2017

IC-DISC Rules and

Regulations
DISCUSSES THE FUNCTION OF THE IC-DISC AND THE RULES AND
REGULATIONS GOVERNING THEM
JUSTIN STRAUB, CPA
IC-DISC Rules and Regulations

Background and Purpose

IC-DISC Concept and History
Against the backdrop of inflation and trade deficits of the late 1960s and early 1970s, the Nixon
administration enacted tax law in 1971 to subsidize export of US goods and services by US taxpayers
through the creation of a Domestic International Sales Corporation, a separate entity with no economic
substance that receives privileged tax benefits. A US exporter would then set up a DISC, transfer its
exports to the DISC for a fee, which is tax deductible for the exporter and is non-taxable for the DISC.
The DISC then in turn can distribute its tax-deferred profits in the form of a qualified dividend to its
shareholders at preferable capital gains rates. The European Community at the time found that this tax
benefit for US exporters was unfair and challenged its legitimacy under the General Agreement on
Tariffs and Trade in 1976. The US countered that European tax regulations concerning export income
were also GATT incompatible and in 1976, a GATT panel found that both DISCs and European
regulations were incompatible with GATT. Ultimately, the US replied to international concerns in 1984
by requiring that interest be charged on tax deferred amounts and the treatment of profits in excess of
certain limits to be treated as deemed distributions. From then on, the DISC became an Interest-Charge
Domestic International Sales Corporation, or an IC-DISC for short.

How an IC-DISC Functions

An IC-DISC creates tax savings by converting ordinary income into qualified dividend income for the
taxpayer. The tax savings mechanism requires two parts: the IC-DISC and an operating company. The IC-
DISC is merely a shell company that exists on paper only and an IC-DISC does not need to have
employees, operations or property. The operating company is the existing company where all normal
operations take place. From the revenue generated by Qualified Export Receipts, as described in the
following paragraphs, the operating company pays a fee to the IC-DISC. The operating company
subsequently treats the fee as an expense and reduces taxable income for the corporation or its
shareholders. Correspondingly, the IC-DISC treats the fee as tax deferred income taxed upon distribution
to shareholders as a Qualified Dividend. The tax savings are the difference between incomes taxed at
the ordinary income rates versus incomes taxed at qualified dividend rates.

Qualifying as an IC-DISC
Qualification Requirements for an IC-DISC
To qualify for and benefit from an IC-DISC, a taxpayer must meet rules and guidelines promulgated by
the Internal Revenue Code, revenue rulings and regulations. The creation of an IC-DISC falls under the
laws of a state or the District of Columbia and the majority of its business must be export related, that
the taxpayer must be profitable and that the taxpayer must be a US taxpayer. The IRC requires that 95%
of the gross receipts of an IC-DISC during the tax year must be Qualified Export Receipts. At the end of
the tax year, the IRC requires an IC-DISC have an adjusted basis of Qualified Export Assets equal to at
least 95% of the total adjusted basis of all of its assts. The IC-DISC can only have one class of stock that is
required to maintain par or stated value of $2,500 on each day of the tax year. If the corporation is a
new corporation, then the corporation is required to maintain this stock from the last day to elect IC-
DISC status and for each subsequent day thereafter. The IC-DISC is required to maintain separate books
and records and must conform to the tax year of the principal shareholder who has the highest
percentage of voting power. An IC-DISCs election to treating it as such applies for the tax year of the

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election. An IC-DISC cannot be an IRC 501 exempt corporation, an IRC 542 personal holding
company, an IRC 581 or 593 financial institution, an insurance company subject to tax under IRC
subchapter L, and IRC 851(a) regulated investment company nor an S corporation.[2]

Distributions Made to Meet IC-DISC Qualification Requirements

In the event that an IC-DISCs Qualified Export Assets are less than 95% of its total assets or an IC-DISCs
Qualified Export Receipts are less than 95% of its gross receipts, an IC-DISC will be required to make a
distribution to its shareholders to maintain its status as an IC-DISC. The IC-DISC must inform its
shareholders when it makes a distribution that the purpose of the distribution is to meet qualification
requirements. If the IC-DISC did not have enough Qualified Export Receipts, then the distribution will
equal its portion of taxable income related to gross receipts that are not Qualified Export Receipts. If the
IC-DISC did not have enough Qualified Export Assets, then the distribution will equal the fair market
value of assets that are not Qualified Export Assets on the last day of the IC-DISCs tax year. In the event
that the IC-DISC meets neither requirement, then its mandatory distribution will be equal to the sum of
both amounts.

Accounting Methods for IC-DISCs

IC-DISCs are required to keep accounting records and books separate from their corresponding
operating corporation and from the taxpayer themselves. Allowable accounting methods for IC-DISCs
include cash, accrual or any method allowable by the IRC. The method of accounting an IC-DISC chooses
is subject to certain rules promulgated by the IRS. If an IC-DISC has average annual gross receipts of over
$5 million, the IC-DISC must adopt the accrual method of accounting. IC-DISCs must use the accrual
method of accounting for sales and purchases of inventory unless they are a qualified taxpayer or a
qualifying small business taxpayer. If the IC-DISC is a member of a controlled group, they must use an
accounting method that does not distort any group members income, including its own.[3]

Taxation
Taxation of the IC-DISC
Generally, an IC-DISC is not subject to taxation under subtitle A of the IRC (Income taxes) with the
exception of taxes covering tax avoidance transfers. An IC-DISC is subject to all other taxes imposed
under subtitles other than subtitle A. Although an IC-DISC is not a taxable entity and its shareholders
ultimately bear any impost, taxable income must be determined to ascertain the tax effect for its
shareholders. Computation of taxable income for the IC-DISC is as if the IC-DISC made no election for its
status and remained a domestic corporation. Consequently, the IC-DISC chooses its accounting methods,
inventory methods and elections.

Grouping of Transactions
An IC-DISC generally computes taxable income on an individual transaction basis. Annually, the taxpayer
can make an election to group some or all transactions by product or product line for computing taxable
income. It is up to the taxpayers discretion to determine which products or product lines to group, and
the grouping is permissible if it conforms to either of two standards. The first standard being that the
group must be a recognized industry or trade usage and the second standard being that it must be a
two-digit major group of the Standard Industry Classification issued by the Statistical Policy Division of
the Office of Management and Budget. Additionally, tax courts have held that country-by-country

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grouping is not permissible.[1] The choice to group by product or product line applies only to the
transactions covered under said grouping. For example, a taxpayer could group one product line and
choose to treat another on a transactional basis. Grouping rules for services follow different rules. The
IRC deems that an IC-DISC can have income from services under three scenarios. The first being services
which are related and ancillary to any qualified exchange, sale, lease or disposition of export property,
the second being architectural and engineering services for construction projects outside of the US and
the third being managerial services to facilitate the production of Qualified Export Receipts of an
unrelated IC-DISC. Taxpayers can group related and ancillary services are with the sale or lease they
correspond to provided they are booked in the same year as the sale or lease. If related and ancillary
services are not booked in the same year as the export property, taxpayers can group the services to the
products or product lines they correspond to so long as the grouping is consistent with the grouping of
export property for the taxable year of the sale, or the receipt or accrual of payment. Taxpayers cannot
group service income from engineering, architectural services or service income from rendering
managerial services to facilitate Qualified Export Receipts; only a transactional basis is permissible.

Taxation of the IC-DISC Shareholder

The earnings and profits of the IC-DISC distributed to its shareholders are taxable to the shareholders.
There are three types of earnings and profits an IC-DISC can have; these are accumulated IC-DISC
income, previously taxed income and other earnings and profit. The class of earnings and profit
determines whether IC-DISC distributions are taxable and to what extent. Accumulated IC-DISC income
are earnings and profits that are not Deemed Distributions and they may be tax-deferred so long as they
are not actually distributed. Partial or complete termination of tax-deferral can arise due to certain
foreign investment corresponding to Producers Loans, revocation or disqualification of IC-DISC status or
certain dispositions of IC-DISC stock where there is realized gain.

Order of Actual and Deemed Distributions

Generally, any actual distribution to a shareholder from the IC-DISCs earnings and profit follows a
proscribed order. The distributions first come from the extent of previously taxed earnings and profit,
followed by the extent of accumulated IC-DISC income and lastly from the extent of other earnings and
profit. Deemed Distributions and distributions made to meet IC-DISC qualifications follow a different set
of rules. These distributions first come out of the extent of accumulated IC-DISC income, followed by the
extent of other earnings and profit, lastly by the extent of previously taxed income.

Pricing Rules
Intercompany Pricing Rules
When a related party sells export property to an IC-DISC, the IC-DISC must follow proscribed
intercompany pricing rules to determine taxable income for the IC-DISC and the related party seller. The
intention of intercompany pricing rules are to prevent the related party from pricing export property at
a loss. Regardless of the sale price of export property, the IC-DISCs taxable income from the sale of
export property purchased from a related party cannot exceed the greatest of three thresholds. The first
threshold is 4% of Qualified Export Receipts plus 10% of related Export Promotion Expenses. The second
threshold is 50% of the combined taxable income from Qualified Export Receipts of the related party
and IC-DISC plus 10% of related Export Promotion Expenses. Finally, the third threshold is taxable
income derived on the sale price of export property, provided the taxable income of the related party

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and the IC-DISC clearly represents the sale price. If either the 4% of Qualified Exports Receipts method
or the 50% combined taxable income method is used, it is subject to a no loss rule, which disallows
either method should it cause a loss for the related seller.[4]

Marginal Costing Pricing Rules

In addition to the Intercompany Pricing Rules, the IRS provides another set of pricing rules called
Marginal Costing. The Marginal Costing rules apply only for taxpayers using the 50% of combined
taxable income method for computing IC-DISC taxable income. Marginal Costing is a method that only
factors variable or marginal costs of producing and selling when calculating combined taxable income.
The IRS defines variable costs as either direct production costs or Export Promotion Expenses, only if
claimed as such in calculating IC-DISC taxable income under the 50% combined taxable income method.
Direct production costs are necessary costs that arise from production and are part of the cost of either
direct labor or direct materials.[5] Direct material costs include the cost of integral materials for the
specific product during the ordinary course of manufacturing and which are associated with particular
units or groups of units. Direct labor is the cost of labor associated with particular units or groups of
units. Direct labor costs include basic compensation, overtime pay, vacation and holiday pay, sick leave
pay, shift differential, payroll taxes and payments to unemployment benefit plans on behalf of
employees. A taxpayer can choose to use Marginal Costing rules when they want to establish or
maintain a foreign market for sales of Qualified Export Receipts. An IC-DISC is seeking to establish or
maintain a foreign market when its combined taxable income calculated from the Marginal Costing
Rules is greater than the combined taxable income from the full costing rules. The overall profit
percentage limits the Marginal Costing. The numerator of the overall profit percentage is the full costing
combined taxable income of the IC-DISC and the related seller plus all other taxable income of the
related seller from all sales foreign and domestic of a product or product line. The denominator is the
worldwide sales of that product or product line and taking the product of the result with the Qualified
Export Receipts from the respective transaction. If the Marginal Costing combined taxable income
subject to the overall profit percentage limitation is greater than the full costing combined taxable
income, the marginal costing combined taxable income may be used to determine the IC-DISCs income
under the 50% combined total income pricing method.

Definitions
Related Foreign Export Corporation
Stocks or securities of a Related Foreign Export Corporation are Qualified Export Assets under the IRC. A
Related Foreign Export Corporation is an umbrella term that includes Foreign International Sales
Corporations, Real Property Holding Companies and Associated Foreign Corporations, subject to certain
criterion for each.

Foreign International Sales Corporation

To be a Related Foreign Export Corporation, a Foreign International Sales Corporation must have 50% of
the total voting power of its stock directly owned by the IC-DISC. In addition, at least 95% of the Foreign
International Sales Corporations gross receipts must come from Qualified Export Receipts or interest on
Qualified Export Assets. The gross receipts provision for Qualified Export Receipts only includes receipts
from the exchange, sale or leasing of export property, the supporting services for any qualified sale of
export property or the gross receipts from exchanging or selling of Qualified Export Assets, which are

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not export property where there is recognized gain. Interest from Qualified Export Assets is limited to
accounts receivable as defined prior and temporary investments.

Real Property Holding Company

A Real Property Holding Company is a Related Foreign Export Corporation under two conditions. The
first condition is that an IC-DISC must directly own more than 50% of the voting power of the Real
Property Holding Companys stock. The second condition is that the holding companys primary and sole
function is to possess title for real property located outside of the US for the sole use of the IC-DISC
where foreign law prevents the IC-DISC from holding title to the property.

Associated Foreign Corporation

An Associated Foreign Corporation is a Related Foreign Export Corporation when either the IC-DISC or a
controlled group in which the IC-DISC belongs owns less than 10% of the voting power of the Associated
Foreign Companys stock. A controlled group of corporations can consist of parent-subsidiary controlled
groups, brother-sister controlled groups, combined groups or certain insurance companies. To be a
parent-subsidiary controlled group, the parent corporation must possess at least 80% of the combined
voting stock or 80% of the value of shares of all classes of stock for each corporation in the group.[6] A
brother-sister controlled group is a group comprised of two or more corporations if up to five persons
who are individuals, estates or trusts own stock comprising greater than 50% of the voting power of all
classes of voting stock or 50% or more of the total value of shares for each corporation.[7] A combined
group comprises three or more corporations where one of the corporations is a parent corporation of
the others and the other corporations are in either a brother-sister group or parent-subsidiary group.[8]
There are provisions for insurance companies, where groups of two or more life insurance corporations,
which are members of a controlled group, are themselves a controlled group separate of the other
groups to which they belong.[9] In addition to meeting ownership requirements of the foreign
corporation, the IC-DISCs ownership of the foreign corporations securities must facilitate Qualified
Export Receipts for the IC-DISC.

Export Promotion Expenses

Export Promotion Expenses are expenses that assist in the distribution or sale of export property outside
of the US. Export Promotion Expenses include 50% of the cost of shipping the export property on US
owned and operated ships and aircraft but do not include income tax.

Producers Loans
Qualified Export Assets are obligations that arise under a Producers Loan. What constitutes a
Producers Loan is limited two ways by the IRC. The first limitation adds all of the Producers Loans that
do not exceed the sum of the adjusted basis of plant, property and equipment acquired by the loans. In
addition, the amount of the borrowers property held for sale or lease in the normal course of business
at the beginning of the year adds to this sum, along with the aggregate amount of research and
experimental expenditures in the US during all preceding taxable years beginning December 31, 1971.
This sum is further multiplied by the sum of Qualified Export Receipts as a percentage of total receipts
for the three tax years immediately preceding the current taxable year not including any taxable year
commencing prior to 1972 to arrive at the first limitation for what constitutes Producers Loans. The
second limitation is the sum of a Producers Loan added to the unpaid balance of all other Producers
Loans that does not exceed the adjusted basis of plant, property and equipment acquired by the loan.

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The amount of the borrowers property held for sale or lease in the normal course of business on the
first day of the taxable year adds to the preceding sum, along with the aggregate amount of research
and experimental expenditures in the US during all preceding taxable years beginning December 31
1971 on the first day of the taxable year. The aggregate amount of the borrowers research and
experimental expenditures during the taxable year are also included in this amount.[10] At the start of
the month of origination, a Producers Loan must not raise the unpaid balance on all of its Producers
Loans above the level of accumulated IC-DISC income. A Producers Loan is also required to have a note
or other written instrument of indebtedness with a stated maturity date not to exceed 5 years
specifically marked as a Producers Loan. The Loan can only be for a person who makes, grows or
extracts export property.

Qualified Export Receipts

Qualified Export Receipts are sales of export property to jurisdictions outside of the US. To be a
Qualified Export Receipt, the exporter must manufacture, produce, grow or extract export property
within the US. Additionally, the exporter must hold export property primarily for sale, lease or rental in
the ordinary course of business or trade for the direct use, consumption or sale outside the US.
Exporters must also ship property out of the US within one year of purchase and cannot be return the
shipment to the US within three years. An exporter must also prove that at least 50% of the fair market
value of the exports must have derived from the US. Export items that do not qualify as Qualified Export
Receipts include intangible goods, products where a deduction for depletion is allowable, products
where there are prohibitions or curtailments on exports, any unprocessed softwood timber and services
other than engineering or architectural services.

Qualified Export Assets

Related to Qualified Export Receipts, Qualified Export Assets refer to property produced in the US held
mainly for sale or use outside of the US, but they also refer to assets used to service export property,
certain accounts receivable, securities, obligations and deposits. Export property is as property made,
grown or extracted in the US by a person other than an IC-DISC. The property cannot be property leased
or rented by an IC-DISC for use by any member of a controlled group nor can it be an intangible asset
such as a patent, invention, model, trademark or franchise.[11] The property cannot be an asset with an
allowable deduction for depletion [13], nor can it have a prohibition or curtailment on its production.
Unprocessed softwood timer is not a Qualified Export Asset.[12] Accounts receivable are also Qualified
Export Assets provided they correspond to gross receipts from the exchange, leasing or supporting
services of export property or the gross receipts from architectural or engineering services in connection
with construction outside the US. Temporary investments can also be Qualified Export Asset provided
the investment is in an amount reasonable to meet the working capital needs for the IC-DISC.
Obligations related to a Producers Loan, obligations issued or insured by the US Export-Import Bank or
the Foreign Credit Insurance Association or obligations issued by a domestic corporation that facilitates
the financing of export property under an agreement with the Export-Import Bank where the bank
guarantees the obligations are also Qualified Export Assets. Stocks or securities of a Related Foreign
Corporation or Amounts on Deposit in the US in excess of reasonable working capital used to acquire
Qualified Export Assets are themselves Qualified Export Assets.

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Amounts on Deposit in Excess of Reasonable Working Capital

When an IC-DISC has amounts in excess of reasonable working capital on deposit to acquire Qualified
Export Assets, the IRS has proscribed rules relating to the timing of such deposits. The IRS refers to these
deposits as Funds Awaiting Investment and provides regulations to define its parameters. Funds
Awaiting Investment are deemed as such only if by the last day of each of the sixth, seventh and eighth
months following the end of the tax year the sum of the adjusted bases of the IC-DISCs Qualified Export
Assets exceeds 95% of the sum of the adjusted bases of all IC-DISC assets.[14] Funds Awaiting Investment
do not need to correspond to a Qualified Export Asset during any of the time intervals listed.

Deemed Distribution in a Qualified Year

Income earned by an IC-DISC is taxable to its shareholders not only when it is actually distributed. The
IRC provides that earnings and profit not distributed are taxable under certain conditions. The most
common form of a deemed distribution is a distribution in a qualified year. During any year when a
corporation qualifies as an IC-DISC, a deemed distribution is limited to current year earnings and profit
and a shareholders pro rata share of several items. A deemed distribution can be the pro rata share of
gross income derived from Producers Loans. The gain recognized by the IC-DISC on the sale of export
assets previously transferred to it can be a deemed distribution, but only to the extent of non-
recognition of gain. If the export assets are Qualified Export Assets, the export assets cannot be
inventory and the gain is limited to the extent of previous non-recognition, provided the gain would be
ordinary income on its sale or exchange rather than its transfer to the IC-DISC. A deemed distribution
can also be 50% of the taxable income of an IC-DISC attributable to military property [15], 100% of the
taxable income corresponding to Qualified Export Receipts of the IC-DISC in excess of $10 million [16] or
the amount of foreign investment corresponding to Producers Loans of an IC-DISC for the current tax
year.[17]

Deemed Distributions upon Disqualification

When a corporation revokes its IC-DISC election or fails to satisfy the IC-DISC qualification requirements,
a deemed distribution is made to its shareholders. The distribution is equal to the shareholders pro rata
share of IC-DISC income accumulated during the immediately preceding consecutive taxable years when
the corporation was an IC-DISC.[18] The distributions are in equal installments on the last day of each of
the ten taxable years of the corporation following year of termination or disqualification.[19]

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Appendix
Example Facts
S Corporation has $6 million in domestic sales and $2 million in foreign sales. Taxable income is
$600,000 from the domestic sales and $120,000 from the foreign sales. What is the federal tax savings
with or without an IC-DISC? Assume that the individual tax rate is 39% and the capital gains tax rate is
20%.

With IC-DISC Election

=
$600,000 $120,000 = $480,000
$480,000 39% = $187,200 =
= $120,000
$120,000 20% = $24,000 =
$187,200 + $24,000 = $211,200 =

Without IC-DISC Election

($600,000 + $120,000) 39% = $280,800 =

Tax Savings
$280,800 $211,200 = $69,600

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IC-DISC Rules and Regulations

References
1. Napp Systems, Inc. v. Commissioner, T.C. Memo 1993-196 (1993)
2. Treas. Reg. 1.992-1(f)
3. Treas. Reg. 1.991-1(b)(2)
4. Treas. Reg. 1.994-1(e)(1)(i)
5. Treas. Reg. 1.4711-11(b)(2)
6. IRC 1563(a)(1)
7. IRC 1563(a)(2)
8. IRC 1563(a)(3)
9. IRC 1563(a)(4)
10. IRC 993(d)(2)
11. IRC 993(c)(2)(B)
12. IRC 993(c)(2)(C)
13. IRC 993(c)(2)(E)
14. Treas. Reg. 1.993-2(j)
15. IRC 995(b)(1)(D)
16. IRC 995(b)(1)(E)
17. IRC 995(b)(1)(G)
18. IRC 995(b)(2)(A)
19. IRC 995(b)(2)(B)

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