CLIENT ALERT: TAX BENEFITS FOR EXPORTERS OF US-MADE GOODS IN 2010 AND BEYONDOctober 29, 2009
There is an underused, but very significant, federal income tax break for businesses exporting US-manufactured goods. For these businesses, the tax break can reduce taxes on current income and improve cash flow. The tax break essentially is an export subsidy found in Sections 991 through 996 of the Internal Revenue Code. To take advantage of this tax break, exporters will generally need to establish a new corporation, which qualifies as a “Domestic International Sales Corporation” (“DISC”). The DISC typically is owned by the same persons who own the business making the export sales (“export company”). The DISC is not required to perform business activities. Rather, it is simply a device to shelter up to 50% (or more) of the net income otherwise earned from the export sales. The sheltered income is exempt from tax under the DISC rules and, therefore, can result in substantial income tax savings.
How the DISC Works: The owner of the export company (which may be a C corporation, S corporation, LLC, partnership or sole proprietorship) forms a new corporation (the DISC). The new corporation makes an election with the Internal Revenue Service to be a DISC. The election is made on Form 4876-A and should be submitted to the IRS within 90 days of the beginning of the DISC’s first taxable year. The DISC must have an initial capitalization of at least $2,500. The DISC and the export company then may enter into a “commission agreement,” which provides that the DISC is entitled to “commissions” for export sales made by the export company. The DISC’s commissions are exempt from income tax, while tax deductible to the export company.
Amount of Tax-Exempt Commissions. There are 3 prescribed methods for determining the amount of commissions payable to the DISC. One method allows for commissions of 50% of the net income from export sales (the “50-50 method”). Another method permits commission of 4% of the gross sale price of the export sales. A third method provides for a commission based on an arm’s length price. Under the 50-50 method, 50% of the net income derived from the export sales would be payable to the DISC by the export company (as commissions) and exempt from income tax (since the DISC is a tax exempt entity). For example, if the export sales otherwise generate $500,000 of taxable income to the export company, the export company, after implementing the DISC, would have only $250,000 of taxable income and the DISC would have $250,000 of tax exempt income. Assuming a 40-percent tax rate, the tax on such income would be reduced from $200,000 to $100,000 by adopting a DISC. The extra $100,000 in tax savings would be available to the business or distributable to the owner.
Taxable Distributions by DISC. Although the DISC is not required to perform sales activities, the “commissions” that it earns must actually be paid by the export company to it. Continuing the above example, the DISC would be paid $250,000 of commissions. The question then is, what does the DISC do with the cash? The DISC can distribute the $250,000 to its owner, which would be subject to a tax-favored rate of 15% for federal income tax purposes. This favorable 15% rate is less than half of the ordinary income tax rate (currently 35%). In this example, the DISC results in a tax savings of $50,000 on distributed earnings ($250,000 times 20%) (20% is the difference between the 15% rate and the 35% rate). The 15% rate on dividends applies generally to dividends paid on or before December 31, 2010. At this time, it is unclear whether Congress will extend the favorable dividend tax rate beyond 2010.
Tax Deferral Through Loans. Alternatively, the $250,000 of cash held by the DISC may be loaned back to the export company with no current tax to the owner of the DISC. The loan proceeds must be reinvested in the export company and the loan must meet certain other requirements. However, the IRS imposes an interest charge (at the U.S. Treasury Bill rate, currently 0.37% annually) to the owner on the deferred taxes. If export sales revenue exceeds $10,000,000, the owner of the DISC is taxed currently on the DISC’s share of the net income in excess of $10 million.
Conclusion. The tax incentive created by a DISC should not be overlooked by wholesalers or manufacturers of exported goods. This tax incentive can create substantial tax savings, resulting in additional cash flow for the business.