The U.S. tax code contains a number of incentives for desirable activities that U.S. taxpayers can engage in. Some of the incentives can come and go at the whim of Congress, like the research & development credit, but the one incentive that has remained relatively unchanged since 1971 is a benefit for U.S. exporters. That benefit reduces the effective tax rate on export profits by up to 10 percent by converting ordinary income into qualified dividends.
To illustrate how the benefit works, please refer to this example:
- USCo is an S-corporation that has a profit of $1,000 on products it exports.
- If USCo does not have a DISC, its shareholders would pay up to $1,000 * 40.5 percent or $405 in income taxes. The 40.5 percent rate is from the highest individual tax bracket rate of 39.6 percent plus the 0.9 percent Medicare surtax. The taxpayers have an effective tax rate of 40.5 percent.
- If USCo forms a DISC, USCo could pay up to $500 in commissions to the DISC. The commission deduction reduces USCo taxable income and replaces it with a dividend paid by the DISC. USCo’s shareholders would pay only $321.50 in income taxes (i.e. $500 * 40.5 percent plus $500 * 23.8 percent rate for qualified dividends). The taxpayers have an effective tax rate of 32.2 percent.
While the mechanics may look complicated, running the DISC is quite easy. To claim the benefit, the taxpayer must:
- Form a separate entity that meets the requirements of a DISC
- Identify qualifying export sales
- Determine the profit on the export sales
- Pay commissions quarterly to the DISC while the DISC also pays dividends quarterly
- Comply with other statutory rules
If you are an exporter that wants to reduce your effective tax rate on export sales, a DISC is a proven strategy that can help you meet your goal.