Kathleen Nilles is a Partner and Kenneth Parsons is an Associate in Holland & Knight's Washington D.C. office
- Indian tribes making substantial per capita distributions are seeking solutions to reduce their members' tax liabilities.
- One consideration is to establish a deferred per capita plan – similar to a 401(k) plan or an executive deferred compensation plan – that provides current tax reductions and long-term savings for participating tribal members.
With the top tax bracket at nearly 40 percent, Indian tribes making substantial per capita distributions are asking what they can do to reduce their members' tax liabilities. One option to consider is a deferred per capita plan, which helps participating tribal members reduce taxes, encourages savings and protects beneficiaries. This alert provides an overview of deferred per capita plans and answers common questions.
Question: What is a deferred per capita plan?
Answer: A deferred per capita plan is a plan sponsored by an Indian tribal government that permits its members to voluntarily invest a portion of their per capita distributions in a tax-deferred savings vehicle. It is similar to a 401(k) plan sponsored by employers for their employees and almost identical to an executive deferred compensation plan. However, since per capita payments are not "earned income," they cannot be contributed to an individual retirement account, a 401(k) plan or other compensation-oriented plans.
Question: What are the advantages of making deferrals?
Answer: In addition to the tax savings discussed below, deferred per capita plans permit tribal members to contribute to a long-term savings account that grows in value on a tax-deferred basis. For some tribes, per capita distributions from gaming are high right now, but this boom is not guaranteed to last. By saving a portion of their distributions, members can plan for the future and not have to depend exclusively on future tribal revenue. This way, if the current per capita distributions decrease, members will still have financial resources. This may be especially important for members who are in or nearing their retirement years or who support family members who do not qualify for per capita distributions.
Question: What kind of tax savings are available?
Answer: The federal tax savings that deferred per capita plans create are twofold: (1) reduced taxation on current per capita distributions, and (2) tax-free growth of contributions to the plan. Amounts contributed to the deferred per capita plan by the tribe on behalf of a participant are not subject to taxation in the year during which the contribution is made. Instead, they are taxed when they are distributed or otherwise made available for distribution. Also, the contributions grow tax-deferred because investment gains are taxed only when they are distributed or made available for distribution.
Deferred per capita plans also offer significant collateral tax savings. By reducing income subject to tax, a tribal member may become eligible for certain tax credits and deductions that he/she otherwise would be unable to claim or use. For example, many credits and deductions are phased out for those with adjusted gross income above a certain level. Also, for tribal members who are subject to state taxation, reducing federal income subject to tax generally reduces state income that is subject to tax and thus reduces state tax liability.
Assume that Rosa, an unmarried tribal member living on the reservation, receives $150,000 in per capita distributions from gaming revenues as her sole source of income in 2015. If Rosa does not defer any income to a deferred per capita plan and takes the standard deduction, her taxable income will be $139,200 and her federal income tax approximately $32,187.
If Rosa decides to defer one-third (or $50,000) of her per capita distribution into a deferred per capita plan, her income subject to tax will be $89,700. Under this scenario, Rosa will owe only $18,228 in federal income taxes, resulting in a net tax savings of $13,959.
In addition to saving $13,959 in federal income tax by contributing to the plan, Rosa has saved $50,000 that will grow tax deferred for a rainy day.
If Rosa saves $50,000 per year ($4,167 per month) beginning in 2016 for the next 15 years and averages approximately 5 percent annual growth in a diversified, balanced investment, she will have accumulated savings of approximately $1,211,966 before taxes in 2030.
Assume that Robert, a minor tribal member, is due to receive $25,000 in per capita distributions from gaming revenues when he turns 18 in 2016. Robert also has a minor's trust that will pay him a lump-sum distribution of $125,000 when he turns 18. If Robert does not defer any income to a deferred per capita plan and takes the standard deduction, his taxable income will be $139,200 and his federal income tax approximately $32,187. Under the "kiddie tax," Robert's tax liability would increase if his parents were in a higher tax bracket than he is.
If Robert decides to defer his entire 2016 per capita distribution into a deferred per capita plan, his income subject to tax will be $114,200. Under this scenario, Robert will owe only $25,047 in federal income taxes, resulting in a net tax savings of $7,140. Additional tax savings could be achieved if Robert's tribe staggered his minor's trust distributions over a period of several years.
After college, Robert begins working as an engineer at an annual salary of $65,000. If Robert decides to defer $10,000 of his per capita distribution into a deferred per capita plan each year until he turns 65 and averages approximately 5 percent in annual growth, he will have accumulated savings of approximately $1,863,901 before taxes in 2065.
Question: Has the Internal Revenue Service (IRS) ever approved a tribal deferred per capita plan?
Answer: Yes, in Private Letter Ruling 199908006 (PLR), the IRS approved a plan that allows tribal members to defer a portion of their per capita distributions. Before the PLR was issued, the IRS regularly permitted deferrals of earned income. However, no other known rulings address the elective deferral of unearned income from gaming revenues.
The IRS has also issued two Revenue Procedures in related areas that provide helpful guidance. Revenue Procedure 92-64 provides a model grantor trust for use with deferred compensation agreements. Although not directly applicable, the principles underlying deferral of taxation in Revenue Procedure 92-64 are useful in preparing deferred per capita plans. Revenue Procedure 2011-56 provides a safe harbor under which the IRS will treat an Indian tribe as the grantor and owner of a trust for the receipt of gaming revenues for the benefit of minors or legal incompetents. From a tax perspective, a minor's trust and a deferred per capita plan are very similar in structure.
Question: What are the basic features of the plan approved by the IRS?
Answer: In the PLR, the IRS approved two specific deferred per capita plans established by a tribe. Both plans were completely elective. Under either plan, a tribal member could elect to defer all or any part of his/her per capita distribution; the IRS did not limit the deferral amount. Assets contributed to the tribe's plan were placed in a grantor trust. Although placed in a trust, the assets were subject to the claims of the tribe's general creditors.
Before the beginning of each year, every participating tribal member submitted an election form. The member used the election form to designate the portion of his/her per capita distributions to be contributed directly to the trust. The plan required this election to be completed and submitted before the funds used for the per capita distribution were earned by the tribe. The annual elections were irrevocable once made, but the plan permitted advance distributions for unforeseeable emergencies at the discretion of the plan administrator.
Distributions under the two plans occurred in accordance with a variety of schedules. Participants could defer as follows:
- under Plan A, to age 65 (or until death or disability)
- under Plan B, to a set term of 10 or 15 years
- under both plans, distributions could be paid out in a lump-sum payment or in installments
Question: Who owns the funds contributed to the plan?
Answer: The tribe owns the funds contributed to the plan. Unlike an employee who contributes wages to a 401(k) plan, the individual tribal member who elects to defer receipt of per capita payments does not have an ownership interest in those funds while they are being held in trust. Instead, he/she has only an enforceable right against the tribe for payment.
If the tribal member were to have an ownership interest in the amounts, the member would need to include them in his/her taxable income because the IRS' constructive receipt rules would be triggered. Under the constructive receipt doctrine, income is taxable to a person when it is first made available. Additionally, amounts may become taxable if the individual received the "economic benefit" of the funds. Therefore, if the deferred per capita plan is improperly structured, contributions to the trust would not be on a tax-deferred basis and the investments in the trust would not grow tax-deferred.
Question: Can participants provide advice on investments?
Answer: Yes, although the tribe has the responsibility of investing the assets, it can permit contributing members to provide advice regarding investment allocations. Additionally, the tribe may – and should – use investment advisors and other professionals as needed.
Question: Are there risks in implementing such a plan?
Answer: Yes, a tax-deferred trust cannot be completely walled-off from the reach of the tribe's general creditors. In addition, anticipated financial gains associated with tax deferral may be reduced if Congress enacts significantly higher marginal tax rates in the future. However, at present it appears highly unlikely that Congress will raise individual tax rates above their current top level of 39.6 percent.
Question: Who are the responsible parties and what are their duties?
Answer: The trustee generally is the primary person (or persons) responsible for trust administration, investments and distributions. The role of the trustee is typically performed by an independent financial institution or trust company. The grantor – the tribe – funds the trust and will generally provide administrative assistance. The tribe may also engage a third-party administrator or an investment manager.
Question: How does a tribe establish a deferred per capita plan?
Answer: Counsel to the tribe should prepare a list of key terms that are (1) explicitly required by IRS guidance, (2) specifically permitted by IRS guidance, and (3) not addressed by IRS guidance but reflect applicable trust laws and/or best practices. Counsel should review this list of key terms with the tribe and prepare a draft-deferred per capita plan (and trust agreement, if desired) customized to the tribe's preferences. The documents are shared with the plan's trustee, third-party administrator and investment advisor for their comments. Counsel then negotiates a final agreement, going back to tribal decision makers for their assent to any material changes.
Tribal staff should educate tribal members on the availability of the deferred per capita plan and the benefits of participating. If tribal law requires a Revenue Allocation Plan (RAP) amendment that must be voted on by tribal membership, this education process should be undertaken even before the plan is formally adopted and implemented.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.