For exporting companies, this is the perfect time to examine whether or not it would be beneficial to establish an Interest Charge – Domestic International Sales Corporation (IC-DISC). Given the prospective nature of an IC-DISC, timing can play a critical role in maximizing tax savings. If a company is planning to have export sales in 2018, establishing an IC-DISC as of 1/1/2018 will enable a company to take full advantage of this tax benefit.
Currently, the Tax Cuts and Jobs Act has created a great deal of uncertainty regarding the utilization of an IC-DISC. By utilizing an IC-DISC, a U.S.-based company can reduce its federal tax liability by converting its export sales income, which is taxable at ordinary income rates, into qualified dividends, taxed at capital gains rates. In previous years, this benefit resulted in a tax savings of approximately 15.8%, which was the difference between the marginal rate of 39.6% and the qualified dividend rate of 23.8% (20% plus the 3.8% net investment income tax).
Based on the new legislation, the top marginal rate is reduced to 37% and pass through entities can now deduct 20% of their combined qualified business income. In effect, the lower marginal rate combined with the 20% deduction will shrink the effective pass-through marginal rate to 29.6%. However, this deduction does not appear to apply to qualified dividends, which leaves this tax rate at its current 23.8%. Therefore, the reduced pass-through effective marginal rate versus the qualified dividend rate ultimately shrinks the arbitrage to approximately 5.8%. Although the IC-DISC benefit will reduce for pass-through entities as compared to previous years, there is still great potential for companies to benefit from this tax-planning tool.
As an example, McGuire Sponsel worked with a company with approximately $18 million in total sales, including $6.7 million of export revenue, and $3.0 million in income. By running a transaction-by-transaction calculation, we were able to generate an IC-DISC commission of approximately $1.0 million. Using the new tax laws current pass through guidelines and the 20% deduction on combined qualified business income, the benefit would result in approximately, $58,000 in tax savings.