Call it an incentive, or call it a loophole, but when IC-DISC and foreign sales are paired, tax advantages aboutnd. IC-DISC corporations are a way that foreign export companies both big and small can help their shareholders significantly reduce their tax rates. Companies that sell US sourced products overseas can trade ordinary income tax for capital gains rates by running sales through an IC-DISC.
Like the Domestic Production Activities deduction, definitions for what is US sourced product for an IC-DISC are pretty broad. It can include tangible items, such as parts, materials, and finished goods; and it can include intangible items such as software and software subscriptions.
An IC-DISC is an election made to a separate C Corporation. The election allows the corporation to forgo income tax on the corporate level and pay dividends out to shareholders which are taxed at the capital gains rate. As an added plus, IC-DISC stock does not need to be owned for a year in order for the dividends to be treated as qualified dividends.
The IC-DISC income is calculated one of three ways. It can be up to 4% of the gross export income from the related company plus 10% of promotion costs, up to 50% of net taxable export income from the related company plus 10% of promotion costs, or 100% of the net taxable export income from its own operations completely separate from any related company. The 4% of gross export income method makes sense when overall margins fall below 8%. The 100% method requires a complete separation between the two companies and a Sect. 482 transfer pricing study to make sure shareholders are not unfairly shifting income to the IC-DISC. It also requires separate functions, such as billing, from any related companies.
While the IC-DISC can save a high income shareholder as much as 20% marginally on their taxes, there are some downsides. One of those downsides is the administrative costs of starting and maintaining a separate export corporation. While the operations of the IC-DISC are pretty simple as a flow-through for exports, compliance is the key for maintaining the tax benefits of the company. The IC-DISC tax return is not a normal corporate tax return either.
The other issue coming down the line for IC-DISC corporations is whether or not current capital gains rates will be made permanent. In 2009 the 15% rate was extended until 2013 when it will jump back to the pre-Bush tax cut rate of 20%. In addition, Obama’s healthcare law will levy an additional 3.8% on dividend income for families with adjusted gross incomes of $250,000 or higher. The result would be an 8.8% increase in taxes on dividends.
Neither of these tax increases are sure to happen. We will find out this summer if the Supreme Court has struck down the healthcare bill, which would eliminate the 3.8% tax. Additionally, Congress and the President have until the end of the year to extend the Bush tax cuts and keep dividend rates at 15%. Even if they don’t, there is also a chance that a Romney administration would extend them in early 2013 and would make the extension retroactive. Alternatively, if the none of the Bush tax cuts are extended, then ordinary income tax rates would also jump between 3-5% making capital gains rates and the IC-DISC still advantageous.