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Will the 20% Export Tax Benefit Disappear on December 31, 2010?

One benefit for US companies trying to sell to foreign markets is the Interest Charge Domestic International Sales Corporation, (IC-DISC) which can provide an attractive opportunity for income tax deferral and income tax savings. With the current low dividend environment, the IC-DISC can provide a 20% tax savings for certain companies. Even with a probable increase in dividend rates, the IC-DISC can provide significant tax deferral opportunities. The IC-DISC is often overlooked but can be a very valuable and beneficial opportunity for manufacturing companies to defer and reduce income taxes.

In order to qualify for an IC-DISC, the US exporter must have "qualified export sales". The definition of export sales does not necessarily mean you have to directly export the product. If the product is indirectly bound for exporting, it may qualify as export property and thus qualify as export sales and eligible for IC-DISC treatment. In other words, manufacturers don’t necessarily have to sell directly to foreign countries to be eligible for an IC-DISC. As long as the products manufactured are eventually used in foreign countries then it would qualify. This is an often overlooked factor in determining whether a company would qualify for an IC-DISC.

The IC-DISC was created as an export incentive to help US manufacturers and producers compete in the global marketplace. Under the IC-DISC rules, a US exporter can create a small sales corporation (the "DISC") to handle its export sales. In exchange, the US exporter pays an annual commission equal to a percentage of its export income. The exporting company can then defer or reduce tax on this income (limited to $10 million of direct or indirect foreign sales). IC-DISC income is deferred until it is distributed to the IC-DISC shareholders as a dividend.

The exporting company receives a tax deduction for the commission it pays to the DISC and any dividends paid by the IC-DISC to its shareholders qualify for the 15% qualified dividend rate (under current law). Therefore, the tax benefit can be as much as a 20% tax savings – 35% regular tax, less 15% qualified dividends tax rate.

For example, assume Company X is an S-Corporation that manufacturers goods which are sold to Canada for $100 with a profit of $20. Company X forms an IC-DISC to be the sales corporation for its foreign sales. Company X, through various pricing rules, determines that IC-DISC will earn a commission of $8 for this sale. Company X gets an immediate deduction for the $8 commission paid to IC-DISC, thus only paying tax on $12 of profit. IC-DISC, being a foreign corporation, does not pay tax on the commission income until it is paid out to the IC-DISC shareholders. If the shareholders of the company and IC-DISC are individuals then the $8 commission could be an ordinary deduction to the company at 35% and taxed to shareholders as a qualified dividend at 15%, thus essentially saving 20%. The IC-DISC could also choose not to pay a dividend and continue to hold the earnings in the IC-DISC tax deferred. This tax deferral is subject to an interest charge using the T-Bill rate (currently at approximately 0 .6%) on the unpaid tax on the accumulated income.

In summary, the following are a few advantages of an IC-DISC:

• The U.S. exporter pays a tax-deductible commission.
• The IC – DISC pays no U.S. income tax on the commission income, deferring the tax.
• The commission income is accumulated in the IC – DISC and remains untaxed until the IC – DISC decides to pay a dividend to its shareholders.
• The IC-DISC could use retained funds to purchase foreign accounts receivable or inventory from the manufacturing company and pay the interest charge of the 0.6%. In doing so, the manufacturer may be able to benefit from a lower rate on borrowing or reduce its borrowing altogether.

Given the current economic and political situation it is very reasonable to assume that income tax rates will be increasing in the near future. Even if dividend rates increase to where the 20% benefit described above is no longer relevant, the IC-DISC structure should be considered as the value of income tax deferral becomes more and more beneficial in a rising tax environment.

For more information regarding IC-DISCs please contact Brian Carter at 312-980-2994 or bcarter@blackmankallick.com or your Blackman Kallick representative.

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.