Formation of DISC. Once a business establishes that it is exporting US-made goods, the business will need to form a new, separate corporation (such as an Ohio corporation) and file an IRS “Domestic International Sales Corporation” (“DISC”) election for that new corporation. 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 taxable year or inception of the DISC. The DISC may be owned by the same persons who own the export business or, in some cases, may be owned by a wholly owned subsidiary of the export business itself. The DISC is a tax-exempt entity.
Purpose of DISC. The sole purpose of the DISC is to act as a “sales agent” for the business. However, the DISC is not required to perform any specific activities or have employees. The DISC will be deemed to provide such services on behalf of the business and will be entitled to a “commission” payment that is tax-deductible to the business. This tax deduction generates the tax savings for the business. The tax deduction lowers the business’ taxable income thereby lowering the taxes that are owed to federal and state government. The DISC is tax-exempt so it does not owe any tax on the commission amount.
Amount of Tax-Exempt Commissions. There are three methods for determining the amount of commissions payable to the DISC. One method provides that the commissions are equal to 50% of the net income from the export sales (the “50-50 method”). Another method provides that the commissions are equal to 4% of the gross sale price of the export sales. A third method provides for a commission based on an arm’s length price. To illustrate, if the annual export sales generate $500,000 of net income, use of a DISC would allow an additional $250,000 tax deduction under the 50-50 method. Assuming a 40% tax rate, the tax savings would be $100,000.
Taxable Distributions by DISC. The commissions that are payable to the DISC may be distributed to the DISC shareholder (who would be the same person who owns the business or the business itself). Distribution of the commission to the owners of the DISC would be subject to the currently tax-favored rate of 15% for federal income tax purposes. This favorable 15% rate is less than half of the highest ordinary income tax rate (currently 35%) applied to individuals. Continuing the above example, if the DISC distributes the $250,000 of commissions, the owner of the DISC would be subject to a 15% federal income tax rate (applicable for 2011 and 2012). The tax savings would still be $50,000 ($250,000 times 20%) (20% is the difference between the 15% rate and the 35% rate).
Tax Deferral Through Loan. Alternatively, the $250,000 of commissions may be treated as a loan by the DISC to the export business with no current tax. The export business would simply retain the commission payment (but deduct it for tax purposes). The loan amount must be reinvested in the business and the loan must meet certain other requirements. The IRS imposes an interest charge on the deferred taxes (at the U.S. Treasury Bill rate, currently 0.34% annually). Given the current low Treasury Bill rate, the deferral of tax may make the most sense.
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 exporters of US-manufactured goods, since it creates substantial tax savings and is designed to encourage the exporting of such goods. Establishing a DISC early in 2011 allows for a greater tax savings in 2011.