By Aaron M. Thompson,
Senior Manager, Mountjoy & Bressler, LLP

As a result of the recently enacted American Jobs Creation Act of 2004, the tax benefits previously available to U.S. exporters by virtue of the Extraterritorial Income Exclusion (ETI) will be phased out by the end of 2006. However, there are still provisions of the Internal Revenue Code that can provide significant tax benefits to the closely held exporter.

Background
For many years the United States has offered tax incentives to encourage domestic manufacturers to export products. In 1971, provisions were enacted for the creation of Domestic International Sales Corporations (DISCs). America’s trading partners were not pleased with the DISC regime, or its successor, the Foreign Sales Corporation (FSC). In response to repeated European challenges, the U.S. has continually modified its export incentives, most recently with the ETI provisions. The European Union was successful in challenging the ETI regime before the WTO in 2002, and pursuant to that challenge, the EU began levying tariffs on certain American products in retaliation until the ETI provisions were repealed.

As a result of these European tariffs, the American Jobs Creation Act of 2004 was put in place to repeal the ETI regime completely beginning after 2006. Despite this, the DISC regime provisions are still alive and well, although they’ve not been used frequently due to the benefits previously available under FSC and ETI (in 2000, only 727 DISCs filed U.S. income tax returns, compared to 4,200 FSCs). In addition, the decrease in the federal tax rate on dividend income further enhances the appeal of DISCs in today’s environment.

What is a DISC?
A DISC, or in today’s terms, an Interest Charge DISC (IC-DISC), is a domestic corporation, authorized by the Internal Revenue Code, that earns a commission based on the export sales of its related supplier. The related supplier receives a tax deduction for the commission, but the IC-DISC does not pay federal income tax on its commission. The IC-DISC can then either distribute the earnings as a taxable dividend to its shareholders, or retain the earnings, deferring the taxation until the earnings are distributed. If earnings are not distributed currently, interest is charged by the IRS on the tax deferred by not making a distribution. Dividends paid by the IC-DISC to a U.S. individual shareholder are taxable at a maximum rate of 15%. The benefit of the IC-DISC comes from the fact that the commission paid to the IC-DISC is deductible at the highest marginal tax rates, while the dividend paid by the IC-DISC is only taxed at 15%.

Example
ABC Exporters is an S corporation which manufactures and exports widgets. The shareholders of ABC incorporate another U.S. entity and make an election for it to be treated as an IC-DISC. An agreement is signed between the companies allowing the IC-DISC to earn a commission on any qualifying export sales of ABC. Such commission calculation is set forth in IRC §994.

During 2005, ABC exports $3 million of widgets, earning a net profit of $300,000, after allocation of all SG&A expenses. The IC-DISC is entitled to a commission of $150,000 (50% of the export profits), which is paid in cash by ABC. ABC is allowed a tax deduction for the $150,000 commission, reducing the ABC shareholders’ tax liability by $52,500, while the IC-DISC pays no income tax on the commission. The IC-DISC in turn pays a dividend of $150,000 to its shareholders, on which they pay tax of $22,500. The net savings to the ABC shareholders is $30,000 compared to not having the IC-DISC in place.

What Are the Requirements for Forming an IC-DISC?
An IC-DISC is ideal for closely held corporations or LLCs who export goods and who have cash flow available to make distributions to shareholders. To qualify as an IC-DISC, a U.S. corporation must only have one class of stock outstanding and must be capitalized with at least $2,500. In addition, the corporation must make an election to be treated as an IC-DISC before the beginning of the tax year. There are other requirements and limitations placed on IC-DISCs, including requirements related to the types of export property that can qualify for these benefits.

Summary
Although export tax incentives have been eliminated for the large, publicly traded corporations, powerful tax savings can still be achieved by the smaller, closely held exporter. This reduced tax burden on export profits can affect pricing decisions and company marketing strategy. The ability to transfer additional cash to shareholders with preferential tax treatment makes IC-DISCs an option that U.S. exporters should examine closely.

To contact the author:

Aaron M. Thompson, Senior Manager
Mountjoy & Bressler, LLP
2300 Waterfront Plaza, 325 West Main Street
Louisville, KY 40202-4244
Office: (502) 992-2741
E-Mail: athompson@cmbcpa.com