“Is your retirement plan setting you up for a catastrophic tax event?” This may sound like a dramatic question, but it’s an important one—and one that your clients may never have asked themselves. Many taxpayers lean into the most popular retirement strategies, like funneling money into a 401(k) or IRA, without evaluating if that is actually the best approach for their specific financial situation.
As a proactive tax planner, you are well aware that these retirement plans come with some ticking time bombs. Before retirement, 401(k)s and IRAs can feel like an ideal option as taxpayers enjoy deferred taxes on their savings. What about when it comes time to pay out? Some taxpayers who have maxed out their retirement accounts may find that they are paying more in taxes during retirement than when they were working—all because they ended up in a higher tax bracket and didn’t realize it.
This is where it is your job as a tax planner to help your clients explore every savings option, including those that are a bit more obscure. In today’s blog, we are examining another little-known retirement strategy: the Interest Charge Domestic International Sales Corporation or “IC-DISC.”
Benefits of an IC-DISC
Here is the major selling point for setting up an IC-DISC: the commission paid from the exporter to the new entity is tax-deductible. Because of a loophole in the law, the IC-DISC also happens to be exempt from income tax. So this means no tax owed on the commission income by the IC-DISC and a tax deduction for the exporter—double tax benefits!
So essentially this is an income recharacterization strategy. Through the commission payment, the IC-DISC converts ordinary business income into qualified dividends tax. That means your client gets to enjoy long-term capital gains rates rather than a 37% ordinary income tax rate. The highest that capital gains rate will go is 23.8%—20% if the taxpayer falls within the highest income bracket for capital gains tax and 3.8% if they are required to pay the net investment income tax.
Taxpayers may also be won over by the flexible ownership rules. Since the shareholders of the IC-DISC do not need to be the same as the shareholders of the exporting company, the taxpayer can leverage the IC-DISC as an employee benefit or a part of their children’s inheritance. By making a key employee a shareholder in the IC-DISC, they get additional income from any dividends. If your client is interested in making their children or grandchildren shareholders, set this up early on when the IC-DISC has low or no value. That way, the taxpayer can shift assets out of their estate, lower their taxable income, and transfer those assets to the heirs via the IC-DISC. Plus, the heirs will receive qualified dividends from the IC-DISC as it earns money.
If your client has a Roth ITA, another clever strategy is to have the Roth own the IC-DISC. When the IC-DISC pays qualified dividends to its owner, the Roth IRA is not a taxable entity, so those dividends are tax-free. This provides an excellent alternative to a typical retirement plan. With an IC-DISC, unlike with retirement accounts, the taxpayer does not have to account for mandatory contributions, employee matching, discrimination testing, or age limits to withdraw those funds.
Lastly, even though an IC-DISC is a domestic C corporation, dividends are taxed as foreign income. So if you have a taxpayer who is holding onto foreign tax credits and carryovers, the IC-DISC now qualifies them to make use of those credits.
Limitations of an IC-DISC
If your client meets the requirements to set up an IC-DISC, there are not many drawbacks to consider. You will want to prepare your client for the fact that the IC-DISC will have to maintain separate books and records from the exporting company. After all, this is true of any new business entity. Also, the IC-DISC must be a privately held company; it cannot be publicly traded. This may be a factor if your client had a vision for how to generate income through the IC-DISC. However, the tax benefits that come with the IC-DISC can outweigh all of the above if the taxpayer knows how to maximize its use.
Summary
An IC-DISC is a tax strategy most business owners (and even some tax professionals) have never heard of yet—and yet it’s a treasure trove of flexible options and tax benefits. This one tax strategy can demonstrate the value of working with an actual tax planner. With one move on the chessboard, you achieve upfront tax deductions, lower tax rates (on dividends), flexible timing on distributions, and flexible ownership options. For the right client, the IC-DISC can solve a number of retirement planning and business tax reduction problems all at once.
To learn more about this and other alternative retirement savings strategies, sign up to become a Certified Tax Planner today.
