When the 15 percent qualified dividend tax rate was introduced in 2003, businesses that exported goods to foreign countries had a unique opportunity to leverage the difference between qualified dividend and ordinary tax rates by setting up an Interest Charge Domestic International Sales Corporation (IC-DISC). With the possibility that the 15 percent qualified dividend rate will expire at the end of the year, the benefits of the IC-DISC need to be reevaluated and current IC-DISC owners may have actions to take before year-end.
What is an IC-DISC?
A qualifying domestic entity that has elected under IRC Section 991 to be taxed as an IC-DISC is exempt from Federal income tax (state tax treatment varies). An IC-DISC essentially serves as a sales intermediary for a company's exporting activities. An IC-DISC earns income from commissions or actual buy/sell activities for exported goods that are manufactured, produced, grown, or extracted within the United States.
The vast majority of IC-DISCs earn commissions from the related operating entity without any effect on business operations. The commission earned is computed using mathematical formulas defined in Section 994 (generally the greater of 50 percent of export net income or 4 percent of export gross receipts). The related operating entity pays a deductible commission to the IC-DISC which then may either pay a dividend to its owners or retain the earnings (subject to limitations). IC-DISCs are subject to certain gross receipts and assets requirements to maintain IC-DISC status.
One of the primary benefits of the IC-DISC under the current law is that the operating entity receives an ordinary deduction for the commission paid to the IC-DISC (a maximum tax benefit of 35 percent) while the dividend paid to the IC-DISC owners is taxed at the qualified dividend tax rate of 15 percent – a 20 percent arbitrage. This benefit may be in jeopardy with the impending tax increases resulting from the provisions set to expire at the end of 2012.
Expiring Provisions
If all of the Bush tax cuts expire as scheduled at the end of 2012, all dividends will be taxed at ordinary tax rates, which will increase to a maximum rate of 39.6 percent. IC-DISC dividends will also be subject to the new 3.8 percent Medicare contribution tax on net investment income of upper income taxpayers that goes into effect in 2013. The combination of the expiring and new provisions could result in the highest rate on dividends increasing from the current 15 percent up to 43.4 percent.
What Now?
If an existing IC-DISC has accumulated income, it should consider distributing that income to its shareholders by December 31, 2012. Failing to distribute that income by year-end could result in losing the benefit of the 15 percent dividend rate in exchange for the 39.6 percent ordinary income rate and will most certainly subject future dividends to the 3.8 percent Medicare contribution tax.
It is possible that Congress will retain the qualified dividend rate but increase it and the long-term capital gains tax rate to 20 percent. Combined with the Medicare contribution tax, this will result in a dividend tax rate of 23.8 percent, which would still provide more than an 11 percent arbitrage over the 35 percent corporate tax rate. If the operating entity is an S corporation, partnership or LLC, where the commission deduction essentially passes through to the owners, the 23.8 percent dividend rate provides almost a 16 percent arbitrage over the highest individual tax rate of 39.6 percent. So depending on what happens in Congress, the IC-DISC may still offer some valuable tax savings. There would be no arbitrage, however, if the qualified dividend rate is completely repealed.
If this is the case, IC-DISCs may still retain one last benefit, a deferral subject to a small interest charge on undistributed IC-DISC income. Section 992(a)(1)(B) states, however, that in order to qualify as an IC-DISC, the adjusted basis of qualified export assets must equal or exceed 95 percent of the sum of the adjusted basis of all assets at the end of the year.
IC-DISC operators are not permitted to accumulate excessive deferred IC-DISC income beyond export working capital requirements if this would cause the taxpayer to fail the 95 percent qualified asset test. Alternatively, commission IC-DISCs could loan the deferred IC-DISC income back to the IC-DISC supplier as a producer loan.
Section 993(d)(1) describes the requirements for producer loans. These requirements are restrictive and complex to administer but, in general terms, producer loans are limited to a term not to exceed five years and will only apply in situations where the producer's business is growing.
Finally, deferred IC-DISC income can be invested in PEFCO ("Private Export Funding Corporation") notes. These notes are guaranteed by the U.S. Government and made by the export-import bank of the United States. They bear a stated interest rate and maturity date and are much easier to administer than a producer loan.
Presently, we must wait to see what the fate of the qualified dividend rate will be. Current IC-DISC companies, however, should be prepared to pay out their deferred IC-DISC income before the end of 2012 to be sure that shareholders do not lose the benefit of the current 15 percent qualified dividend rate in the event that rate increases. For more information on IC-DISC tax benefits and administration, please contact your local CBIZ MHM tax advisor.
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