With the recession dragging on it is a wonder more small businesses are not taking advantage of one of the largest legal tax breaks given to them. A tax break that will help drive American exports, improve our nations competitiveness, and help the balance of trade account.
Small business owners are largely missing out on one of the largest tax benefits given by our government for exports. This tax break could effectively change a business owners tax rate from 35% to 15%. The legal way to make a small business owners who export the lowest taxed people in the nation outside of the very poor.
This tax break is called the “Interest Charged Domestic International Sales Corporation,” IC-DISC, allows profit made on exports to be taxed at a lower rate. The IC-DISC does not pay any tax provided its profits are 95% from exports. The IC-DISC Is a paper corporation that exists to export only and is associated with an actual corporation that manufactures, distributes or provides services.
Since the 1970's exporting companies have complained ro Congress that European and other nations used the VAT system, which offer a tax rebate on exports from these countries. Due to the different tax system this left US companies at a trade disadvantage to companies based in Europe and elsewhere using the VAT system. Congress responded with a number of attempts, for example the foreign overseas sales corporation, that where challenged by other countries in the World Trade Organization Dispute Settlement Body as an illegal subsidies on exports.
Finally Congress passed the IC-DISC provisions into the US Tax code. It allows small companies to lower their taxes on the profits they make from exports. In order for them to avoid the taxes the need to set up a separate corporation, the IC-DISC, the paper corporation mentioned above. All this is filing few papers and making a few accounting adjustments and cashing in on tax savings. Although it does not level the playing field it can help some small businesses.
But small businesses are not using this provision mostly because they do not know about it. Furthermore their tax preparers and accountants are too busy keeping on top of all the new changes to the old regulations to go through this one. Learning about how a IC-DISC can benefit a company can be a daunting task. One thing is certain this provision can only save small businesses on their taxes. There is no provision to increase a tax elsewhere that you would not have had to pay. I will try to explain this in more detail.
What is an IC-DISC?
An IC-DISC is a paper corporation use to lower tax liabilities. It is a creation of the U.S. tax code that does not pay taxes. The restrictions it must follow are: 1) it must earn 95% of its revenue from exporting U.S. products; 2) it must elect to be an IC-DISC by filing form 4879 with the internal revenue service; 3) it must be a “C” corporation filed with any state; 4) must have a par value of no less that $2500 per share and 5) it must maintain separate books.
Then it can start earning revenues. The revenues it earns are deducted from the earnings of the related corporation.
How does the IC-DISC earn money?
The IC-DISC earns money by using the greater of three methods. The higher the IC-DISC earnings are the more taxes savings can be earned. The first method is the 4% of gross sales method plus 10% of the export promotion costs. Here the earnings are 4% of the gross sales price plus 10% of the cost attributed to ‘export promotion.’ Example:
Export Sale: $100,000.00
Export promotion costs: $10,000.00
4 % of gross income: $4,000.00
10% of export promotion costs $1,000.00
IC-DISC earnings: $5,000.00
The 4% method will give higher profits to exports with low margins. Alternative the next method is the 50/50 profit plus 10% of export promotion costs. Example:
Gross Sales $100,000.00
Cost of goods sold $80,000.00
Export promotion costs $10,000.00
Total DISC Profit $10,000.00
50/50 profit $5,000.00
10% of promotion cost $1,000.00
Total DISC Profit $6,000.00
In this case the IC would earn more money with only a 10% profit margin. The last way is by following the Section 482 method. Example:
Gross export sales $100,000.00
Arms length transaction price $75,000.00
IC-Disc expenses $5,000.00
Total DISC profit $20,000.00
The profits the IC-DISC makes are deductible as non-taxable expenses by the related company. It depends on the method used. If its treated as a arms length transaction then the export gross receipts are taken off the income of the related party and replaces with the arms length transaction price. If, however, the income of the IC-DISC is treated as a commission then those commission are treated as an expense. In no case can the related corporation lose money on the transaction.
Then the profit can be kept in the DISC until they are either paid out in dividends or they are deemed paid out as dividends. They are deemed paid for example when ever the accumulated profits in the DISC are over $10,000,000.00 for example or they are deemed for a number of reason listed in the code.
How are the IC-DISC earnings treated by the related corporation?
The earnings of the IC-DISC are deducted from the earnings of the related corporation. When they are paid or deemed paid dividends then it can have different tax consequences depending on the corporate structure.
If the corporate structure is a closed “C” Corporation or an “S” Corporation it can be set up that the DISC will pay the individual shareholders directly and it will be taxable to those shareholders at the 15% dividend income rate. So for small exporters this is a huge tax break for exporting.
If the DISC is held by 100% by a corporate shareholder the income paid through in dividends is taxed as general income. The dividends do not qualify as most corporate dividends would as tax free status. So the benefit to a large C corporation is less but it can be used to defer income up the $10,000,000.00 mark.
Dividends deemed paid but not paid instead of paying income tax can be set to be interest charged instead. Dividends that are deemed paid will be taxed either at the dividend rate or the corporate income tax rate. But the corporation, or shareholders, can elect to pay interest on the taxes the tax. The interest rate would be the interest rate on US treasuries currently 4.5%.
Before the DISC:
Export Profits $20,000,000.00
Total Taxes 35% $7,000,000.00
After the DISC $20,000,000.00
Accumulated non taxed DISC income $10,000,000.00
Deemed paid dividends $10,000,000.00
If dividends paid individuals $1,500,000.00
If dividends paid to a corporation $3,500,000.00
If elected “Interest Charge” by a Corp. $157,500.00
While the small business gets the best break, even a large corporation can save by having taxes deferred. It is unknown how long you can keep the taxes deferred. However, if the income of the DISC on the accumulated earnings from investment or interest exceeds 5% of the total income from the year it will cease to be a DISC. So maybe that is what is keep people from keeping a horde of money at low interest rates.
What I can do to start you going?
I can help by filing to start a corporation following the rules. Filing to have the corporation elected to be an IC-DISC. Then set up procedures to have your export profits reported on the 1120 IC-DISC for instead of your 1120. Then report the disbursed the 1120 IC-DISC income to your shareholders (or shareholder) so they pay the dividend tax rate instead of either the personal income rate or the corporate income rate.
Also we can file you tax returns.