DISC and the potential benefits and savings it can offer.
The IC-DISC was added to the tax code in 1984, and is essentially a paper entity that can be utilized as a tax-savings vehicle. Basic requirements of this type of corporation are that it may have no more than one class of stock, and a minimum value of $2,500. To create the corporate entity, the shareholders simply file a form, Form 4876-A, with the IRS. The overwhelming majority of users of IC-DISCs are small business exporters, because the IC-DISC only allows for a maximum of $10 million in profit to be taxed at a lower rate. Shareholders of an IC-DISC can be corporations, individuals, or a combination of both.
An IC-DISC is quite simple in operation. After an IC-DISC is created, the owner-export company can pay up to 50% of its profits from export sales as a commission to the ICDISC. This amount is tax deductible, thus, half of the profits are not taxed at the corporate tax rate of 35%, and go directly into the IC-DISC. The IC-DISC then distributes this commission, at least annually, as a dividend to its shareholders. The shareholders of the IC-DISC are usually comprised of the shareholders of the parent export corporation, or the parent corporation itself. This income distributed by the ICDISC is not taxed at the corporate rate of 35%; instead it is taxed as a dividend at 15%, resulting in a 20% tax savings. It allows up to half of a company’s profits from export sales to be taxed at this lower rate, resulting in significant savings for the shareholders. This money can be kept by the individual shareholders, or reinvested in the parent export company to facilitate growth.
An example will help to illustrate the usefulness of the IC-DISC. If an export company brings in $2 million in profits from sales, it could pay $1 million (50% of the net profits) to the IC-DISC as a commission. Instead of these profits being directly taxed at 35%, resulting in an expense of $350,000, the $1 million is distributed to shareholders as a dividend, and taxed at only 15%. This results in an expense of only $150,000 in taxes, and results in savings of $200,000 on $2 million in income. As shown on the chart below, an IC-DISC allows the exporting company to save up to $100,000 per $1 million generated in profits. Again, it is important to note that up to only $10 million can be paid as a commission to an IC-DISC, and therefore, it is not a viable option for large exporters generating hundreds of millions of dollars in income.
There have been multiple initiatives introduced in Congress over the past two years with an aim at abolishing the IC-DISC; however, these have been unsuccessful. A 2006 initiative to amend the tax code and eliminate the IC-DISC did not pass. In 2007, a provision was initially included in a tax reform bill that would have raised the tax rate on IC-DISC dividends to 35%, which would have eliminated its usefulness. However, a strong outcry from members of the House against this measure, which would have drastically impacted many small business constituents, resulted in the removal of this provision from the bill. The House and Senate then passed the legislation, the Tax Technical Corrections Bill, in late December. It appears that despite these efforts to do away with the IC-DISC, it will not be removed from the tax code anytime in the near future.
Ultimately, all small and mid-sized export companies that are able to create an IC-DISC should be aware of its existence, and the savings it can provide. The 20% reduction in tax rate on up to half of an export company’s profits can result in huge savings. As a paper entity relatively easy and simple to create, it should be utilized by any qualifying corporation. While other export tax incentives have been eliminated by Congressional legislation, it appears that the IC-DISC will continue to provide domestic export companies with an invaluable mechanism to save money and stimulate growth.