IC-DISC Audit Preparation for IRS Scrutiny

An Interest Charge Domestic International Sales Corporation (IC-DISC) is a U.S. corporation established to foster the export of American goods and services. It functions as a tax incentive structure, allowing exporters to defer income and reduce their overall tax liability. The related exporting company pays a commission to the IC-DISC, which is a deductible expense for the exporter. These commissions can then be distributed to the IC-DISC’s shareholders as qualified dividends, which are taxed at a lower rate than ordinary income.

Due to the tax advantages offered by an IC-DISC, the Internal Revenue Service (IRS) closely examines these entities. An audit focuses on adherence to the statutory and regulatory framework governing their operation. Understanding the areas of IRS focus is the first step in preparing for scrutiny, and an organized approach to compliance and record-keeping is necessary to substantiate the tax benefits claimed.

IC-DISC Qualification Requirements

To maintain its status, an IC-DISC must satisfy two tests annually related to its income and assets. The first is the 95% qualified gross receipts test, which mandates that at least 95% of the corporation’s gross receipts consist of “qualified export receipts.” These receipts are generated from the sale, exchange, or disposition of export property, and include income from the lease or rental of export property used outside the United States.

Qualified export receipts also encompass gains from certain asset sales, dividends from a related foreign export corporation, and fees for engineering or architectural services on foreign construction projects. Receipts that do not qualify include those from the sale of property for ultimate use in the United States. An auditor will trace sales documentation to ensure the IC-DISC’s income originates from qualifying export activities.

The second operational requirement is the 95% qualified export assets test, measured at the close of the IC-DISC’s taxable year. This test requires that at least 95% of the sum of the adjusted basis of all assets be composed of “qualified export assets.” These assets directly support the company’s export activities and include inventory held for export, business assets used in export activities, and trade receivables arising from qualified export receipt transactions.

Producer’s loans are a complex category of qualified export assets. These are loans from the IC-DISC to its related U.S. producer of export property. To qualify, loans must meet specific criteria, including having a note with a stated maturity of five years or less and being designated as a producer’s loan when made. The total amount of these loans is limited, making them a frequent target for adjustment during an IRS audit.

Commission Calculation and Transfer Pricing Scrutiny

The calculation of the commission paid by the exporter to the IC-DISC is another area of IRS examination. Because the commission is a tax deduction for the exporting company, the IRS requires the amount to be determined using specific intercompany pricing rules. Taxpayers can choose the method that yields the largest commission for each transaction, but the calculation must be defensible.

One method is the 4% of qualified export receipts method. This safe harbor calculation allows the commission to be 4% of the qualified export receipts from the transaction, plus 10% of the export promotion expenses incurred by the IC-DISC. This method is straightforward but may not always produce the largest commission.

The most common method is the 50% of combined taxable income (CTI) method. This approach allows the commission to be 50% of the CTI from qualified export receipts, plus 10% of the IC-DISC’s export promotion expenses. CTI is the gross receipts from the export sale less the total related costs of the supplier and the IC-DISC. This requires a detailed allocation of expenses like cost of goods sold, research and development, and administrative costs to export sales.

Because expense allocation directly impacts the CTI and commission amount, IRS auditors scrutinize these calculations. Taxpayers must maintain detailed records justifying how each expense category was apportioned between export and domestic sales. Errors or aggressive positions in these allocations are a source of proposed adjustments, and the calculation requires careful accounting to withstand IRS review.

A third option is the Section 482 method, based on the “arm’s-length” standard. This method requires determining the commission as if the transaction occurred between two unrelated parties, which often involves a complex transfer pricing study. While less common for IC-DISC commissions due to the two safe harbor methods, it remains a valid option.

Essential Documentation for an Audit

Organized documentation is the foundation of a successful IC-DISC audit defense. An IRS agent’s examination will review the core documents that establish and maintain the IC-DISC’s status. This includes the initial election on Form 4876-A, signed shareholder consents, and the annual income tax return, Form 1120-IC-DISC, which outlines the year’s activities.

To substantiate the gross receipts test, a company must provide transactional proof. This includes all export sales invoices, purchase orders, and shipping documents like bills of lading or airway bills. These documents serve as evidence that the goods were sold for direct use or consumption outside the United States, as a lack of this proof can lead to disqualification of the receipts.

Supporting the commission calculation requires a formal, written agreement between the IC-DISC and the related supplier that outlines the pricing methodology. The taxpayer must also provide CTI calculation spreadsheets. These workpapers must show how gross receipts were determined and how all related expenses were allocated between export and domestic sales, especially when using the 50% of CTI method.

Documentation must support the 95% qualified export assets test. For producer’s loans, executed loan agreements and promissory notes are required, along with records demonstrating that the loan amounts comply with legal limitations. Bank statements for the IC-DISC’s separate account and a balance sheet detailing all assets are necessary to prove the year-end asset composition.

Navigating the IRS Audit Process

The IRS audit process for an IC-DISC begins with a formal letter notifying the taxpayer of the examination. The company will then receive an Information Document Request (IDR), a list of documents the IRS examiner needs to review. The IDR will ask for foundational documents, like the IC-DISC election and annual returns, and support for the qualification tests and commission calculations.

Once the initial documents are submitted, the IRS agent begins the fieldwork phase. This involves reviewing the provided records and may include follow-up questions or additional IDRs. It is advisable to manage all communications through a designated point of contact, like an internal tax director or external tax advisor, to ensure responses are consistent and accurate.

The audit concludes when the agent has completed their review and analysis. If the agent finds no issues, the IRS will issue a “no-change” letter, formally closing the examination without any adjustments. If the agent proposes adjustments to the tax liability, they will issue a Revenue Agent’s Report (RAR). The RAR explains the proposed changes and the reasons for them.

Upon receiving an RAR, the taxpayer also receives a “30-day letter.” This letter gives the company 30 days to either agree with the proposed adjustments or appeal the findings to the IRS Independent Office of Appeals. This provides a formal path to dispute the agent’s conclusions before litigation.