Manufacturers and distributors who export products should consider the use of an interest charge domestic international sales corporation (IC-DISC) to reduce their tax burden. Here are some frequently asked questions about this strategy.

An IC-DISC is a separate entity that earns a “commission” on the operating company’s export sales based on the greater of 1) 50% of net income on sales of qualified export property or 2) 4% of gross receipts from sales of qualified export property. A properly executed IC-DISC isn’t taxable at the entity level. So, the operating company receives a deduction for the commission paid at ordinary tax rates and the IC-DISC pays no tax.

The IC-DISC distributes all of its profits as qualified dividends, and the owners pay tax on the dividends at more favorable capital gains tax rates. Depending on the owners’ personal income levels, federal capital gains tax rates could be as low as zero or 15% — or as high as 23.8% (the highest federal capital gains rate of 20% plus an additional 3.8% of net investment income tax).

To illustrate, let’s suppose Widgets, Inc. (a fictional S corporation) ships $2 million internationally and pays $80,000 in commissions to its IC-DISC. Assuming the owners qualify for the highest capital gains tax rate of 23.8%, they’ll owe federal tax of $19,040 on qualified distributions from the IC-DISC.

However, the owners also owe less tax on their S corporation earnings. Widgets can deduct $80,000 in commissions paid to the IC-DISC, resulting in a tax savings of $31,680, assuming that the owners are in the highest federal tax bracket of 39.6%.

The net savings is $12,640 ($31,680 – $19,040), or 15.8% of the commission charge. It’s often possible to pay a higher commission using the 50% of net export income calculation, however.

A properly executed IC-DISC strategy follows these procedures:

1. Form the new IC-DISC entity under state law.
2. Make the IC-DISC election within 90 days of formation.
3. Offer only one class of stock with par or stated value of the stock of at least $2,500.
4. Maintain a separate set of books and records for the IC-DISC.

Taxpayers may also be able to structure their state footprint in a way that reduces or eliminates state income tax on IC-DISC income.

The potential tax savings can outweigh the costs of creating and administering an IC-DISC. If you export a significant amount of products, discuss this strategy with your tax advisor today.