A product of the IRS Tax Code, an IC-DISC is a tax-exempt corporation deemed to function as a sales agent for a company’s export sales. The exporting company pays the IC-DISC a sales commission based on its export sales, an expense which serves to reduce the ordinary income coming to shareholders from their company. The IC-DISC then turns around and distributes the commission cash right back to the operating company as a qualified dividend. The company’s tax return net income stays the same, only its composition has now changed (and operations are not permanently out of that cash except for maybe 24 hours turn-around time).
Shareholders or partners pick up that dividend income on the Form K-1 issued by their business. So, in effect, the company has converted a portion of income from ordinary to the lower-taxed qualified dividend, moving it out of its K-1’s Box 1 down to Box 5b for S-corps, or 6b for LLCs. The greater the commission/dividend, the greater the conversion of income, and the greater the tax benefit realized from the rate arbitrage.
The tax benefit of an IC-DISC (“Interest Charge Domestic International Sales Corporation”) is based on realizing the arbitrage between tax rates. The marginal ordinary income tax rate for an individual is currently 37%, while the marginal rate for long-term capital gain is 23.8% (inclusive of the net investment income tax rate of 3.8%), a difference of 13.2%. This rate difference can be a valuable tax mitigating tool for shareholders or partners of pass-through entities (e.g., S-corporations and LLCs) as the ordinary income passed through to them from their business can be taxed as high as the 37% rate, whereas qualified dividend income would only be taxed at the lower capital gains rate of 23.8%. The IC-DISC can affect this strategy by allowing the individual to realize the lower tax rate from his business.
As conceived by the IRS, the IC-DISC only exists on paper to “house” and report the commission calculation and resultant qualified dividend. It is an IRS-ordained tax benefit offered to incentivize the export of American-made product. It does not pay tax or have employees; it merely files an annual tax return reporting the commission income and to whom it paid out its dividend. As long as that tax rate arbitrage exists, every exporting S-corporation shareholder or LLC partner owes it to themselves to investigate the use of an IC-DISC.
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Jason Rauhe, CPA is a Principal in the firm’s Global Business Services practice and is responsible for assisting clients and adding depth in all areas of the firm’s international tax consulting services including transfer pricing, and the firm’s compliance expertise.
Rauhe previously served as Director of International Tax at a Top 100 CPA Firm, where he was responsible for the firm’s international tax division and major industry alliance networks.