Tax Cuts and Job Act (TCJA): Impact on IC-DISC Effectiveness
Let’s explore the use and effectiveness of the Interest-Charge Domestic International Sales Corporation (IC-DISC) in the new tax environment.
For those new to an IC-DISC, the IC-DISC converts what would normally be ordinary business income into qualified dividends, thus generating a tax savings due to the tax rate differential between ordinary business income and qualified dividend income rates. For 2017, an individual subject to the highest tax brackets including the Net Investment Income Tax (NIIT) could save 15.8% in tax rate savings (39.6% – 23.8%) for every dollar run through an IC-DISC.
The recently enacted TCJA may greatly reduce the effectiveness of an IC-DISC. Assuming an individual in 2018, who is subject to the highest tax rates and allowed the maximum 20% business deduction under §199A for the businesses activity, said individual is estimated to have an effective tax rate on the businesses ordinary income of 29.6%. Under the TCJA the IC-DISC’s effectiveness for every dollar converted would then be 5.8% (29.6% – 23.8%). This correlates to a potential 2/3 reduction in the effectiveness of the IC-DISC on a go forward basis.
AND THAT IS NOT OUR ONLY CONCERN
For 2018 most businesses with $25 million in average gross revenues will be subject to the new business interest expense limitation, under §163(j). In general, business interest expense is limited to any business income plus 30% of the business’ adjusted taxable income. An IC-DISC commission reduces a business’ adjusted taxable income and thus increasing the likelihood of running into the business interest expense limitation. If you fail to incorporate §163(j) into your IC-DISC planning, your potential worst-case scenario of a 5.8% tax rate benefit may have gotten even worse.
NOT ALL IS LOST
The TCJA certainly brought with it additional planning needs when considering opening and operating an IC-DISC. Your potential tax savings in using an IC-DISC is dependent on a host of new and old questions, to include;
- What ordinary and capital gains rates may I fall under
- How much IC-DISC Dividend is taxable in the year of the IC-DISC commission deduction
- Am I a large business subject to the Business Interest Expense Limitations under §163(j), (NEW)
- Does my business qualify for the §199A business deduction, and if so, what is my before and after §199A deduction after incorporating the IC-DISC commission deduction, (NEW)
- When should the commission payments actually be made
I have yet to come across a single business that knows their taxable income on the final day of their tax year-end let alone their book financial income. The good news, a business using and operating an IC-DISC under the old tax regime was not required to know with certainty their IC-DISC commission deduction on or before their tax year end, and the TCJA certainly does not change nor expedite this need. The TCJA does, however, require a business to incorporate additional limitations and calculations when considering what their IC-DISC commission should be for the given taxable year.
POTENTIAL PLANNING OPPORTUNITIES
Again, without going into the weeds, we are going to talk in general terms. How you calculate and make payments for an IC-DISC commission is a separate article in itself. The important part to remember is the cash payments towards a commission expense can happen before year end or after. And an IC-DISC may be structured to incorporate this unknown and provide additional time post year-end to calculate the final commission payment deducted on the businesses tax return. This gives companies the flexibility to maximize the IC-DISCs effectiveness without pigeonholing them into a position before all the facts are known.
AND THAT’S NOT ALL
The TCJA may have opened the door to a much greater benefit. This, however, is a much more hotly contested area with the IRS and careful research and planning should be considered before utilizing such a tool. This deals with an individual’s Roth IRA owning and receiving dividends from an IC-DISC. Why is this such a big deal?! The corporate tax rate is 21%, plus investment earnings from a Roth IRA are tax free upon a qualifying distribution. If a Roth IRA receives the dividends from an IC-DISC there will now be a flat corporate tax hit of 21% upfront to pay. This corporate rate is lower if instead the IC-DISC was held by the individual outright who may be subject to the maximum individual capital gains rate of 23.8% (20% capital gain + 3.8% NIIT). If those dividends received from the Roth IRA are reinvested and later distributed the earnings on the investments while in the Roth are tax free upon a qualifying distribution to the individual. Prior to 2018, the corporate tax rate hit 25% after just $50,000 of taxable income. This limited the tax rate benefit of a Roth IRA owning the IC-DISC versus the individual who at worst would be subject to the maximum 23.8% capital gains rate. However, with a flat corporate tax rate of 21% a Roth IRA could receive any amount of dividends and would never reach a tax rate higher than what an individual would pay if held outright and subject to the highest capital gains and NIIT tax rates. The Roth IRA strategy is based on current litigation. One can expect the IRS to lobby Congress to eliminate this planning opportunity. Understand your risk and opportunity before pursuing the Roth IRA strategy.