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Exporters Can Realize Tremendous Tax Reductions (but the window on U.S. Tax incentives for business may be closing)

Exporters Can Realize Tremendous Tax Reductions (but the window on U.S. Tax incentives for business may be closing)

SML Perspectives
(November 20, 2012)

Today, many U.S. businesses find themselves competing in the “global marketplace.” If your business is currently involved in exporting products abroad or in providing architectural or engineering services to construction projects outside the U.S., you may be able to take advantage of significant tax savings due to the reduction in the federal tax rates on “qualified dividends” which are dividends paid by corporations to individuals.

The tax rate on qualified dividends is currently 15 percent versus the normal 35 percent. This special rate is scheduled to expire at the end of 2012 unless a sunset provision enacted in 2010 is removed. With the economy still recovering, it is possible it could be extended. Whether this low rate exists for the short or longer term, a business meeting certain requirements can establish a company called an “interest change domestic international sales corporation” or “IC-DISC” for its export business and enjoy a tremendous tax reduction on the income from those export sales.

The statutory authority for IC-DISCs has been in the Internal Revenue Code for decades, but the incentives offered in the past were not useful as the World Trade Organization threatened sanctions against the U.S. for offering them. However, there are no such issues with utilizing the reduced tax on dividends to increase your net export income.

An IC-DISC is a separate legal entity, but it can exist solely on paper - with no offices, equipment or employees. Before considering an IC-DISC, you should determine whether your business has “qualified export income.” The following three requirements must be satisfied for this determination:

  1. the goods sold must be manufactured, produced, grown or extracted in the U.S. by an entity other than the IC-DISC;
  2. the export property must be held primarily for sale, lease, consumption or disposition outside the U.S., and
  3. the export property must contain at least 50 percent of its fair market value attributable to U.S. produced content.

Assuming these requirements are satisfied, the easiest way to take advantage of the tax benefits is to set up the IC-DISC as a “commission DISC.” The IC-DISC would enter into a commission agreement with your business which would pay the IC-DISC a tax deductible commission on the export sales. The commission income is tax exempt as long as the IC-DISC distributes the income to its shareholders. If the distribution is a qualified dividend, the shareholders pay federal income tax at the rate of 15 percent versus 35 percent.

If your business is set up as a tax pass through entity, such as an S corporation or limited liability company, then the IC-DISC can be owned directly by your business and the reduced rate will apply. If your business is not a tax pass through entity, some or all of the business owners can still set up the IC-DISC with them as owners and enjoy this tax benefit. The IC-DISC tax benefit will not be available to corporate recipients of dividends which are not pass through entities as the 15 percent rate does not apply to them.

The commission payable to IC-DISC is computed on a transaction-by-transaction basis and is the greater of 4 percent of the qualified export receipts or 50 percent of the foreign service taxable income. The following example demonstrates the commission calculation and the tax savings:

ABC Corporation, an S corporation, is owned equally by Sue and Stan. ABC has gross sales of $10,000,000 with $3,000,000 being qualified export income. ABC’s net income is $1,000,000 with $300,000 of net income attributable to the exports. With no IC-DISC, the federal income tax to Sue and Stan will be $350,000 on the ABC net income leaving them with $650,000 of after tax cash available. If ABC set up an IC-DISC, ABC would pay it a Commission of $150,000 under the 50 percent method (the 4 percent of receipts commission would be $120,000). This would reduce ABC’s net income to $850,000 generating federal income taxes to Sue and Stan of $297,500. The $150,000 commission would be distributed with $22,500 of taxes at the 15 percent rate. Therefore, with the IC-DISC, the total federal income tax liability is $320,000, a savings of $30,000.

The IC-DISC benefits are available to the extent that the qualified export receipts from the export sales do not exceed $10,000,000 per year. An IC-DISC does have to observe several legal formalities and make certain tax elections in being established and operated. However, the process involved in setting up the IC-DISC entity, preparing the commission agreement for the business, and filing the tax forms is relatively straightforward. If this type of entity could increase your business bottom after taxes, you should consult your legal and tax advisors to learn more about using this structure.

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