Using a domestic international sales corporation (DISC) can provide significant tax savings to exporters with $10 million or less in export sales. The tax advantages under the DISC provisions for a U.S. exporter result because (1) a DISC that is established in the United States will not be subject to income tax; (2) tax deferral on the income of the DISC can be obtained to the extent such income exceeds the amount currently taxed to the DISC shareholders; and (3) in some cases the tax rate on the export income can be reduced from 35 percent to 15 percent.
What is a DISC
A DISC is a new corporation set up as by the owners of an exporting company that elect to treat the corporation as a DISC for federal income tax purposes. The DISC will usually have the same ownership structure as the exporting company. The exporting company will enter into a commission agreement with the DISC under which the DISC will earn a commission based on the export sales of the exporting company, the size of which is limited under the tax rules.
Implementing a DISC strategy will not require an exporter to change its operations in any significant way. The exporter will continue to operate its business in the same manner. Its employees will continue to perform their same functions. The DISC is not required to have any employees or perform any specific function. The existence of a DISC will generally be transparent to the exporter's customers.
How it Works
By using a DISC the exporter (a closely held C corporation, an S corporation, an LLC, or a partnership) will pay commissions to the DISC for the exporter's qualified export sales.The commissions are deductible by the exporter for U.S. federal income tax purposes and the DISC is not subject to federal income tax under the DISC provisions of the Internal Revenue Code. The shareholders of the DISC will generally not recognize income until the commission income is distributed to the shareholders as a dividend.
Because a DISC will qualify as a "qualified domestic corporation," the dividend payment of the commission income is currently taxable to the exporter's individual shareholders or partners at the favorable 15 percent tax rate rather than the 35 percent ordinary tax rate. In addition, because a DISC is exempt from tax, any tax on its income is deferred to the extent it exceeds the amount currently distributed to its shareholders. For each tax year, a DISC may defer tax only on the first $10 million of qualified export receipts. For amounts exceeding $10 million, shareholders of a DISC are treated as having received a distribution taxable as a dividend.
The state income taxation of a DISC varies among states. While some states follow the federal income tax treatment of a DISC, others do not recognize the federal DISC treatment. Exporters may want to consider incorporating their DISC in Delaware because it recognizes the DISC as a tax-exempt entity.
Qualifying as a DISC
From a formation perspective, the DISC must be a domestic corporation with a single class of stock that has a minimum par value of $2,500. In most cases the shareholders or partners of the exporter will own the DISC, or in some cases the exporter may own the DISC directly. The corporation must make a timely election to be treated as a DISC, which election must be consented to by all of its shareholders, and in effect for the current tax year. For a corporation's first tax year, the election should be made within 90 days after the beginning of the year.
To qualify as a DISC the corporation must meet both the qualified export receipts and qualified export asset tests. The qualified export receipts test is satisfied if 95 percent of the gross receipts of the DISC constitute qualified export receipts. Qualified export receipts include commissions from sales of export property, rents for the use of export property outside of the U.S., services related to export sales, and engineering or architectural services for construction projects located outside of the U.S.
To qualify as export property the property must be manufactured, produced, grown or extracted in the United States by a person other than the DISC, the export property must be held primarily for the sale, lease or rental for direct use, consumption or disposition outside the United States, and the export property must have a minimum of 50 percent U.S. content.
The qualified export asset test is met if 95 percent of the assets of the DISC are qualified export assets. Qualified export assets include accounts receivable, temporary investments, export property and loans to producers.
Once the DISC is formed it should enter into a commission agreement with the related exporter pursuant to which the DISC will be permitted to charge the exporter a commission on the exporter's qualified export sales. The commission can be calculated under various methods but the two most common approaches are 4 percent of the revenue of the qualified export sales; or 50 percent of the taxable income of the qualified export sales.
DISCs can significantly reduce the tax rates on export profits. The benefits from a DISC are effective from the date the DISC is created. Because of this the longer a taxpayer waits to form a DISC, the less benefits they will receive.