How to Increase Tax Savings with a Roth IRA-Owned IC-DISC
Did You Know Combining these Strategies Can Help You Save Even More Tax Dollars?
Many business owners may already be aware of the very popular tax saving strategies that exist regarding the use of Interest Charge Domestic International Sales Corporations (IC-DISCs) as well as Roth Individual Retirement Accounts (Roth IRAs). What may come as a surprise is the fact that combining these two strategies can exponentially increase the tax dollars saved as a result.
Understanding IC-DISC Tax Savings
IC-DISCs are corporations that typically exist in form only, and are the recipient of a commission payment from an exporter of domestically manufactured goods. The commission payment, which is calculated based on the qualifying activity of the exporter, results in a deduction from the ordinary income of the exporter. The commission amount received by the IC-DISC is not taxable assuming it is distributed to the owner of the IC-DISC as a qualified dividend. Tax savings result due to the tax rate difference between ordinary income (which the commission expense reduces) and qualified dividends (which the owner of the IC-DISC receives when the commission amount is distributed).
What is a Roth IRA?
A Roth IRA is a special type of retirement vehicle where funding is accomplished through the contribution of after-tax dollars. Withdrawals during retirement years are tax-free, including any growth that occurred inside the account. As a result of these very tax-friendly characteristics, there are limitations that apply to annual contributions, including a maximum contribution ($6,000 to $7,000 in 2020 and 2021), as well as earned income requirements restricting certain individuals from being eligible to contribute if they earn over certain amounts.
How to Combine Tax Saving Techniques Using a Roth IRA Owned IC-DISC
As a result of several taxpayer-favorable court decisions in the First, Second, and Sixth Circuit Courts, judicial authority may now exist to combine these tax saving techniques using a Roth IRA owned IC-DISC.
Let’s Take a Look at How it Could Work
- Company A is an S corporation that exports domestically manufactured goods
- Company A is 100% owned by Tom Taxpayer
- Tom Taxpayer lives comfortably on the cash flow from business activity and other investments and wants to find ways to pass along some of his wealth to his children, Ted and Judy, who are both in high school and work summer jobs that result in limited wage income to each
- Tom decides to form an IC-DISC that will ultimately be owned equally by Ted and Judy’s individual Roth IRA accounts
- Each of Tom’s children take a nominal amount of their earned income and contribute to a Roth IRA account
- A new C corporation is formed called IC-DISC Holdco and each of the Roth IRA’s invest in exchange for 50% of the C corporation stock
- Tom appoints himself as a member of the board of directors of IC-DISC Holdco so that he can make decisions on behalf of the IC-DISC and common control requirements are met
- An IC-DISC is formed and 100% of the IC-DISC stock is issued to IC-DISC Holdco
- During year one of the IC-DISC, Company A generates export activity that results in a $250,000 commission
- The commission payment is deducted from Company A’s income, yielding a tax benefit of $74,000 (assuming Company A’s activity also qualifies for the Qualified Business Income deduction and the effective tax rate on the pass-through income is 29.6%)
- The receipt of the commission payment by the IC-DISC is not taxable, however when the IC-DISC pays a dividend to IC-DISC Holdco, it is considered income to the C corporation and is subject to federal corporate income tax at a rate of 21%, or $52,500
- After IC-DISC Holdco pays the related corporate income tax, the excess ($197,500) is paid out of the corporation as a tax-free dividend to both Ted and Judy’s Roth IRAs ($98,750 each)
What is the Benefit?
While the tax rate arbitrage in this example saves Tom $21,500 ($74,000 tax benefit from ordinary deduction less $52,500 tax cost of corporate income tax), the real benefit lies in the fact that the Roth/IC-DISC structure has allowed him to get almost $100,000 into each of his children’s Roth IRAs in one year. Those amounts, as well as any future contributions that result from this structure, will grow tax free until they withdraw the funds during their retirement years (which is likely 40+ years in the future).
The ultimate tax savings become exponential when you compare the above scenario to one in which the same after-tax commission amount is invested in something that does not grow tax free over the same time horizon (~40 years). Depending on the tax rates that apply to the income generated and the rate of return someone could get on the assets invested in their Roth IRA, several years of similar contributions could yield millions of dollars in tax savings to individuals and their heirs over their lifetimes.
Keep in mind that the simplified example cited above is just one variation of a structure that can be put in place to take advantage of this strategy. In addition, depending on the cash needs of the operating business involved, there can be multiple IC-DISCs in place to provide flexibility with respect to how much of the annual commission can be re-directed back into the business or through a Roth-owned structure. Furthermore, the Roth owner can always be the business owner as well.
Taxpayers should be aware that in order to utilize such a structure and have the corresponding judicial authority apply, they would need to reside in the First, Second, or Sixth circuits (ME, MA, NH, RI, CT, NY, VT, KY, MI, OH, & TN). Furthermore, taxpayers need to be aware of the listed transaction disclosures that may be required when using Roth/IC-DISC structures and consult with tax and legal advisors prior to implementing.
If you would like more information about IC-DISC tax savings and Roth IRAs, please call us at 248.208.8860 or contact us today. We look forward to speaking with you soon.