Tax Planning for Exports: IC-DISC Primer

By: Greg Bryant esq./CPA and Sarah Frazier, Esq.

Although it has been in existence since 1971, the Interest Charge Domestic International Sales Corporation (“IC-DISC”) planning opportunity is often-overlooked. Since IC-DISCs began, IC-DISCs have been upstaged by a host of alphabet tax incentive regimes: Foreign Sales Companies (“FSCs”), Domestic Production (“DPD”), and Foreign Intangible Income (“FIDI”). However, IC-DISCs do something very unique: IC-DISCs perform a type of tax alchemy in that they generate an ordinary deduction, which goes against higher taxed income, and creates dividend income, which is taxed at lower rates. The amount of that tax deductible dividend is based on the sales value of products made in the United States that are exported to markets outside the United States.  So, the IC DISC creates a tax deductible dividend. 

I. The Original Domestic International Sales Corporation Tax Incentive Structure of 1971.

This tax incentive was created originally in 1971 in the form of the Domestic International Sales Corporation (“DISC”). Under the original structure, companies that sold products overseas could set up a DISC and defer taxes on commissions paid to the DISCS until dividends were paid to shareholders. Eventually, the European Union spoke out against this arrangement and argued that it went against the General Agreement on Tariffs and Trade (“GATT”) because DISCs were able to avoid paying taxes indefinitely (with no interest charges) by loaning income generated overseas to a DISC’s U.S. operated headquarters rather than using it directly to benefit shareholders. After many years of challenges to the DISC provisions, the U.S. amended the DISC provisions to include an interest charge (hence the “IC”), thus limiting the amount of the commission which could be deferred. Consequently, the loophole allowing for indefinite tax avoidance (as opposed to mere tax deferral) was closed and the IC-DISC structure we know today was born.

II. The IC-DISC Structure Today

IC-DISCs transform ordinary income into dividend income. While ordinary dividends are taxable as ordinary income, and thus are taxed at higher rates, qualified dividend income is taxed at a lower rate. The amount of that tax deductible dividend is based on the sales value of products made in the United States that are exported to markets outside the United States.

IC-DISCs are created under Internal Revenue Code Sections 991 – 996. Under these rules, IC-DISCS are exempt form tax to the extent it distributes its earnings to its shareholders. That dividend is funded with a commission payment from the principal. The principal deducts the commission payment against its income. The IC-DISC, however, has no income tax per Internal Revenue Code Section 991. That dividend must be paid to the shareholder within one year of receipt. When it is paid, it is no different than any other dividend.

To illustrate, if a commission is $1 million a year, then the principal can reduce federal and state tax. Assuming 21% federal tax and 4% state (after federal deduction), this generates a $250,000 annual benefit. Furthermore, the $1 million is not taxable to the IC-DISC but must be paid to shareholder(s) before the end of the tax year. The IC-DISC generally is not subject to state tax unless part of a unitary group.

The amount of the commission is based on a statutory formula. The taxpayer can choose from three permissible IC-DISC commission calculation methods: 4% of qualified export receipts, 50% of the combined taxable income from export sales, or the arm’s length amount determined under Internal Revenue Code Section 482. A different method can be used for each sale (this is called “marginal costing”). This marginal costing approach can maximize the amount of the commission deduction. This means commissions will be, on average, between 4% and 6% of sales.

Since dividends are taxed at 15% to 20% for domestically owned IC-DISCS, the rate arbitrage is mostly only on state tax savings. Owners of S Corps and LLCs that export products can convert deductions at the ordinary income tax rate of 37% (as of 2024) and pick up the income at 15% to 20% (the long-term capital gain rate). The rate of arbitrage may be 17%, but they do not get any benefit at the state level.

The real benefit today is for foreign owned IC-DISCs. These are IC-DISCs that have a non-US corporate shareholder. When this structure exists, the rate of arbitrage is larger. The principal gets a deduction of 25% (federal and state) but that tax on the dividend is controlled by the bilateral double tax treaty, and that can be anywhere from 0% to 15%. Under most treaties, if the owner is a publicly owned corporation or a member of a group that is publicly owned, the withholding tax rate can be 0%. For a non-publicly held foreign corporate shareholder, the treaty rate is usually 5% to 10%

III. When determining whether an IC-DISC is right for your business it is important to consider whether a double tax treaty is in effect as well as the effect of Internal Revenue Code Section 996(g).

We highly recommend utilizing an IC-DISC in business structures where a US Company is owned by a non-US corporation that is also a resident of a country where the US has a double tax treaty. Utilizing IC-DISCs in these business structures is an important tax planning opportunity that is often overlooked.

While Section 861(a)(2)(D) of the Internal Revenue Code treats dividends received from DISCS that are attributable to export sales as foreign source income for U.S. shareholders for foreign tax credit purposes, Section 996(g) of the Internal Revenue Code provides that in the case of a foreign shareholder, all DISC distributions are treated as effectively connected income earned through a permanent establishment and derived from sources within the US. Section 996(g) is an embodiment of Congress’ intent for DISC Shareholders to be taxed at ordinary dividend rates on DISC distributions. When DISC provisions were initially passed, the provisions of Section 996(g) were generally considered to prevail over any contrary tax treaty provisions. Per Section 996(g):

In the case of a shareholder who is a non-resident alien individual or a foreign corporation, trust, or estate, gains referred to in section 995(c) and all distributions out of accumulated DISC income including deemed distributions shall be treated as gains and distributions which are effectively connected with the conduct of a trade or business conducted through a permanent establishment of such shareholder within the United States and which are derived from sources within the United States. 

Why was this important? The U.S. has income tax treaties with a number of foreign countries under which residents of foreign countries may be eligible to be either taxed at a reduced rate by the U.S. federal government OR exempt from U.S. income tax on certain items of income received from U.S. sources. Therefore, a determination that Section 996(g) prevailed over contrary tax treaty provisions affected the ability for foreign shareholders to seize income treaty tax advantages afforded by the treaties. 

For a foreign owned IC-DISC, the rate arbitrage can be even greater because it will be the difference between the corporate income tax rate (federal and state) versus the withholding tax rate under the double tax treaty. For over 150 years, courts have applied the “last-in-time” rule to resolve conflicts between treaties and federal statutes. See Whitney v. Robertson, 124 U.S. 190, 194 (1888). The last-in-time rule gives effect to whichever – the treaty or the federal statute in question – that was enacted later in time. This means that since Section 996(g) was ratified in July 1984, any income tax treaty ratified after July 1984 is last-in-time and will thus control in situations where there is conflict between the treaty language and Section 996(g). However, if Congress decided to amend Section 996(g), then Section 996(g) would control.

There have been a number of treaties which have come into effect subsequent to the last amendment of Section 996(g) of the Code in 1984. In most cases, the point where Section 996(g) and the income tax treaty are inconsistent is the “deemed permanent establishment” language. Under those conflicting treaties, there can be no permanent establishment in the absence of an actual physical presence in the US. As a result, the language within the IC-DISC rules that deems a foreign person to have a permanent establishment in the United States is inconsistent and overruled by the treaty. If the treaty’s language prevents a permanent establishment, then the treaty’s regular dividend provisions apply. The result? U.S. income tax on dividends is reduced to as low as 5%.  It is also important to consider the treatment of DISC dividends under the laws of the DISC’s foreign shareholders. Depending on the foreign tax rate that DISC dividends or deemed distributions to foreign shareholders are subject to, there is a chance that the benefits of a obtaining the lower U.S. tax rate may be lost. On the other hand, in situations where foreign taxation on DISC dividends is relatively low, relying on the tax treaty could be your pathway to saving substantial taxes in your global operations.

An example of a conflicting tax treaty which was enacted after the last amendment of Section 996(g) is the US/UK tax treaty. Specifically, Article 10 is at odds with Section 996(g). Section 996(g) would provide that distributions out of accumulated DISC income made to non-resident UK shareholders should be treated as gains and distributions effectively connected with the conduct of a trade or business conducted through a permanent establishment within the US and which are derived from sources within the United States.

By contrast, Article 10 of the US/UK income treaty provides, among other relevant points, that there is a cap on the tax charged where the dividends are beneficially owned by a resident of the other Contracting State. This cap is “5 per cent of the gross amount of the dividends if the beneficial owner is a company that owns shares representing directly or indirectly at least 10 per cent of the voting power of the company paying the dividends.” Further, the treaty provides that a “Contracting State may not impose any tax on dividends paid by a company which is a resident of the other Contracting State, except insofar as the dividends are paid to a resident of the first-mentioned State or the dividends are attributable to a permanent establishment situated in that State, nor may it impose tax on a company’s undistributed profits . . . even if the dividends paid or the undistributed profits consist wholly or partly of profits or income arising in that State.

IV. IC-DISC Formation

The formation of an IC-DISC is different than other corporations, especially if it will be foreign owned.  Generally, to form an IC-DISC, a new corporate entity is formed within the U.S. that has a single class of stock. At all times, the entity must maintain a minimum capitalization of $2,500 and maintain a bank account. It is NOT necessary, however, for the IC-DISC to have a physical office space, assets (beyond fulfilling the minimum capitalization requirement), or employees. The IC-DISC does, however, need to maintain records separate from those of its relevant exporting company. Within 90 days after the entity is formed, a Form 4876-A (Election to be Treated as an Interest Charge DISC) needs to be filed with the IRS. In addition to receiving approval from the IRS, the IC-DISC must also meet an annual qualified export receipts test and a qualified export assets test.

To satisfy the annual qualified export receipts test and the qualified export assets test, at least 95 percent of the IC-DISC’s gross receipts and assets must be related to the export of property whose value is at least 50 percent attributable to U.S.-produced content – with certain exceptions. One important exception permits engineering and architectural firms to receive IC-DISC benefits for services related to foreign construction projects. What counts as export property for the purpose of the qualified export receipts test and the qualified exports assets test?

First, to be qualified export property, the property must be manufactured in the U.S. by a person/entity other than the IC-DISC itself. Property is considered to be manufactured within the U.S. if one of the following apply: (1) U.S. conversion costs incurred constitute 20% of the cost of goods sold; (2) there is a substantial transformation of the product within the U.S.; OR (3) the U.S. operations are generally considered to constitute manufacturing.

Second, the export property must satisfy the destination test. In other words, the property be held primarily for use outside of the U.S. In order to satisfy the destination test, it is not always necessary to sell to a foreign customer. Another option is to sell to a U.S. customer so long as you can demonstrate that the product will ultimately be sold to a foreign customer so long as no further manufacturing is going to occur before the product is sold to a foreign customer.

Lastly, to be qualifying export property no more than half of the fair market value of the property may be attributable to the fair market value of imported articles. The fair market value of the foreign content is determined by its dutiable value. Though dutiable value is often the same as the invoice value, it is not always the same. For example, under U.S. customs law, some charges often included in invoice value are exempt from customs duty and fees (so long as those amounts are properly documented). Then, on the other hand, certain types of costs that may not be included in invoice value are dutiable and therefore must be added to the invoice value to find the dutiable value.  In conclusion, although the invoice value is a good benchmark to determine the dutiable value, adjustments both upwards and downwards may be necessary.

If you are able to meet all the requirements to form an IC-DISC, you must then decide how the new IC-DISC entity will fit into your existing corporate structure. U.S. bankers tend to prefer that a U.S. S corporation owns the IC-DISC but there are other structuring options for you to explore. For example, another beneficial structure is for the IC-DISC to be a brother-sister of a flow through entity. Another option is for the IC-DISC could be owned by a trust. For the trust structuring option, the beneficiaries of the trust could be the owners of the C corporation as of the date that the dividends were paid to the IC DISC. Having the IC-DISC owned by a Roth IRA is also an option. We are happy to help you determine whether a new IC-DISC entity would best fit into your pre-existing corporate structure.

V. IC-DISC Reporting Obligations

To stay within compliance, IC-DISCs must file Form 1120-IC-DISC and supporting schedules on an annual basis. Form 1120-IC-DISC is due eight and a half months after the year end of the IC-DISC with no extensions permitted. Annual IC-DISC returns are filed with the Covington Kentucky Service Center, as is the Form 4876 Election to be treated as an IC-DISC. Relevant supporting schedules you may need to file include: Schedule K (Shareholders Statement of IC-DISC Distributions), Schedule P (Intercompany Transfer Price or Commission), Schedule Q (Borrowers Certificate of Compliance with Rules for Producers Loans), and Form 8404 (Interest Charge on DISC-Related Deferred Tax Liability). Keep in mind that state tax requirements for IC-DISCs vary greatly from state to state, we can help you navigate the state differences.

IC-DISC shareholders are required to pay an interest charge to the IRS on the tax liability related to the deferred DISC income. The deferred DISC income is always computed on a one-year lag basis – meaning that a brand-new IC-DISC cannot have deferred DISC income at the end of its first year. The first thing that happens at year end is that the deemed distribution will be computed.

You are treated as having received deemed distributions as of the last day of the IC-DISC tax year and must pay tax on these distributions in your tax year that includes that date. Deemed distributions must be distributed in the year in which they are earned by the IC-DISC.  Various categories of income are required to be deemed distributions, to include: (1) 1/17^th of income attributable to shareholders who are C corporations; (2) 50% of income related to participation in a boycott against Israel; (3) and income that is in excess of $10,000,000 of sales that generated the IC-DISC income.

Then, you must pay tax on actual distributions in the year of receipt. Any cash dividends that have been distributed are first considered to be a tax-free payment of previously taxed earnings. What falls in this category? Deemed dividends from any previous years plus the current year (these are found on Schedule M-3 on Form 1120-IC-DISC) will be considered previously taxed earnings. After distributions have reduced the M-3 to zero, further distributions will reduce the balance of the accumulated DISC income found on Schedule M-4. Notably, the M-4 cannot be reduced below zero by a distribution. However, if a distribution is made in excess of total earnings and profits then, other earnings and profits in Schedule M-2 will be reduced.

This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.