The tax-advantaged entity known as a Domestic International Sales Corporation (DISC) started as an incentive to get small- and medium-sized businesses to extend their sales reach beyond U.S. borders and create jobs in the process. Now, however, it is being used in ways the government never expected: to get personal DISC tax breaks.

DISC Tax Breaks: How Do They Work?

Normally, companies have to pay the ordinary income tax rate – as high as 35% – on the goods and services they sell. However, by setting up a DISC, smaller businesses can dramatically lower what they pay on their overseas income. The parent company pays “commissions” to the DISC without being assessed corporate taxes on that amount. Funds flowing into the DISC are then distributed to shareholders as dividends, which are taxed at a much lower percentage (currently, the top dividend tax rate sits at only 15%). There are, of course, limits in terms of how much revenue can find its way into one of these vehicles. Commissions can’t exceed 4% of gross sales or one-half of the company’s net income from exports. Still, that amounts to a huge deduction for some companies.

You don’t have to directly export products to a foreign market in order to qualify for making use of a DISC. For example, companies who sell components that make their way into a final product that’s sold overseas – such as an electronic module that becomes part of a toy car – can also use the strategy. In addition the tactic is available to firms that offer professional services for foreign manufacturers: for instance, an engineering firm that helps a company build a new smartphone in China.

Novel Strategies

The number of companies that take advantages of the tax break, which dates back to the 1980s, is still relatively small. Only about 4,000 businesses used them in 2012, the last year for which data on DISCs are available. Nevertheless, that number has been growing since around 2003, when the government lowered the dividends tax rate. That made this once-dormant tax shelter suddenly take on new life, and now the strategy is being used to help exporters save even more money.

A federal appeals court last month ruled in favor of two brothers who coupled a DISC with a Roth IRA account in order to limit their tax liability. The Benenson brothers own a controlling interest in a Cleveland-based parent company, Summa Holdings Inc., that sells industrial products overseas. Some of their income made its way through a DISC that they established. That, in itself, was pretty typical of how these entities were designed.

Their novel addition to the tax-reduction strategy was to set up Roth IRA accounts – one for each brother – that invested in the DISC through a third company they created called JC Holding. Their initial investment in 2001 was modest, just $1,500 apiece.

The DISC would cut a dividend to JC Holding, which had to pay a 33% business tax on it. But what was left over went tax free into the brothers’ Roth accounts. As a result, those accounts ballooned in a just a few short years. By 2008 each was worth more than $3 million. Based on Roth IRA rules, the brothers won’t have to pay any additional taxes on qualified withdrawals.

The IRS took the men to the U.S. Tax Court, which found that the brothers had used the stratagem simply to sidestep the annual contribution limit for IRAs. However, the Sixth Circuit Court of Appeals overturned that decision, in effect arguing that even if the brothers defied the spirit of the law, they never violated it. That verdict could encourage other investors to try something similar, which would only add to the momentum that DISCs have enjoyed of late.

The Bottom Line

When the government created Domestic International Sales Corporations years ago, it envisioned them as a way to open up overseas markets to small businesses that otherwise sold closer to home. Now, however, investors are stretching the tax shelter for personal gain in ways Uncle Sam never intended. (For more, see How Large Corporations Get Around Paying Taxes and U.S. Exporters in Favor of Border-Adjustment Tax.)

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