Important Updates Regarding Deferred Per Capita Plans for Indian Tribes
 
February 19, 2008
 

What is a deferred per capita plan?

A deferred per capita plan is a plan sponsored by a 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 or an executive deferred compensation plan. However, since per capita payments are not “earned income,” they cannot be contributed to an IRA, a 401(k) plan or other compensation-oriented plan.

What are the advantages of making deferrals?

In addition to the tax savings discussed below, deferred per capita plans permit Tribal members to have a long-term savings mechanism that grows in value on a tax-deferred basis. For some Tribes, per capita distributions from gaming are very 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 distributions. 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.

What kind of tax savings are available?

The federal tax savings that deferred per capita plans create are two-fold: (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 available for distribution.

Example

Assume that in 2008, “Rosa,” an unmarried Tribal member living on a reservation, receives $100,000 in per capita distributions from gaming revenues as her sole source of income. If Rosa does not defer any income to a deferred per capita plan and takes the standard deduction, her taxable income will be $91,250 and her federal income tax will be approximately $19,654.

If Rosa decides to defer 25 percent (or $25,000) of her per capita distribution into a deferred per capita plan, her income subject to tax will be $66,250. Under this scenario, Rosa will owe only $12,980 in federal income taxes, resulting in a net tax savings of $6,674.

In addition to saving $6,674 in federal income tax, by contributing to the plan, Rosa has saved $25,000 for a rainy day that will grow tax deferred.

If, beginning in 2009, Rosa saves $25,000 per year ($2,083 month) for the next 15 years and averages approximately 9 percent annual growth in a diversified, balanced investment (65 percent stocks/35 percent bonds), she would have approximately $800,085 before taxes in 2024.

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 or she otherwise would be unable to claim or use (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.

Has the Internal Revenue Service (IRS) ever approved a Tribal deferred per capita plan?

Yes, the IRS has approved a deferred per capita plan. 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, we are aware of no other ruling that has addressed the deferral of unearned income.

The IRS has not approved any deferred per capita plans since the PLR and has temporarily taken a “no ruling” stance. The “no ruling” stance was adopted in connection with the solicitation of comments on similar deferred income arising in connection with a Tribe’s administration of minors’ trusts set up to hold gaming revenues for minors. While the comment deadline has long since expired, the “no-rule” policy has not been lifted. On January 7, 2008, the IRS released their 2008 “no-rule” list, which included tribal-sponsored deferred per capita plans. There is no indication that the IRS is inclined to issue guidance that would effectively revoke the PLR. However, to minimize risk, Tribal deferred per capita plans should be structured as much as possible like the plan described in the PLR and consistent with Revenue Procedure 2003-14, which sets forth the safe harbor requirements for Tribally-sponsored minors’ trusts.

What are the basic features of the plan approved by the IRS?

The plans approved by the IRS in the PLR included two specific deferred per capita plans established by a Tribe. Both plans were completely elective. Under both plans, a member could elect to defer all or any part of his or her per capita distribution; the IRS did not limit the amount that may be deferred.

Assets contributed to the plan are placed in a grantor trust. Although placed in a trust, the assets must be subject to the claims of the Tribe’s general creditors.

Before the beginning of each year, each Tribal member who wants to participate in the plan submits an election form. The member uses the election form to designate the portion of his or her per capita distributions that should be contributed directly to the trust. This election must be completed and submitted before the funds used for the per capita distribution are earned by the Tribe. These annual elections are irrevocable once made, but advance distributions may be made for unforeseen emergencies at the discretion of the plan administrator.

Distributions under the two plans may occur in accordance with a variety of schedules. Participants could defer as follows:

• under Plan A, to age 65 (or until their death or disability, if sooner)
• under Plan B, to a set term of years:

− 10 years
− 15 years

Under both plans, distributions could be paid out in a lump-sum payment or in installments

Summary of Features

• Irrevocable annual elections to defer
• Unlimited deferrals
• Deferred amounts placed in a trust (optional)
• Funds subject to claims of Tribe’s general creditors
• Enforceable contract right against Tribe
• Distributions available at a certain age, upon death or disability, or after a term of years
• Distributions to be made in a lump sum or installment payments

Do the contributions need to be made to a trust?

No, the assets do not need to be kept in a trust. The purpose of the trust is to provide extra security to the contributing members. As discussed below, the Tribe is the owner of the assets and, if placed in a trust, the assets are segregated from the Tribe’s other funds. If segregated, the assets are not as accessible to the Tribe. This separation may be of more importance when a new Tribal council is elected or if Tribal revenues decrease significantly. But regardless of whether the assets are kept in a trust, they must be subject to the claims of the Tribe’s general creditors.

Who owns the funds contributed to the plan?

The Tribe owns the funds contributed to the plan. Unlike employees who contribute to a 401(k) plan, an individual Tribal member who makes contributions to a deferred per capita plan does not have an ownership interest in those funds. Instead, he or she has only an enforceable contractual 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 or her taxable income because the IRS’ constructive receipt rules would be triggered.

Can participants choose to direct their own investments?

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.

Can the Tribe invest the participant’s deferrals in the Tribe’s own enterprises?

Yes, the Tribe may invest amounts contributed to a deferred per capita plan in its own enterprises. As discussed above, the Tribe owns the assets and can use them any way it would like, as long as the Tribe maintains its end of the contractual agreement with the members who make the deferrals.

However, two issues must be appropriately dealt with when the Tribe does not invest the members’ deferrals in outside investments, such as mutual funds or other similar financial investments:

1) the resulting lack of diversification (the Enron problem)
2) avoiding even the appearance of giving Tribal members an individualized equity interest in tribal profits

Are there any risks in implementing such a plan?

Yes, constructive receipt and the IRS’ current “no ruling” stance are two risks associated with deferred per capita plans.

If a plan is not structured properly, it could trigger “constructive receipt.” 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 receives 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 income would not grow tax-deferred.

As discussed above, the IRS’ “no-rule” policy applies to adult-deferred per capita plans and other deferred income trusts that involve Indian gaming revenue. As a result, Tribes are currently unable to receive formal written IRS guidance on any deferred income trust variation. In our view, the continuing “no-rule” position does not mean that deferred income trusts should not be implemented, but it counsels a conservative approach to the arrangement. Based on repeated public comments by IRS officials, coupling deferred per capita plans with other tax-favored investments, such as life insurance, or borrowing to increase deferrals, will likely increase the risk of IRS scrutiny and/or challenge.

For more information, email Kathleen M. Nilles or Telly J. Meier at kathleen.nilles@hklaw.com or telly.meier@hklaw.com, respectively, or call toll free, 1.888.688.8500.