The current tax laws contain potential benefits available for US companies that export their goods. The interest-charge domestic international sales corporation (IC-DISC) rules and the foreign-derived intangible income (FDII) rules provide significant income tax advantages for US business owners, especially those who manufacture goods in the US and sell those goods outside the country.
How does an IC-DISC work?
The IC-DISC is a separate entity created and earns a deemed commission from the US taxpayer (the manufacturer), who receives income from its export transactions. While the commission is fully deductible by the US taxpayer, the IC-DISC pays no taxes at the corporate level. The IC-DISC shareholders pay tax on dividends received by the IC_DISC at the lower capital gains tax rate when the IC-DISC revenue is distributed. These benefits are available to US taxpayers that are individuals, C corporation, S corporations, partnerships, or LLCs.
To illustrate, let’s suppose an S corporation manufactures goods and sells them for $5 million to customers outside the US and pays $200,000 in commissions to its IC-DISC. Assume the owners are in the highest federal tax bracket of 37% and the highest capital gains tax rate of 23.8% (the highest federal capital gains rate of 20% plus an additional 3.8% of net investment income tax). Further, for purposes of this illustration, assume that the owners are not taking the qualified business income deduction (QBID).
The S corporation can deduct $200,000 in commissions paid to the IC-DISC, resulting in a tax savings to its owners of $74,000 (37%*$200,000). The owners will pay a federal tax of $47,600 (23.8%*$200,000) on qualified distributions from the IC-DISC. The net savings is $26,400 ($74,000- $47,600), or 13.2% of the commissions paid.
How does the FDII incentive work?
The FDII deduction, introduced by the 2017 Tax Cuts and Jobs Act, provides a valuable tax break to US corporate exporters of goods and services. This benefit only applies to taxpayers organized as C corporations. The calculation of the FDII deduction is rather complex, however, a corporation can claim a 37.5% deduction of the excess of the net income from export sales over a fixed return on the tangible depreciable assets, resulting in an effective tax rate of 13.125%, compared with a 21% corporate tax rate from January 1, 2017, to December 31, 2025, after which the deduction is reduced to 21.875%, resulting in an effective tax rate of 16.406%.
The impact of TCJA and the Biden administration
C corporations can claim the benefits of both the IC-DISC and the FDII incentive in the same tax year. The benefit of utilizing an IC-DISC has diminished for non-C corporation taxpayers after the introduction of the QBID.
President Biden’s proposed tax plan will affect the advantage of the IC-DISC for high-income earners. The proposed increase in the individual ordinary income tax rates would widen the “spread” between ordinary and dividend tax rates, which will increase the value of IC-DISC. However, if the top tax rate on the dividend tax rate is raised, the benefit of IC-DISC would be diminished, possibly even eliminated.
If you have any questions about these strategies or any other matter, please contact your WilkinGuttenplan advisor.