With the economy moving more to a global footing, many family and middle-market companies are seeing an increase in foreign sales. However, many of these companies are not aware of a tax strategy taking advantage of their foreign sales that can result in substantial tax savings. This strategy is an IC-DISC.
What is an IC-DISC
An IC-Disc company is a tax entity that can be set up to receive a commission on foreign sales from the “producer” company (your existing company). The “producer” company receives a tax deduction for the foreign sales commission at regular ordinary rates (maximum rate 35% for C-corporations and 39.6% for flow thru entities). The IC-DISC company is a tax free entity that pays no tax on the commission income received from the “producer” company until it is distributed out to the owners. When the income is distributed out it is taxed at qualified dividend rates which are lower than ordinary tax rates (15% - 23.8% depending on income levels). This savings is a “play” between the regular rates (maximum of 35% - 39.6%) and the qualified dividend rates (23.8% - 15%) that results in a permanent tax savings that can be quite substantial (11.2% - 20%). For example the tax savings on a $100,000 foreign sales commission could save $11,200 to $20,000.
How are Foreign Sales Commissions Calculated
Generally you are allowed to calculate the foreign sales commission based on the largest of 4% of qualified foreign revenue plus 10% of export promotion expenses or 50% of net income on foreign sales plus 10% of export promotion expenses. For example a $20 million company that has $5 million in foreign sales and made 10% net profit on those foreign sales with no export promotion expenses. It could take a foreign sales commission of $250,000 the larger of the amount based on revenue of $200,000 ($5 million in foreign sales times 4%) or the amount based on 50% of net income of $250,000 ($5 million in foreign sales times 10% net profit = $500,000 times 50%).
Within the 50% of taxable income method there are marginal costing rules that can be utilized. The calculation can be done on a transaction by transaction method (T by T) that “slices and dices” sale transactions out by various categories such as product lines, product categories, etc. It looks at each foreign sales transaction individually and calculates the commission based on the greater of the various methods - 4% of sales, 50% of overall net income, product line net income, etc. This can result in substantial savings over just grouping all foreign sales together. Often times a 20% - 40% increase in the commission can be obtained.
What Foreign Sales (Export Receipts) Qualify for an IC-DISC
Qualified foreign sales are gross receipts from the sale, exchange or other disposition of export property. The “producer” company must manufacture, produce, grow or extract product in the United States. It must be held primarily for sale, lease or rental for direct use, consumption or disposition outside the U.S. No more than 50% of the fair value of the export property can be attributable to foreign content. Export property sold to domestic distributors who then sell overseas may also qualify (if no further manufacturing is done in the U.d States).
Who Can Own the IC-DISC Company?
The ownership structures could vary based on what type of entity the ‘producer” company is. To receive the income tax savings discussed above the ultimate owner of the IC DISC has to be an individual. Typical ownership structures for “producer” companies that are C Corporations is to have the same or similar individuals own both the C Corporation and IC DISC. Typical ownership structures for “producer” companies that are pass thru entities (partnerships, LLC’s and S Corporations) is to have the IC DISC owned by the pass thru entity. There are also more sophisticated ownership structures involving IRAs that can be utilized.
Initial costs would include incorporating an entity, filing the IC DISC election and preparing the related supplier agreement. All three are typically prepared by legal counsel. Ongoing annual costs would include calculating the annual foreign sales commission and preparation of the IC DISC tax return. These would normally be minimal in comparison to the potential benefit.
If you are a Company that has foreign sales and meets the requirements for an IC-DISC you should investigate whether an IC-DISC would be beneficial to your organization.
Likewise if you have an IC-DISC but are only calculating the foreign sales commission on an overall basis you should investigate whether utilizing the transaction by transaction marginal costing method (T by T) would be cost effective and result in additional income tax savings.
We would be glad to review your foreign sales and margins and give you an estimate of your potential tax savings.
This blog was co-authored by Marne Babich:
Marne W. Babich is a Senior Manager at Meaden & Moore’s Tax Services Group. For over 15 years, she has been actively involved in providing tax planning services to middle-market and closely held companies. She is actively involved with Cleveland Rotary and sits on the board of the American Red Cross. Click here to read more about Marne and to contact her directly.