With the new Tax Cuts and Jobs Act (“TCJA”) of 2017 in full effect, many exporters and CPAs are wondering “Is the interest charge – domestic international sales corporation (“IC-DISC”) is still an effective tax savings strategy?”
Let’s take a step back to answer this question. TCJA made no changes to any IC-DISC rules. IC-DISCs function as they always did by replacing ordinary income with qualified dividend income taxed at lower capital gains rates. The new complications arise from the TCJA’s reduction of the C-corporation tax rate to a flat 21%, combined with the new ability to deduct 37.5% of your C-corp’s foreign-derived intangible income, coinciding with the addition of a deduction of 20% of “qualified business income” for pass-through entities (i.e., S corporations and LLCs). That’s a lot of moving parts.
While the new C-corp 21% rate looks enticing initially, recall that its purpose is to incentivize existing foreign manufacturers – as well as the foreign operations of American companies – to relocate to the United States. It is not necessarily something to be desired by smaller US S-corporations and LLCs who do not have to deal with the double-taxation created by the C-corporation form of entity; shiny, new lower tax rate notwithstanding. C-corp status means income is still taxed at the corporate level when earned, and then again in the hands of the shareholders once distributed; that does not change.
To determine a preferred structure – whether to continue on with an IC-DISC being held by your S-corp or LLC, vs. converting your “S” to a “C” and try to realize export tax benefits under the new tax rules for C-corps – you need to make sure you’re comparing apples with apples. You must factor in the impact of double taxation: any dividend received from your company will be taxed at 23.8% in the shareholders’ hands; the difference is whether that income is first taxed at 21% (domestic income) or 13.125% (export income) on the C-corporation level, or if it’s being paid out of a nontaxable IC-DISC. Though the rate arbitrage in favor of S-corporation ownership has been lessened in some instances under the TCJA, in most realistic scenarios the best a C-corporation can do with an IC-DISC is achieve a tax parity with the S-corporation’s ownership structure once the double taxation is realized.
For existing C-corporations that currently use an IC-DISC, there is still tax benefit in replacing ordinary salary and other forms of compensation paid to shareholders and officers with qualified dividends from your IC-DISC. But keep in mind that a dividend paid out of a C-corporation to its shareholder leaves the operations permanently; a dividend paid by an IC-DISC to its S corporation shareholder is recycled right back in to operations with the tax benefit being recognized through the K-1. For many smaller, closely held S-corporations and LLCs, that would be the deciding factor in not pursuing a C-corporation conversion which at the end of the day would typically not offer a lower overall tax burden. Thirty years ago under the TRA of 1986 we were all happy to leave the constraints of the C-corporation behind. The TCJA of 2017 still does not make reversing that history attractive for most smaller and mid-size taxpayers. In the wake of the TCJA the IC-DISC definitely remains an effective tax savings strategy.