More than half of Americans have a traditional retirement plan like a 401(k) or IRA. For many, these can be straightforward and effective ways to set aside the funds needed for the future. However, taxpayers may not realize that retirement plans can come with ticking time bombs. If you land in a higher tax bracket during retirement, you could find yourself facing a catastrophic tax event. Why? Most retirement plans are tax-deferred, which means you pay tax when you take distributions. What’s more, most retirement plans also have required minimum distributions each year, so you have no control over how much to withdraw or when.
While this is not to say that you should avoid traditional retirement plans, some taxpayers may find it helpful to explore alternative retirement plans—or to supplement their IRAs and 401(k) with additional strategies. Today, we’ll explore a second option that can be leveraged by business owners: the Interest Charge Domestic International Sales Corporation or “IC-DISC.”
What is an IC-DISC?
An IC-DISC is a legitimate way for U.S. exporters to lower their tax liability. To set up an IC-DISC, your company must export goods that were grown, produced, manufactured, or extracted in the U.S. By this definition, farmers, software companies, or creators of art, writing, and other intellectual property can all qualify.
Here’s how an IC-DISC works: The exporting company sets up a separate legal entity known as an IC-DISC. This new entity does not need employees, an office, or even capital. The IC-DISC just functions as a “commission agent” for the exporter. So the exporter continues business as usual with one change—it begins paying commission to the IC-DISC based on its export sales. This allows the exporter to benefit from the IC-DISC’s tax breaks (more on that in a moment).
Several things must be true of an entity for it to be considered an IC-DISC:
• The business must be a C corporation based in the U.S.
• The business must have just one class of stock.
• The business must have buyers outside the U.S. (i.e. exporting).
• The business must meet the 95% qualified gross receipts tests and the 95% qualified export assets test.
What Are the Benefits of an IC-DISC?
At first glance, setting up an IC-DISC seems like a strange complication to introduce. Why would your business take the time to set up a business that doesn’t do anything? Here’s the big benefit: the commission you pay to the IC-DISC is tax-deductible. Not only that but the IC-DISC itself is also exempt from income tax. So immediately you get to enjoy two tax benefits:
• The exporting company gets a tax deduction for paying IC-DISC commission
• The IC-DISC does not owe taxes on that commission income
But wait, there’s more: when the IC-DISC then pays dividends to the shareholders, this income also enjoys a lower tax rate. That’s because the IC-DISC is basically converting ordinary income into capital gains. While ordinary income can face a tax rate as high as 37%, the highest long-term capital gains rate is 20%. If you are high-income, you may also owe the net investment income tax, which is 3.8%, putting your highest possible tax at a total of 23.8%.
In addition to tax benefits, the IC-DISC is also flexible when it comes to ownership. The shareholders of the IC-DISC do not need to be the same as the shareholders of the exporting company. So you could set up an IC-DISC as a benefit for a key employee. You could use it as an estate planning tool and make your children or grandchildren owners of the IC-DISC while the entity either has no value or very low value. Now you can shift assets out of your estate and therefore lower your taxable income. Those assets become taxable to your heirs, but they also received qualified dividends from the IC-DISC as earnings.
Keep in mind, we’re also not throwing your typical retirement accounts out the window. In fact, you can actually gain more tax benefits by setting up your Roth IRA as the owner of your IC-DISC. Because a Roth IRA is not a taxable entity, when the IC-DISC pays its dividends, they are tax-free. Compare this to using a traditional IRA where you have to factor in mandatory contributions, employee matching, discrimination testing, and age limits to withdraw your funds.
Lastly, the dividends from an IC-DISC are taxed as foreign income, so this also allows you to use any foreign tax credits and carryovers you might have and reap additional tax benefits.
What Are the Limitations of an IC-DISC?
By and large, the IC-DISC comes with far more benefits than drawbacks. Since an IC-DISC is a separate company, it does require you to maintain separate books and records. This is an administrative lift but not necessarily heavy enough to outweigh the many tax benefits. The company must also be privately held—it cannot be publicly traded, though given the reason most people set up an IC-DISC, this is unlikely to become an obstacle.
Summary
IC-DISCs were created as a tax incentive for exporters, and so they can be slam-dunk when it comes to lowering your business’ tax liability. By setting up this new entity, you get to enjoy:
• Immediate tax deductions (from commission payments)
• Lower tax rates (for shareholder dividends)
• No age restrictions or no minimum distributions when you want to withdraw funds
• Flexible ownership options (that come with additional tax benefits)
For those who qualify, the IC-DISC is one of the most elegant and underutilized tax strategies in the tax code. The key is to know the rules, document everything, and work with a specialist to ensure you are maximizing the payoffs. To explore whether an IC-DISC could work for you, reach out to a Certified Tax Planner today.
