An IC-DISC exporter's shareholder-officers take their pay as dividends rather than salary, as the federal rules require. Can the company deduct those dividends from its Tennessee excise-tax net earnings?

Plain-English summary

An IC-DISC (Interest Charge Domestic International Sales Corporation) is a federal export tax incentive that lets small and mid-sized exporters cut the rate at which their export income is taxed. In a typical setup, an exporter forms a corporation, makes an IC-DISC election with the IRS, and pays the IC-DISC a "sales commission" (up to 4% of export gross receipts or 50% of export net income). The exporter deducts that commission, and the IC-DISC passes it to its shareholders as a dividend, which the shareholders are taxed on at favorable dividend rates. The IC-DISC itself pays no federal income tax (I.R.C. § 991), but it gives up the ability to deduct that dividend as compensation.

Here, the Tennessee corporation is the IC-DISC, and its two shareholder-officers are paid through dividends instead of salary, as the IC-DISC rules require. The company asked whether it can deduct those shareholder dividends from its Tennessee excise-tax net earnings.

The Department said no, and the reasoning is pure federal conformity. Tennessee's 6.5% excise tax falls on a person's "net earnings" (Tenn. Code Ann. § 67-4-2007(a)), and for a corporation, "net earnings" starts from federal taxable income before the net-operating-loss and special deductions (§ 67-4-2006(a)(1)). Federal taxable income is gross income minus the deductions federal law allows (I.R.C. § 63(a)). Federal law lets a business deduct reasonable salaries (I.R.C. § 162(a)(1)), but it does not allow a deduction for dividends paid to individual shareholders of an IC-DISC — even when those dividends are paid in place of salary. Dividends just aren't among the deductible expenses (I.R.C. §§ 161-249), and the IC-DISC rules don't add one (contrast the special dividends-paid deduction that exists for REITs, I.R.C. §§ 561-565).

So the dividends stay in the company's federal taxable income, and because Tennessee net earnings begins there, they stay in Tennessee net earnings too. Tennessee adds no deduction of its own for shareholder dividends (§ 67-4-2006) and gives an IC-DISC no exemption (§ 67-4-2008). The Department even walked through the return mechanics: a corporation's Tennessee Schedule J-4 starts from federal Form 1120, line 28; an IC-DISC files Form 1120-IC-DISC, whose line 5 captures the same "taxable income before NOL and dividends-received deduction" — keeping the definition of taxable income consistent across Form 1120 and its variations. Bottom line: dividends not deductible federally are not deductible for Tennessee excise tax, so they're part of the excise base.

What this means for you

Exporters using (or considering) an IC-DISC

The IC-DISC delivers its federal benefit at the exporter/operating-company level (the deductible commission) and at the shareholder level (favorable dividend rates). What it does not do is let the IC-DISC entity deduct those dividends — federally or for Tennessee excise tax. If your IC-DISC does business in Tennessee, plan for the dividend amounts to remain in its excise-tax net earnings (6.5%). Structuring shareholder pay as IC-DISC dividends doesn't convert it into a Tennessee-excise-deductible expense.

Accountants and tax professionals

This is a clean federal-conformity holding: Tennessee net earnings = federal taxable income before NOL/special deductions (§ 67-4-2006(a)(1)), so deductibility for Tennessee follows deductibility under I.R.C. §§ 161-249. Dividends to individual IC-DISC shareholders aren't deductible federally (unlike reasonable compensation under § 162(a)(1)), and Tennessee provides neither a dividend deduction (§ 67-4-2006) nor an IC-DISC exemption (§ 67-4-2008). On the return, the Form 1120-IC-DISC line-5 figure flows to Schedule J-4, line 1, mirroring Form 1120 line 28.

Common questions

Q: What is an IC-DISC?
A: An Interest Charge Domestic International Sales Corporation — a federal export tax incentive. The exporter deducts a commission paid to the IC-DISC, and the IC-DISC distributes it to shareholders as a dividend taxed at favorable rates; the IC-DISC itself pays no federal income tax (I.R.C. § 991) but cannot deduct the dividend as compensation.

Q: Can an IC-DISC deduct shareholder dividends from Tennessee excise net earnings?
A: No. Those dividends aren't deductible for federal income tax (they aren't among the deductions in I.R.C. §§ 161-249), so they remain in federal taxable income and therefore in Tennessee net earnings (Tenn. Code Ann. § 67-4-2006(a)(1)). Tennessee adds no dividend deduction and gives an IC-DISC no exemption.

Q: Does it matter that the dividends replace the officers' salary?
A: No. Even paid in lieu of salary, dividends to individual IC-DISC shareholders are not deductible compensation under federal law, so they stay in the excise base.

Q: Can I rely on this letter ruling?
A: No. A Tennessee letter ruling binds the Department only as to the specific taxpayer and facts and can be revoked or modified; the Department also does not rule on federal tax law. Confirm your own situation with a tax professional.

Citations and references

Tennessee statutes (Tenn. Code Ann.):

• § 67-4-2006(a)(1) (net earnings = federal taxable income before NOL and special deductions, for a corporation or a filer of Form 1120 or a variation)
• § 67-4-2007(a) (6.5% excise tax on net earnings); § 67-4-2004(37) ("person" includes every corporation); § 67-4-2105(a), § 67-4-2106(a) (franchise tax on net worth)
• § 67-4-2006 (no deduction from net earnings for dividends paid to individual shareholders); § 67-4-2008 (no exemption for an IC-DISC)

Federal law cited:

• I.R.C. § 992 (IC-DISC election); §§ 991-997 (IC-DISC regime); § 991 (a DISC is not subject to federal income tax); § 995, § 995(a)/(b)(1)(E)/(f)/(f)(1) (shareholder taxation, $10M deferral, and the interest charge)
• I.R.C. § 63(a) (federal taxable income); § 162(a)(1) (deduction for reasonable compensation); §§ 161-249 (allowable deductions — shareholder dividends not among them); §§ 241-247 / § 243 (special deductions, incl. dividends-received deduction); § 316(a)(1)-(2) (definition of "dividend"); § 1, § 1(i)(3) (dividend tax rates); cf. §§ 561-565 (REIT dividends-paid deduction)
• American Taxpayer Relief Act of 2012 (raised the top dividend rate)

Subject

Whether compensation paid by an Interest Charge Domestic International Sales Corporation, in the form of a dividend for federal tax purposes, is deductible from net earnings for Tennessee excise tax purposes

Source

• Landing page: https://www.tn.gov/revenue/tax-resources/legal-resources/tax-rulings.html
• Original PDF: https://www.tn.gov/content/dam/tn/revenue/documents/rulings/fae/13-08fe.pdf

Original ruling text

TENNESSEE DEPARTMENT OF REVENUE
LETTER RULING # 13-08
Letter rulings are binding on the Department only with respect to the individual taxpayer
being addressed in the ruling. This ruling is based on the particular facts and
circumstances presented, and is an interpretation of the law at a specific point in time. The
law may have changed since this ruling was issued, possibly rendering it obsolete. The
presentation of this ruling in a redacted form is provided solely for informational purposes,
and is not intended as a statement of Departmental policy. Taxpayers should consult with a
tax professional before relying on any aspect of this ruling.
SUBJECT
Whether compensation paid by an Interest Charge Domestic International Sales Corporation, in
the form of a dividend for federal tax purposes, is deductible from net earnings for Tennessee
excise tax purposes.
SCOPE
This letter ruling is an interpretation and application of the tax law as it relates to a specific set of
existing facts furnished to the Department by the taxpayer. The rulings herein are binding upon
the Department, and are applicable only to the individual taxpayer being addressed.
This letter ruling may be revoked or modified by the Commissioner at any time. Such revocation
or modification shall be effective retroactively unless the following conditions are met, in which
case the revocation shall be prospective only:
(A) The taxpayer must not have misstated or omitted material facts involved in
the transaction;
(B) Facts that develop later must not be materially different from the facts upon
which the ruling was based;
(C) The applicable law must not have been changed or amended;
(D) The ruling must have been issued originally with respect to a prospective or
proposed transaction; and
(E) The taxpayer directly involved must have acted in good faith in relying upon
the ruling; and a retroactive revocation of the ruling must inure to the taxpayer’s
detriment.
FACTS
[TAXPAYER] (the “Taxpayer”) is a Tennessee corporation. The Taxpayer requested and
received approval by the Internal Revenue Service (“IRS”) to be treated as an Interest Charge
Domestic International Sales Corporation (“IC-DISC”) for federal income tax purposes. The
Taxpayer’s two officers are each 50% shareholders of the corporation. Each officer has a
compensation agreement with the Taxpayer, whereby their compensation for services rendered is
1

characterized for federal income tax purposes as a dividend, as required by the federal IC-DISC
regulations.
RULING
Are the amounts distributed as a dividend to the Taxpayer’s shareholders under their
compensation agreements deductible from the Taxpayer’s net earnings for Tennessee excise tax
purposes?
Ruling: No. The amounts distributed as a dividend to the Taxpayer’s shareholders are not
deductible from net earnings for Tennessee excise tax purposes.
ANALYSIS
I.

INTEREST CHARGE DOMESTIC INTERNATIONAL SALES CORPORATION

An Interest Charge Domestic International Sales Corporation (“IC-DISC”) is a corporation
formed to serve as an “export tax incentive that allows small and mid-sized exporters to
drastically reduce the rate at which their income is taxed.”1 An IC-DISC is the modern day
successor entity to the “foreign sales corporation,” which came under attack by the European
Union and World Trade Organization for being an unfair export subsidy. The IC-DISC is an
entity capable of existing solely on paper, in that it does not need employees, office space, or
tangible assets. The entity simply serves as a conduit to reduce the exporter’s federal tax liability
on export income.
IC-DISCs operate in the following manner: First, an exporter forms a corporation in one of the
fifty states or the District of Colombia and makes an IC-DISC election with the IRS. After
receiving IRS approval, the exporter pays the IC-DISC a “sales commission” in the amount of:
1) 4 percent of the company’s gross receipts from qualified exports, or 2) 50 percent of its net
income from qualified exports.2 Finally, the exporter deducts the commission paid to the ICDISC as an ordinary income tax deduction.3 The IC-DISC then distributes the commission by
way of a dividend to the shareholders.

1

1 ALAN S. GUTTERMAN & ROBERT L. BROWN, GOING GLOBAL: A GUIDE TO BUILDING AN INTERNATIONAL
BUSINESS § 20:36 (2012-2013 ed.).
2

See generally I.R.C. § 992 (LexisNexis 2013). There are additional requirements to form an IC-DISC, including
that the entity: 1) maintain a minimum capitalization of $2,500; 2) have a single class of stock; and 3) meet a
qualified export receipts test and a qualified export assets test. See also Internal Revenue Services, IC-DISC Audit
Guide, IRS.GOV, http://www.irs.gov/Businesses/International-Businesses/IC-DISC-Audit-Guide (last visited June
14, 2013).
3

I.R.C. § 162(a)(1) (LexisNexis 2013).

2

IC-DISCs are governed by I.R.C. §§ 991-997 (LexisNexis 2013).4 I.R.C. § 991 (LexisNexis
2013) states that “a DISC shall not be subject to” the federal income tax. Shareholders of an ICDISC, however, are “subject to taxation on the earnings and profits of a DISC as provided in this
chapter [I.R.C. §§ 1-1563], but subject to the modifications” found in I.R.C. § 995 (LexisNexis
2013).5
The IC-DISC can either distribute the sales commission to its shareholders in the form of a
dividend or retain it and defer paying tax. A “dividend,” for federal tax purposes, is defined as a
distribution by a corporation to its shareholders “out of its earnings and profits accumulated after
February 28, 1913” or “out of its earnings and profits of the taxable year.”6 Dividends are taxed
at a 15 percent rate according to I.R.C. § 1 (LexisNexis 2013). This rate was increased to 20
percent by the American Taxpayer Relief Act of 2012 for those earning a taxable income of
$450,000 or above.7
An IC-DISC may defer distributing earnings and profits, resulting in a deferred tax liability.8
This deferral is limited to $10 million dollars per year in earnings and profits, with any amounts
above this threshold being a deemed dividend that becomes immediately taxable.9 I.R.C.
§ 995(f)(1) states that a “shareholder of a DISC shall pay for each taxable year interest in an
amount equal to the product of – (A) the shareholder’s DISC-related deferred tax liability for
such year, and (B) the base period T-bill rate.”
There are two major benefits bestowed by the IC-DISC election. First, as stated above, the
exporter gets to deduct the commission as an ordinary income deduction. Second, for the ICDISC shareholders, the commission income is treated as a dividend and is taxed at a favorable
rate when distributed.10
As further discussed below, the IC-DISC forgoes its ability, however, to deduct the dividend as
reasonable compensation from its taxable income for federal tax purposes.11

4

Although the Internal Revenue Code refers only to Domestic International Sales Corporations (“DISC”), the
common appellation includes “Interest Charge” to reflect the fact that a DISC may defer up to $10 million in tax
liabilities for which it is charged interest.
5

I.R.C. § 995(a) (LexisNexis 2013).

6

I.R.C. § 316(a)(1)-(2) (LexisNexis 2013).

7

American Taxpayer Relief Act of 2012, H.R. 8, 112th Cong. (2012) (codified in relevant part at I.R.C.§ 1(i)(3)
(West, Westlaw current through P.L. 113-11 (excluding P.L. 113-4)).
8

I.R.C. § 995(f).

9

See I.R.C. § 995(b)(1)(E).

10

The Taxpayer therefore enjoys a significant tax reduction by making the election.

11

See generally I.R.C. §§ 161-249 (LexisNexis 2013).
3

II.

APPLICATION OF TENNESSEE LAW TO IC-DISCS

Tennessee imposes an excise tax at the rate of 6.5% on the net earnings of all persons, as defined
under TENN. CODE ANN. § 67-4-2004(37) (Supp. 2012),12 doing business in Tennessee.13
Tennessee also imposes a franchise tax at the rate of $0.25 per $100, or major fraction thereof,
on the net worth of a person doing business in Tennessee, pursuant to TENN. CODE ANN. §§ 674-2105(a), -2106(a) (2011). Persons subject to Tennessee franchise and excise taxes include, but
are not limited to, corporations.14
TENN. CODE ANN. § 67-4-2006(a)(1) (Supp. 2012) defines “net earnings” pertaining to “a
corporation . . . or any other taxpayer required to file a federal income tax return on a federal
form 1120 or any variation of that form . . . as federal taxable income or loss before the operating
loss deduction and special deductions.”15 I.R.C. § 63(a) (LexisNexis 2013) defines “federal
taxable income” as “gross income minus deductions allowed by this chapter [1].” One of the
deductions enumerated in Chapter 1 is found in I.R.C. § 162(a)(1) (LexisNexis 2013), which
provides that “a reasonable allowance for salaries or other compensation for personal services
actually rendered” shall be deductible.
The Internal Revenue Code, however, does not provide a deduction for dividends paid to
individual shareholders of an IC-DISC, even if the dividends are paid in lieu of a salary.16 Thus,
the dividends paid by the IC-DISC to its shareholders are not deductible as compensation and
consequently, are included in federal taxable income. It follows that IC-DISC dividends paid to
shareholders and included in federal taxable income are also included in “net earnings” for
purposes of the Tennessee franchise and excise tax.17
This result is illustrated by the computation of net earnings on the Tennessee franchise and
excise tax return. The starting point for this Taxpayer, a corporation, when filing its Tennessee

12

“Person” is defined by TENN. CODE ANN. § 67-4-2004(37) in pertinent part as including “every corporation.”

13

TENN. CODE ANN. § 67-4-2007(a) (2011).

14

See TENN. CODE ANN. § 67-4-2004(37) (Supp. 2012).

15

The special deductions are enumerated in I.R.C. §§ 241-247 (LexisNexis 2013). These special deductions are
generally applicable in circumstances where triple taxation would occur. For example, I.R.C. § 243 allows a
corporation to deduct a dividend received by another corporation. See also I.R.C. §§ 241-242, 244-247.

16

Dividends from a corporation to a shareholder are not enumerated among the deductible expenses in I.R.C.
§§ 161-249 (LexisNexis 2013). Furthermore, the statutory regime regulating IC-DISCs does not specifically provide
for the deduction of dividends from taxable income. Cf. I.R.C. §§ 561-565 (LexisNexis 2013) (specifically
enumerating a deduction of dividends paid regarding Real Estate Investment Trusts).
17

Note that the Tennessee Code Annotated does not provide for a deduction from net earnings for dividends paid to
individual shareholders, see generally TENN. CODE ANN. § 67-4-2006 (Supp. 2012), nor is an IC-DISC subject to an
exemption, see generally TENN. CODE ANN. § 67-4-2008 (2011).

4

franchise and excise tax return is Schedule J-4,18 which is used to determine the net earnings for
entities treated as corporations. Line 1 of Schedule J-4 asks for the amount reported on federal
Form 1120, line 28. Form 1120, line 28, shows the “[t]axable income or loss before net operating
loss deduction and special deductions.”
The Taxpayer, however, is required to file Form 1120-IC-DISC for federal income tax purposes,
a variation of Form 1120. Form 1120 IC-DISC, line 5, captures essentially the same amount as
line 28 on Form 1120; that is, “[t]axable income before net operating loss deduction and
dividends-received deduction.”19 This line includes all deductions allowed on Form 1120 ICDISC, Schedule E, which is entered on line 4. By entering the amount shown on Form 1120 ICDISC, line 5, on Schedule J-4, line 1, the definition and application of “taxable income” and “net
earnings” remain consistent among entities required to file Form 1120 or a variation thereof.
Therefore, since dividends are not deductible for federal tax purposes, nor are they deductible
from net earnings for Tennessee excise tax purposes, the Taxpayer’s dividends to its
shareholders must be included in its net earnings subject to Tennessee excise tax.

R. John Grubb II
Senior Tax Counsel
APPROVED:

Richard H. Roberts
Commissioner of Revenue

DATE:

July 11, 2013

18

Since the Taxpayer is a corporation required to complete a variation of federal Form 1120 (i.e., Form 1120 ICDISC), TENN. CODE ANN. § 2006(a)(1) dictates the starting point for completing its Tennessee franchise and excise
return.
19

This line serves as the equivalent of line 28 on Form 1120. The dividends received deduction is one of the
“special deductions” codified at I.R.C. § 243.
5