U.S. exporters often wonder whether organizing as a C Corporation is more tax efficient than organizing as a pass-through entity, such as an S Corporation or partnership. To make this determination, U.S. exporters need to consider their ability to benefit from certain export incentives, such as the interest charge domestic international sales corporation (IC-DISC) and Foreign-Derived Intangible Income (FDII) Deduction.
For years, the IC-DISC regime and related benefits were the primary export tax benefits available to taxpayers. Taxpayers could use an IC-DISC to obtain a tax incentive on certain export sales by paying the IC-DISC a tax-deductible commission, which is calculated based on the related supplier’s foreign sales or foreign taxable income for the year.
Many pass-through entities use IC-DISCs to convert a portion of ordinary income into qualified dividend income, currently taxed at favorable capital gain rates. For C Corporations, the IC-DISC benefit stems from the ability to create a C Corporation deduction for income that ultimately is taxed as qualified dividend income, thereby generating deductible dividends for a portion of the company’s income.
Foreign-Derived Intangible Income Deduction (FDII)
Domestic corporations can deduct a portion of their global intangible income inclusion and their share of foreign-derived intangible income (FDII). At a high level, FDII is the portion of a U.S. Corporation’s intangible income derived from serving non-U.S. markets. Generally speaking, FDII is the taxpayer’s net export income, minus a deemed 10% return on the taxpayer’s aggregate basis in depreciable tangible property.
Specifically, a deduction is allowed in an amount equal to 37.5% of the FDII income of the domestic corporation for the tax year. Given the current corporate tax rate to 21%, this results in an effective tax rate of 13.125% on FDII. For tax years beginning after December 31, 2025, the deduction percentage decreases to 21.875%, which will make the effective rate approximately 16.4% — assuming the corporate tax rate remains at 21%.
A U.S. Corporation’s foreign portion of its deduction eligible income (FDEI) for a tax year is any income (other than certain excluded income) that the corporation derived in connection with:
- Property sold (including a lease, license, exchange or other disposition) to any non-U.S. person that the domestic corporation establishes is for foreign use; or
- Services the domestic corporation establishes it provided to a person; or, with respect to property located outside of the U.S. for foreign use, meaning any use, consumption or disposition outside the U.S.
Which Is Better: IC-DISC or the FDII Deduction?
So, which export tax incentive currently provides taxpayers with a greater benefit, the IC-DISC or FDII deduction? Each is meant to reward U.S. taxpayers that derive income from foreign sales of product that has a connection to the U.S. However, each has its own unique set of rules, meaning a taxpayer’s answer will depend on the taxpayer’s unique circumstances.
Exporters seeking to determine the most tax-efficient structure should analyze the availability and benefits of both the IC-DISC and FDII deduction. Each is a powerful tool for optimizing tax structure.
That said, in general, there are some taxpayers who may favor IC-DISC benefits over FDII, and vice versa, as outlined below.
Taxpayers Who May Favor IC-DISC Benefits Over FDII Benefits
- Taxpayers that are pass-through entities or sole proprietorships, who by definition are ineligible for the Sec. 250 FDII deduction. The IC-DISC benefits are the only income tax export incentives available to pass-through entities such as S Corporations and partnerships. The FDII deduction is only available to U.S. C Corporations (including foreign-owned C Corporations).
- C Corporations that sell to a distributor who then sells to a foreign customer. Under the IC-DISC regime, property is considered export property if it meets the so-called “destination test” – the property is sold for direct use, consumption or disposition outside the U.S. This test is met if the export property is delivered to a purchaser and the property is ultimately delivered, directly used or consumed outside the U.S. by the purchaser within one year after the sale. This means that IC-DISC benefits can be derived from sales to U.S. distributors that, in turn, export the property outside the U.S. within the prescribed time frame.
In contrast, the FDII deduction is only available for direct sales from U.S. taxpayers to foreign persons (for foreign use) and do not include sales to any U.S. persons, even if the ultimate destination is outside the U.S. This definition excludes taxpayers who sell U.S. manufactured product to a U.S. distributer that then exports the product.
Taxpayers Who May Favor FDII benefits over IC-DISC Benefits
- Taxpayers that manufacture a product outside the U.S. One of the requirements for IC-DISC qualification is that exported property is: 1) manufactured, produced, grown or extracted in the U.S., 2) for direct use, consumption or disposition outside the U.S., and 3) not more than 50% of the fair market value is attributable to materials imported into the U.S. In general, this benefit is available for the sale of goods manufactured in the U.S. from primarily U.S. materials, ultimately destined for foreign use.
In contrast, the FDII provisions only require that it be the sale of property to a foreign person for foreign use. The absence of U.S. manufacturing requirements means a much broader group of products are potentially eligible for FDII benefits, including corporations that either manufacture outside the U.S. or distribute foreign manufactured products.
- Taxpayers whose level of export income does not justify incurring the IC-DISC set-up costs. To claim IC-DISC tax benefits, U.S. exporters must form a separate company and make a valid IC-DISC election. In addition, there are certain annual requirements that must be met, including maintaining separate books and records and calculating and paying the related commission expense. While there are also certain administrative requirements to claim a FDII deduction, they are often less burdensome than those to create and maintain an IC-DISC structure.
Contact Ray Polantz at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.