On November 15, 2013, the Internal Revenue Service published a notice of proposed rule making (NPRM) along with proposed regulations regarding the treatment of certain income derived from Indian fishing rights-related activity when it is contributed to a qualified retirement plan such as a 401(k) or other employer-sponsored pension plan. The notice can be viewed at https://www.federalregister.gov/articles/2013/11/15/2013-27331/treatment-of-income-from-indian-fishing-rights-related-activity-as-compensation#h-4.
The proposed regulations clear one of the current hurdles to including employees of an Indian fishing rights operation in a typical employer-sponsored retirement plan, such as a 401(k) plan. Unlike most types of employee compensation, Indian fishing rights-related income is exempt from both income and employment taxes under Internal Revenue Code (IRC) Section 7873(a)(1) and (a)(2). Therefore, Indian fishing rights-related income is not included in a taxpayer's gross income. The IRS has traditionally taken the position that in order to make a contribution to an individual retirement account (IRA) or a 401(k) plan, an individual must have "compensation" that is included in gross income. The proposed regulations clarify that payments received by Indian tribe members as remuneration for services they perform in fishing rights-related activities will not be excluded from the definition of "compensation" for purposes of IRC Section 415 and underlying regulations, merely because such payments are not subject to income or employment taxes. Consequently, the proposed regulations allow employees receiving such payments to participate in and contribute to a retirement plan qualified under IRC Section 401(a).
Background on Fishing Rights-Related Income Taxation and IRS Rules
Many Indian tribal governments and tribal members conduct fishing activities as part of longstanding customs and traditions. Various treaties, federal statutes and executive orders give Indian tribal members the right to fish for both subsistence and commercial purposes. IRC Section 7873 was enacted in 1988 to clarify that compensation received for such fishing activities would not be subject to income or employment taxes. One negative consequence of the broad exemption from income and employment taxes is that individuals whose primary source of income is derived from Indian fishing activities generally will not be able to qualify for full Social Security benefits. Thus, it is important to provide such individuals with other retirement savings options.
In 1998, the U.S. Tax Court considered whether fishing rights-related income exempt under IRC Section 7873 could be used to fund IRAs and how distributions from such IRAs should be taxed in Hall v. Commissioner, T.C. Memo 1998-336. From 1979 through 1992, Robert Hall was employed by the Lummi Indian Tribe (the tribe) as a full-time employee in the tribal fish hatchery. His income was exempt from taxation under IRC Section 7873. In addition to wages, all fisheries employees were given an extra $160 per month that they could deposit into either a health plan or a retirement plan. Mr. Hall directed the funds into two retirement plans, which were apparently set up as IRAs. Then, in 1992, Mr. Hall took distributions from both retirement accounts.
In Hall, the IRS argued that the retirement account deposits were an "addition to wages" and thus fully subject to tax upon distribution. Mr. Hall argued that they were a "temporary deposit" of exempt fishing rights-related income and that they should not be subject to tax upon distribution. (Mr. Hall did not specifically argue that the investment earnings on the amounts he deposited were nontaxable.) The Tax Court treated the retirement accounts like annuities established with previously taxed income and therefore looked to IRC Section 72 to determine the tax consequences of the distributions. Applying the annuity rules, the Tax Court held that the contributions made by the tribe on behalf of Mr. Hall constituted an "investment in the contract" under IRC Section 72(e)(6). Further, under IRC Section 72(f), Mr. Hall was able to receive the amounts allocable to the tribe's contributions (i.e., the amounts treated as an "investment in the contract") free of income tax. Thus, under the Hall case, fishing rights-related income retains its nontaxable status upon distribution from a retirement plan, but any investment earnings on such funds would be taxed upon distribution.
After losing the Hall case, the IRS posted the following questions and answers to its website in the Indian Tribal Governments section. These Section 7873 frequently asked questions include the following notable discussions. To view the Indian fishing rights-related FAQs, go to http://www.irs.gov/Government-Entities/Indian-Tribal-Governments/FAQs-for-Indian-Tribal-Governments-regarding-IRC-Section-7873-(Fishing-Rights).
Can tribal members contribute to an Individual Retirement Account (IRA) if their only income is derived from fishing rights-related activities under section 7873 of the Code?
No. An individual seeking to make a contribution to an IRA must have "compensation" that is included in that individual's gross income. Section 7873 of the Code provides that fishing rights-related income is exempt from federal taxes, including federal income taxes. As a result, it is not included in income and cannot serve as the basis for a tribal member to make a contribution to an IRA.
Can an Indian tribal government set up a 401(k) plan with contributions based on section 7873 income?
No. In order to serve as the basis for an individual's deferring amounts into a section 401(k) arrangement, "compensation" must be included in that individual's gross income. Section 7873 of the Code provides that fishing rights-related income is exempt from federal taxes, including federal income tax. As a result, it is not included in income and cannot serve as the basis for a tribal member to defer amounts into a section 401(k) arrangement.
Because of the IRS' negative position on utilizing IRAs or 401(k) plans to cover tribal members engaged in fishing right-related activities, some tribes have turned to annuities or non-qualified deferred compensation plans to provide their members with some type of retirement savings funds. As noted below, the proposed regulations depart from the prior position taken by the IRS and open up options to the tribal governments when designing their retirement benefits plans.
How Benefit Plans Sponsored by Indian Tribal Governments Are Affected
IRC Sections 415(b) and (c) impose limits on retirement plan contributions from compensation. IRC Section 415(c) defines "participant's compensation" as compensation for the participant from the employer for the year. Section 1.415(c)-2(b) of the Income Tax Regulations generally provides that, for purposes of IRC Section 415, the term compensation includes employee wages, salaries, fees and other amounts received for personal services actually rendered in the course of employment with the employer maintaining the plan, but only to the extent that said amounts are includible in gross income. The NPRM acknowledges that "[b]ecause fishing rights-related income is not subject to income tax, an issue has been raised as to whether such income is included as compensation for purposes of section 415(c)(3) and §1.415(c)-2(b) [of the Income Tax Regulations]." The proposed regulations would add a new item to Treasury Regulations Section 1.415(c)-2(b) clarifying that income from an Indian fishing rights-related activity is compensation for purposes of the limitations imposed by IRC Section 415. The new regulations would affect employee benefit plans sponsored by Indian tribal governments, their plan participants and tribal members. This represents a major change in the IRS position.
Specifically, the proposed regulations state that amounts paid to a tribal member as remuneration for services performed in a fishing rights-related activity (as defined in IRC Section 7873(b)(1)) do not fail to be treated as "compensation" under Section 1.415(c)-2(c)(4) of the Income Tax Regulations merely because those amounts are not subject to income or employment taxes. The regulations further explain that the determination of whether an amount constitutes "wages, salaries or earned income" (for purposes of sec. 1.415(c)-2(b)(1) or (b)(2)) will be made without regard to the fishing rights-related income's exemption from income or employment tax.
The proposed effective date of the regulations is for taxable years ending on or after the date of publication in the Federal Register of the final regulations. However, taxpayers may rely on the proposed regulations for periods preceding the effective date, pending the issuance of final regulations.
Treasury and IRS Request for Comments on Contributions Attributed to Fishing Rights-Related Income and Plan Distributions
The NPRM requests comments by February 13, 2014. Comments may be mailed or hand-delivered to the IRS at the addresses in the NPRM or sent electronically via the Federal eRulemaking Portal at www.regulations.gov (IRS REG-120927-13). In addition to general comments on the proposed regulations, the IRS and Treasury Department request comments on the taxation of qualified plan distributions that are attributable to fishing rights-related income and the application of IRC Section 72(f)(2) — the provision which treats certain amounts as a "basis" for purposes of computing an employee's contributions if those amounts would have not been includible in income had they been paid directly to the employee.
The proposed regulations represent a significant change in the IRS position regarding tribal eligibility for qualified retirement plans; however, the NPRM does not resolve all issues surrounding the participation of recipients of fishing rights-related income in qualified retirement plans. As stated above, the NPRM asks for further comments on "the taxation of qualified plan distributions that are attributable to fishing rights-related income" and specifically "the application of section 72(f)(2)." This may indicate that the IRS is considering taxing such retirement distributions like annuities (i.e., only the amount exceeding the investment in the annuity contract is taxed) and not like ordinary 401(k) plan distributions.
Further, the scope of the NPRM does not appear to resolve the problem of how to provide retirement savings options for self-employed tribal member-owners of fishing rights operations. However, if the owners are also employees, their compensation for services rendered would fall under this rule.
Next Steps for Indian Tribal Governments and Retirement Plan Stakeholders
It is encouraging that the IRS has altered its position and now allows Indian fishing rights-related income received by tribal employees earning such income in exchange for services to be contributed to qualified retirement plans. Tribal employees strongly need the opportunity to participate in qualified employer-sponsored retirement plans since this encourages savings that will compensate for the employees not being eligible to receive Social Security benefits in connection with such exempt income. Although nonqualified deferred compensation plans may still be utilized for certain key employees, the proposed regulations permit qualified retirement plans to be established for the benefits of all employees.
It is surprising, however, that the IRS did not propose regulations consistent with the result in the Hall case. Instead, the IRS asked (1) for public comment on the issue of how to treat plan distributions and (2) whether it would be appropriate to apply the annuity rule to amounts that would not have been includible in income had they been paid directly to the employee. The IRS should publicly acquiesce in the Hall case and resolve any uncertainty about the extent to which distributions made from Indian fishing rights-related income-funded retirement plans are subject to taxation.
Although the proposed regulations are a step in the right direction, Indian tribal governments and other stakeholders should consider these follow-up actions:
- file comments urging the IRS to resolve the "distribution" issue as soon as possible so that this second barrier to retirement plan utilization can be removed
- file comments asking the IRS to clarify the applicability of the new rules to self-employed participants in Indian fishing rights-related operations
- consult with tax and employee benefit counsel about changes that can now be made to retirement plan documents