IC-DISC commission payment provisions

Editor: Robert Venables, CPA, J.D., LL.M.

Since 1971, the domestic international sales corporation (DISC) provisions under Sec. 992 have provided taxpayers a tax–saving opportunity on certain qualifying export income. These tax benefits include the potential for tax deferral and tax rate arbitrage, especially since the advent of the preferential tax rate on qualified dividend income. Qualifying export income is generally income earned on the export of U.S. property manufactured, produced, grown, or extracted in the United States for direct use outside the United States (Secs. 993(a)(1) and (c)(1)). Income from certain assets used in connection with the performance of engineering or architectural services for construction projects located outside the United States also qualifies, along with certain related and subsidiary services (Sec. 993(b)(2)).

A DISC (commonly referred to as an interest charge DISC, or IC–DISC) is a domestic corporation whose income is derived almost exclusively from U.S. export activities, has made a valid DISC election, and continues to meet certain requirements under U.S. tax law (Secs. 992(a) and (b)). IC–DISCs can be either buy–sell IC–DISCs or passive commission IC–DISCs. Buy–sell IC–DISCs operate whereby the IC–DISC purchases goods from a related–supplier company and exports those goods to foreign customers. A commission IC–DISC is treated as if it were a commission agent for a principal that exports outside the United States. Commission IC–DISCs exist largely as “paper companies” — they are paid a commission by a related supplier, and if they meet the statutory requirements and operate under the terms of a related–party commission agreement, their owners will be eligible for certain tax benefits. In practice, most IC–DISCs function as commission IC–DISCs and are not required to perform substantial economic functions.

The commission paid to an IC–DISC reduces the taxable income of the related supplier, which is taxed at either corporate tax rates (for related–supplier C corporations) or, potentially, the highest marginal individual income tax rates (for related–supplier individuals and passthrough entities). On the other hand, IC–DISC income is tax–exempt until it is distributed (or deemed distributed), the IC–DISC shareholders dispose of their stock, or the IC–DISC loses its special tax status. IC–DISC dividends, considered qualified dividends, are eligible for the preferential capital gain rates. However, an interest charge must be paid on deferred distributions by an IC–DISC (hence the “interest charge,” or “IC,” moniker).

Because of the paper–company nature of passive commission IC–DISCs, related suppliers may lack discipline in making commission payments, which could jeopardize the related tax benefits. To ensure they benefit from the preferential tax provisions and avoid inadvertently disqualifying the IC–DISC and jeopardizing future tax planning, taxpayers must adhere to the various IC–DISC commission payment provisions.

IC-DISC requirements

Sec. 992 and the related regulations provide requirements a corporation must meet to qualify as an IC–DISC. Among those are the 95% qualified export receipts test and the 95% qualified export asset test (the 95% tests).

Qualified export receipts test: An IC–DISC must derive at least 95% of its gross receipts from any of eight specified categories of income, including gross receipts from the sale, exchange, or other disposition of export property (Sec. 993(a)(1)). For these purposes, commissions related to qualifying receipts from the sale, lease, or rental of property held primarily for sale, lease, or rental in the ordinary course of trade or business will also be considered qualifying gross receipts (Sec. 993(f)). A detailed discussion of all the categories of qualifying gross receipts is beyond the scope of this discussion.

Qualified export assets test: Regardless of the related supplier’s and IC–DISC’s accounting method, taxpayers must comply with all the statutory requirements to maintain the IC–DISC’s tax–favored status. One of those requirements is that at the close of the IC–DISC’s tax year, at least 95% of the sum of the adjusted basis of all its assets must be considered qualified export assets (Sec. 992(a)(1)(B)). The definition of “qualified export assets” for this purpose is found in Sec. 993(b) and Regs. Sec. 1.993–2 and includes several asset classes. A detailed analysis of the various qualified export assets is beyond the scope of this discussion. However, for a commission IC–DISC, the most relevant is trade receivables — namely, unpaid IC–DISC commissions.

Qualifying trade receivables and unpaid IC-DISC commissions

For the purposes of the qualified export assets test, a commission receivable from a related party is generally considered a qualified export asset if the amount (or a reasonable estimate thereof) is paid to the IC–DISC within 60 days following the close of the tax year during which the transactions occurred (Regs. Secs. 1.993–2(d) and 1.994–1(e)(3)). For calendar–year IC–DISCs, payments must be made by March 1 (or Feb. 29 in a leap year). Therefore, not paying the commission within the 60–day period jeopardizes satisfying the qualified export assets test, which could disqualify the IC–DISC.

It is possible that all the information required to accurately calculate the IC–DISC commission expense may not be available within 60 days of year end and that an estimated commission must be calculated and paid. If this estimate is deemed reasonable and is less than the final commission amount, the difference will be considered a qualified export asset if paid within 90 days after the commission calculation is finalized (Regs. Sec. 1.994–1(e)(5)). Under a safe–harbor test, an estimated payment will be considered reasonable if it results in the IC–DISC realizing at least 50% of the IC–DISC’s taxable income from a completed transaction as reported on its tax return for the tax year in which the transaction is completed (Regs. Sec. 1.994–1(e)(3)(iv)(a)). This means that the initial commission cannot be less than 50% of the final commission or that the final commission amount can be as much as double the initial commission estimate.

Example 1: ABC Inc. is an S corporation that owns 100% of Export Co. Inc., an IC–DISC. In January 2025, ABC realizes that it was eligible to make an IC–DISC commission payment of $150,000 to Export Co.

Because no payments were made in 2024, Export Co. has a $150,000 commission receivable that is considered a qualified export asset if paid within 60 days of year end. If ABC paid $75,000 (50%) of the commission by March 1, 2025, the commission receivable would be considered a qualified export asset.

Example 2: Assume the same facts as Example 1 and that ABC Inc. made a $150,000 commission payment by March 1, 2025. On June 2, 2025, ABC finalizes its commission calculation and determines that it is eligible to make a total IC–DISC commission of $200,000.

ABC can make an additional $50,000 commission payment to Export Co. by Aug. 31, 2025 (90 days after the final commission is determined). Because $150,000 was paid by March 1, 2025, Export Co.’s commission receivable can be as much as $300,000 and still be considered a reasonable estimate and therefore a qualified export asset.

Type of payment

Because IC–DISC commission payments are often received by the IC–DISC and then subsequently distributed to the owners, taxpayers (especially those with subsidiary IC–DISC structures) may become lax and fail to make the actual cash payments. These taxpayers may question whether an actual cash payment needs to occur or if a mere journal entry will suffice to garner the tax benefits of the IC–DISC structure.

Regs. Sec. 1.994–1(e)(3)(ii) provides that the IC–DISC commission payment must be made in the form of money; property (including accounts receivable from sales by or through the IC–DISC); a written obligation that qualifies as debt under the safe–harbor rule of Regs. Sec. 1.992–1(d)(2)(ii); or an accounting entry offsetting the account receivable against an existing debt owed by the person in whose favor the account receivable was established to the person with whom it engaged in the transaction. All these forms of payment seemingly involve the current or prior transfer of property. While this regulation appears to allow for a journal entry in lieu of an actual payment, the regulation specifies that the journal entry must offset an account receivable against an existing debt, which indicates that a prior property transfer occurred to create that account receivable. While the clearest way to document payment may be for a cash commission payment to occur, circumstances may not allow such a payment, making the safe–harbor obligation perhaps the best alternative to meet this requirement.

Deficiency distribution

If an IC–DISC fails the 95% gross receipts test, the 95% asset test, or both, Sec. 992(c) allows a special deficiency distribution to be made to meet the qualification requirement(s) so long as there was reasonable cause for the failure(s).

These rules provide that an otherwise disqualified IC–DISC that failed the 95% qualified export asset test, the 95% gross receipts test, or both, may distribute an amount equal to the nonqualifying gross receipts or the nonqualified export assets as of the last day of the tax year. The distribution must be pro rata to the IC–DISC shareholders. This deficiency distribution may be made in cash or other property and is taxed as a current–year distribution. Although the distribution is taxed as a current–year distribution, if made, the IC–DISC will qualify for the year in which it failed either or both 95% tests.

An IC–DISC’s failure to meet either or both of the 95% tests is considered reasonable if the action or inaction that resulted in the failure occurred in good faith, such as failure to meet the 95% assets test due to blocked currency or expropriation, or failure to meet either test because of reasonable uncertainty as to what constitutes a qualified export receipt or a qualified export asset (Regs. Sec. 1.992–3(c)(2)). Alternatively, if an IC–DISC makes a deficiency distribution for a tax year on or before the 15th day of the ninth month after the close of the tax year, the failure of one or both of the 95% tests will be considered reasonable if at least 70% of the gross receipts of the IC–DISC for the tax year consist of qualified export receipts, and the adjusted bases of the IC–DISC’s qualified export assets on the last day of each month of the tax year are at least 70% of the sum of the adjusted bases of all assets held by the IC–DISC on each such day (Regs. Sec. 1.992–3(d)).

If an IC–DISC makes a deficiency distribution after the 15th day of the ninth month after the close of the tax year with respect to which such distribution is made, the distribution will not be deemed to satisfy the 95% of gross receipts test or the 95% assets test for the year unless an interest charge of 4.5% is paid by the IC–DISC for each year or partial year that the nonqualified assets are retained by the IC–DISC (Regs. Sec. 1.992–3(c)(4)). An IC–DISC does not lose its election to be treated as an IC–DISC unless it does not qualify as an IC–DISC for five consecutive years (Regs. Sec. 1.992–2(e)(3)). Therefore, a deficiency distribution that allows a corporation to qualify as an IC–DISC in any year in a period of five consecutive years will allow the IC–DISC election to remain in effect for all the years in that period.

Example 3: Assume the same facts as Example 1 but that ABC Inc. fails to make a commission payment to Export Co. Inc. by March 1, 2025, of the following year.

Because ABC did not make commission payments within 60 days of year end, Export Co. failed the qualified export asset test. Export Co. will be deemed to meet that test if ABC makes a deficiency distribution (either cash or qualified property) by the 15th day of the ninth month (Sept. 15), provided it has reasonable cause.

Preserving IC-DISC tax benefits

Taxpayers can continue to use commission IC–DISC structures to obtain income tax benefits so long as the IC–DISC continues to meet the statutory requirements. Taxpayers should take care to follow the specific IC–DISC commission payment provisions, including making such payments timely and in the proper form, to ensure they do not unknowingly disqualify the IC–DISC and forfeit current or future tax benefits.

Editor

Robert Venables, CPA, J.D., LL.M., is a tax partner with Cohen & Co. Ltd. in Fairlawn, Ohio.

For additional information about these items, contact Venables at rvenables@cohencpa.com.

Contributors are members of or associated with Cohen & Co. Ltd.