RSM Resources

U.S.-based midsized manufacturing companies are among the big tax-saving winners as a result of the American Jobs Creation Act (AJCA) approved by the U.S. Congress last November.

Not only can manufacturing businesses qualify for the new domestic manufacturers’ deduction, but businesses that export could also benefit from two tax-saving provisions in existing law — the extraterritorial income (ETI) exclusion and interest-charge domestic international sales corporation (IC-DISC).

The recently approved AJCA repeals the ETI exclusion, effective Dec. 31, 2004. However, the law also provides transition rules that allow an ETI exclusion equivalent for the transition years of 2005 and 2006. Depending on the facts, companies may want to investigate other tax-saving strategies such as IC-DISCs, which can create permanent tax savings of up to 20 percent on a portion of export income.

"When you look at the aggregate winner in AJCA, midsized, owner-managed manufacturers come out way ahead," says Chad Koebnick, managing director with RSM McGladrey’s International Tax Services. "That’s because the manufacturers’ deduction in the AJCA is targeted at a wide range of manufacturers, a portion of the ETI deduction can still be used, and the tax-savings from IC-DISCs are only available for individual shareholders. The IC-DISC benefits are generally not available to publicly held companies."

Domestic manufacturers’ deduction

The domestic manufacturers’ deduction was the big-ticket item in the AJCA and was designed to replace the ETI, which in 2002 was ruled an illegal export subsidy by the World Trade Organization (WTO).

Since then, two measures have emerged — IC-DISCs and the domestic manufacturers deduction — to replace ETI. And instead of repealing ETI outright as many had expected, Congress instead chose to phase it out.

Congressional researchers estimate the new domestic manufacturers’ deduction will potentially cut business taxes by $76 billion over the next five years — more than offsetting the $50 billion tax break provided by the ETI.

These tax savings are significant and cover a broad range of businesses, including architectural and construction firms, film production and music recording companies, and computer software development firms. (See New "manufacturers’ deduction" applies to broad range of U.S. businesses in the April 2005 issue of Advantage.)

And the manufacturers’ deduction applies to all gross receipts from qualified domestic production — not just income from overseas sales. While this provision was intended as a replacement for ETI, lawmakers did not eliminate ETI.

Extraterritorial income exclusion

Instead, they chose to phase out ETI over the next two years. The AJCA allows businesses to take 80 percent of their former ETI benefits this year, and 60 percent in 2006 before the incentive is fully repealed in 2007.

So in 2005, certain manufacturing companies that export can also qualify for ETI, which allows U.S. exporters to exclude from federal corporate income tax 15 percent of their net income from the export sale of qualified U.S.-origin goods. Qualified U.S. goods are those where not more than 50 percent of the value is attributable to foreign content or to value added outside the United States.

Alternatively, exporters of low-profit items could exclude 1.2 percent of their gross receipts (not to exceed 30 percent of the net) from the export sale of qualified U.S.-origin goods.

There are some exceptions to the phasedown provision, which could create even greater benefits for some companies. If your company had a contract in place as of Sept. 14, 2003, the full — not reduced — ETI tax-savings benefit could apply through the length of the contract.

IC-DISC benefits

In addition to the tax opportunities available through the manufacturers’ deduction, tax professionals say midsized businesses should consider an IC-DISC.

IC-DISCs serve as conduits for tax savings on qualified export sales. In existence since 1984, the IC-DISC is the original U.S. policy attempt to encourage exports.

Here’s how an IC-DISC works:

• Midsized exporting companies form a corporation (i.e., the IC-DISC), which generally mirrors the ownership structure of the exporting company.
• The IC-DISC charges the exporting company a commission on the exporter’s qualified export sales.
• The exporting company fully deducts the commission expense.
• U.S. income tax is imposed on the IC-DISC shareholder’s dividends.

Instead of the exporting company paying a 35 percent corporate tax, the tax burden falls to IC-DISC shareholders, who pay a 15 percent individual tax rate. Because Congress reduced the dividend tax rate on individuals to 15 percent in 2003, taxpayers realize a 20 percent tax savings. In effect, this allows businesses to more than double their tax savings on qualified export sales.

No employees are required within the IC-DISC, the entity has no effect on exporting operations, and companies can make an election for the entity any time during the year, although accelerated deadlines would apply as the year ends. IC-DISCs are particularly well-suited for midsized companies because individual shareholders — not companies — will benefit from the tax rate reduction.

Here’s an example of how these tax-savings opportunities could work:

After creating an IC-DISC, a company with $20 million in foreign-trading gross receipts and net income of $1 million from export sales could pay an $800,000 commission to the entity. The $800,000 is 4 percent of the $20 million in gross receipts. Because the IC-DISC is not taxable, the commission paid to it is untaxed. The dividend to shareholders is taxed at the 15 percent capital gains rate. In this case, that tax is $120,000, compared with $280,000 if the IC-DISC were taxable and taxed at the 35 percent corporate rate.

That’s a savings of $160,000.

In addition to tax savings, an IC-DISC can increase shareholder liquidity unavailable in other entities. In a C corporation, for example, there may be existing agreements that create restrictions on the salary drawn by top managers. A manager can be made an IC-DISC shareholder, creating liquidity. In a family-owned business, older family members who have diminished their compensation over time for estate planning purposes can boost their income as shareholders in an IC-DISC.

Maximizing the opportunities of these three tax-savings provisions is complex. But tax professionals suggest it’s best to act now before the ETI phase-out expires.