An old idea is brand new again and can result in significant annual U.S. tax savings. Privately owned U.S. exporters (an S corporation, an LLC, partnership, or closely held C corporation) now have the fantastic opportunity to take advantage of the recent reduction of dividend rates from 35 percent to 15 percent if they form a Domestic International Sales Company ("DISC"). Since the American Jobs Creation Tax Act of 2004 has repealed and phased out the tax benefits of the Extraterritorial Income Exclusion tax credits, astute exporters have reaped the unanticipated tax benefits of the dividend rate reduction through the use of DISCS (which Congress created back in 1984 to create incentives for U.S. exporters).
What's even better is that forming a DISC is simple, inexpensive, and in most instances, provides even greater tax benefits than the former Extraterritorial Income Exclusion. Here is a general overview of how it works. The owners of an S corporation, partnership, limited liability company or closely held C corporation, that export U.S. products form a new separate corporation, and will elect to treat this new entity as a DISC for federal income tax purposes. The DISC will typically have the same ownership structure as the exporting company. The DISC also does not require any employees. The exporting company will enter into a commission agreement with the DISC. The commissions are deductible to the U.S. exporter and the DISC will not have to pay tax on the receipt of the commission income. The shareholder of the DISC will only be subject to tax at the reduced 15% rate for deemed or actual dividend distributions.
This means that an exporter with a shareholder who is in the 35% individual tax bracket will be taxed at the current reduced 15% rate on the distribution of the export earnings shifted to the DISC via commission payments. In other words, a 20% savings (35% less 15%) is available on all commission payments made to the DISC.
These tax savings can be substantial. For example, under IRS regulations, the commission payments will depend upon the methodology chosen. Safe harbors allow a DISC to record its share of commission income at the greater of: (i) four (4%) of the qualified export receipts plus 10% of the export promotion expenses, or (ii) fifty (50%) percent of the combined taxable income from export sales of the supplier plus 10% of the export promotion expenses.
The existence of the DISC will be transparent to the export company's customers. The exporter will continue to operate its business in the same manner and its employees will continue to perform the company's manufacturing, sales, billing, shipping and collection functions. The fact that there is a commission agreement between the exporter and the DISC will not have to be disclosed to the exporter's customers and no documentation provided to the customers will need to indicate the existence of, or services deemed provided by the DISC.
In addition, distributors or manufacturers may qualify for the tax benefits of DISCS on their export sales. Architects and engineers may also be surprised to learn that their services can also qualify of DISC benefits for construction projects located outside of the U.S if professional services related to those projects can be performed in the United States.
To qualify as a DISC, among other things, the new entity must be a U.S. corporation with one class of stock that has a par value of at least $2,500. Also, at least 95% of the Disc income must be from exports (including commissions from exports) and 95% of its assets must be export related. No more than 50% of the fair market value of its exported products can be attributable to article imported into the United States. While these rules are quite technical, the rules were set up as an export incentive and the thresholds are relatively easy to satisfy.