INTRODUCTION

Regardless of their political affiliations, presidential administrations and members of Congress share the goal of maintaining U.S. competitiveness on the global market. We often hear statements directed toward strengthening the U.S. manufacturing sector and bringing production activity back to the U.S. These words would be futile without implementing initiatives favoring U.S. business interests.

Providing tax incentives is one mechanism in which the government can act upon these objectives.1 Well-known examples include:

  • The F.D.I.I. Deduction: Corporations may claim deductions under the Foreign Derived Intangible Income rules of §250 of the Internal Revenue Code of 1986 as currently in effect (the "Code"). F.D.I.I. derived by a U.S. corporation is eligible for a deduction of 37.5% for tax years beginning before 2026 and 21.875% thereafter. At the U.S. corporate income tax rate of 21%, the deductions have the effect of reducing the tax rate on F.D.I.I. to 13.125% for tax years beginning before 2026 and 16.406% for tax years beginning after 2025.
  • The Q.B.I. Deduction: For partnerships and L.L.C.'s owned by individuals, the Qualified Business Income ("Q.B.I.") deduction of Code §199A provides a deduction for partners and members of partnership or L.L.C. employing many employees or having significant investment in capital assets.2 For partners or members of L.L.C.'s that do not fit the profile, caps are place on the benefit.

An often-overlooked incentive is the Interest Charge Domestic International Sales Corporation ("I.C.-D.I.S.C.") regime, a long-lived descendent of the (i) the original Domestic International Sales Corporation ("D.I.S.C.) regime, in effect between 1972 and 1984, (ii) the Foreign Sales Corporations ("F.S.C."),3 in effect between 1985 and 2000, a successor of the D.I.S.C., (iii) the Extraterritorial Income ("E.T.I.") regime was adopted in 2000 and remained in effect until its repeal in 2004, which provided an exclusion for the portion of gross income consisting of extraterritorial income. The common thread of all the foregoing predecessors of the was their complexity. The lone exception was the I.C.-D.I.S.C., an attractive tax planning tool for smaller companies without fully staffed tax departments. For privately held companies operating as an L.L.C. treated as a pass-through entity, the goal is not the deferral of tax over an indefinite period of time. Rather, the benefit is an immediate and permanent tax rate reduction. 

This article is the first of a two-part series. Part I highlights the technical aspects of the I.C.-D.I.S.C. and how certain taxpayers can benefit when structuring export activities. Part II will identify issues that frequently arise during I.R.S. examinations.

HISTORICAL CONTEXT

As originally enacted in 1971, a D.I.S.C. was simply a domestic corporation that made an election to be treated as a D.I.S.C. If it met all the requirements under the law, the D.I.S.C. was exempt from U.S. corporate income tax. Its function, which could take place "only on paper" accompanied by journal entries, was to serve as a buy-sell distributor or a commission sales agent. Either way, the U.S. exporter reduced its income, while the D.I.S.C. paid no U.S. tax as its paper profits grew.

At that point, the goal of the U.S. exporter was to access the proceeds of profits building up in the D.I.S.C. in order to use the cash in the export business, without triggering a loss of deferral. Methods were available – the D.I.S.C. could finance export promotion expenses, purchase export receivables from the related exporter, or make a producer's loan to finance the production of export property. Each method had its own set of rules designed to provide the appearance of substance, when none existed but for the paperwork. More importantly, as profits remained in the D.I.S.C. and sales remained relatively flat, it became harder to utilize the resulting proceeds in ways that met rules established by the I.R.S. Failing to meet those rules resulted in loss of D.I.S.C. status and recapture of the D.I.S.C. deferred tax over a period of time.

In 1985 when the F.S.C. regime was adopted in lieu of the D.I.S.C. regime, one limited category of D.I.S.C.'s was allowed to continue in existence. Under the 1985 regime, Small D.I.S.C.'s that agreed to pay an interest charge on the amount of tax deferred were allowed to continue on in the form of an I.C.-D.I.S.C. To be categorized as a Small D.I.S.C., the amount of D.I.S.C. profits that could be deferred was capped at $10 million. D.I.S.C. export profits exceeding that amount were deemed to be distributed immediately and were not eligible for deferral. The interest charge on deferred profits was imposed at a rate that was announced annually by the I.R.S.

As explained in the next portion of this article, deferral of tax is not the goal of the L.L.C. exporting from the U.S. The benefit is the permanent rate reduction for the portion of export profits allocated to the I.C.-D.I.S.C. under a special set of transfer pricing rules.

TAX BENEFIT OF AN I.C.-D.I.S.C.

The export commission payment paid by the U.S. exporter or the amount by which its export sales margin is reduced by the sale to the I.C.-D.I.S.C. generates an immediate and permanent tax saving for the partners or members of the business. To illustrate, the maximum tax rate for ordinary income realized by individuals is 37%. In addition, self employed individuals must pay 12.4% self-employment tax on self-employment income up to a ceiling that increases each year with inflation. In 2023, the ceiling is $160,200 of self-employment income. Finally, self-employed individuals must pay a 2.9% Medicare tax. Because there is no cap on the tax base for the Medicare tax, the maximum effective tax rate for the partners or members of the business is 39.9%, disregarding self-employment tax.

The amount of net profits generated by the I.C.-D.I.S.C. under special transfer pricing rules applicable to I.C.-D.I.S.C.'s and exporting companies are not subject to tax at the I.C.-D.I.S.C. level. When the I.C.-D.I.S.C. distributes its net profits to the shareholder group – here comprised of members of the related business – the shareholder will be treated as having received a qualified dividend taxed at a maximum rate of 20%. To that tax, a 3.8% add-on for net investment income tax ("N.I.I.T.") likely will apply. Assuming that each partner or member generates self-employment income from the business and disregarding the 12.4% self-employment tax on the first $160,200, each dollar of export commission paid to the I.C.-D.I.S.C. or margin on exports allocated to the I.C.-D.I.S.C. is taxed at the lower combined rate of 23.8% rather than 39.9%. This creates a net effective tax reduction of 16.1 percentage points, yielding a 40% reduction of Federal income tax. For most entrepreneurs, a 40% tax reduction for doing nothing would seem to be more attractive than a deferral opportunity that is constantly subject to risk of early recapture.

TECHNICAL ASPECTS OF THE I.C.-D.I.S.C.

The technical details of operating an I.C.-D.I.S.C. are as follows. As mentioned above, they must be meticulously followed in order for the members of an L.L.C. operating an export business to benefit from the tax rate reduction.

Requirements

An entity must meet the following conditions to qualify as an I.C.-D.I.S.C.:

  • It must incorporated under the law of one of the states of the United States. 4
  • At least 95% of the gross receipts during the taxable year must qualify as export receipts.5
    • Qualified export receipts consist primarily of revenues from the sale of export property.6
    • Export property must be property produced in the U.S. by a person other than the I.C.-D.I.S.C. for sale outside the U.S.
    • Not more than 50% of the value of the property may be attributed to articles imported into the U.S.7
    • Export property does not include intellectual property or property leased to another member of a control group in which it belongs. 8
  • At least 95% of the total adjusted bases maintained by the I.C.-D.I.S.C. in its assets at the close of the taxable year must consist of qualified export assets. Qualified export assets generally include
    • export property,
    • assets used in connection with the sale of export property,
    • accounts receivable from sale of export property,
    • working capital,
    • producer's loans, and
    • other related assets.9
  • It must have only one class of shares, with a stated value of at least $2,500 on each day during the taxable year.10
  • It must make an effective election to be treated as a D.I.S.C.11
    • An election shall be made during the 90-day period before the beginning of the tax year with the consent of all shareholders.12
    • If the entity fails to make a timely election, it can request an extension to file with the I.R.S. by demonstrating it acted reasonably and in good faith, and the grant of relief will not prejudice the government's interest. 13

Failure of an entity to qualify as an I.C.-D.I.S.C. will subject the commission payment to double tax: a corporate tax when received by the I.C.-D.I.S.C. and second level of tax when distributed.

The I.C.-D.I.S.C. is not required to follow the arm's length principle under Code §482.14 If Code §482 were applicable, all profits of the I.C.-D.I.S.C. would be reallocated to the exporting company.

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Footnotes

1. The extent to which a tax incentive to promote exports may violate trade agreements is beyond the scope of this article. For articles on illegal tax subsidiaries see Beate Erwin and Christine Long, "E.U. State Aid – the Saga Continues," Insights Vol. 3 No. 6 (June 2016); Beate Erwin and Kenneth Lobo, "Treasury Attacks European Commission on State Aid – What Next?," Insights Vol 3 No. 8 (September 2016); and Fanny Karaman, Stanley C. Ruchelman and Astrid Champion, "European State Aid and W.T.O. Subsidies," Insights Vol. 3 No. 9 (October 2016). For the dispute between European jurisdictions and the U.S. over the D.I.S.C. rules, see Block, 6360 T.M., Export Tax Incentives, Section I, Prior Export Tax Incentives Under the Code.

2. See Fanny Karaman and Nina Krauthamer, "The Devil in the Detail: Choosing a U.S. Business structure Post-Tax Reform," Insights Vol 6 No. 6 (June 2019) and Fanny Karaman and Nina Krauthamer, "Qualified Business Income – are You Eligible for a 20% Deduction?," Insights Vol. 5 No. 2 (October 2018).

3. Code §922 through 927 in effect between 1984 and 2000).

4.Code §992(a)(1).

5 Code §992(a)(1)(A).

6 Code §993(a)(1).

7. Code §993(c)(1).

8. Code §993(c)(2).

9. Code §993(b).

10. Code §992(a)(1)(C).

11. Code §992(a)(1)(D).

12. Code §992(b)(1).

13. Treas. Reg. §301.9100-3(a).

14. Code §994(a).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.