Many U.S. employers maintain operations in Puerto Rico. Employees frequently are hired in Puerto Rico, and some employees are transferred from the United States to Puerto Rico.
What starts off as a temporary assignment to Puerto Rico may evolve into full-time employment. As changes in employment status occur, U.S. employers must consider alternatives to provide U.S. benefits to employees transferred to Puerto Rico and locally hired employees.
The Commonwealth of Puerto Rico is governed by most federal laws, but significant tax differences exist (the Puerto Rican Internal Revenue Code was substantially changed in 2011.
References here are to the 1994 Puerto Rican Code, as it will govern the interpretation of most provisions until new regulations are issued.) Although Puerto Rico is a commonwealth of the United States, no income taxes are paid in the United States on any income earned in Puerto Rico.
However, U.S. Social Security taxes are paid by Puerto Rican residents, since they are U.S. citizens. A separate tax structure exists, with taxes being paid to the Puerto Rican Hacienda.
The alternatives to provide retirement benefits to employees in Puerto Rico include:
* Maintaining a Section 1165(e) retirement plan in Puerto Rico. This is the simplest alternative. A Section 1165(e) plan is very similar to a U.S. 401(k) plan. The most favorable Puerto Rican tax treatment will be given to Puerto Rican employees with distributions from a Section 1165(e) plan, and the least amount of administrative issues are encountered under this approach.
However, when the number of employees in Puerto Rico are below five or 10, U.S. employers generally are reluctant to incur the expense of establishing and maintaining a Section 1165(e) plan.
* Maintaining a dual plan. A 401(k) plan with a U.S. domestic trust that covers both U.S. and Puerto Rican employees may qualify under both the 1994 Puerto Rican Code (now the 2011 Puerto Rican Code) as well as the U.S. Internal Revenue Code to provide Puerto Rican employees with favorable tax benefits.
These plans are generally referred to as "dual-qualified" plans. A dual-plan should apply for and obtain an opinion letter from the Puerto Rico Hacienda to confirm that the plan is qualified in Puerto Rico and should also obtain a U.S. favorable determination letter.
More effort is required to maintain a dual plan than a local Section 1165(e) plan in Puerto Rico, since the U.S. plan must contain provisions to satisfy the U.S. and Puerto Rican tax codes.
* Inclusion in U.S. plans. The last alternative is to simply include Puerto Rican employees in the U.S. qualified retirement plan.
This alternative is generally encountered when employees initially transfer to Puerto Rico and may be on a dual payroll in both the U.S. and Puerto Rico, for individuals transferred from the U.S. full time to cover a Puerto Rican territory, and for small groups of people treated as U.S. employees for general benefit purposes.
The primary difficulty with including Puerto Rican employees in a U.S. qualified retirement plan is that the U.S. and Puerto Rican tax rules differ. Puerto Rican employees may not make employee salary deferral contributions in excess of $10,000 in 2011, while U.S. employees may make contributions up to $16,500.
Furthermore, Puerto Rican employees may only contribute $1,000 as a catch-up contribution if they are age 50 or older by the end of the 2011 calendar year, compared to the $5,500 catch-up contribution in the United States.
Many U.S. recordkeeping systems cannot differentiate between U.S. and Puerto Rican employees to ensure that the Puerto Rican contribution limitations are not exceeded. Therefore, manual efforts are required to avoid a violation of Puerto Rican tax rules in a U.S. qualified retirement plan.
Including Puerto Rican employees in a U.S. 401(k) plan usually is not the preferred alternative, since distributions from a U.S. plan to Puerto Rican employees are subject to U.S. income taxes and withholding taxes, and cannot be rolled over to a Section 1165(e) plan in Puerto Rico.
Perfect solution
When employers discover that they have Puerto Rican employees participating in U.S. retirement plans, efforts may be taken to freeze benefits for such individuals and eventually remove them from a U.S. plan. Employers can consider "spinning off" assets to a Puerto Rican 1165(e) plan, distributing benefits and other alternatives.
None of these alternatives are perfect. However, in Revenue Ruling 2008-40, the IRS reviewed the tax issues associated with a transfer of assets and liabilities from a U.S. qualified plan to a Puerto Rican Trust.
In general, a transfer of assets from the U.S. plan to a Section 1165(e) plan, and the associated Puerto Rican Trust, would be deemed to a "distribution" from the U.S. plan, subjecting employees to taxation. Furthermore, a spinoff of assets will be considered to be an in-service distribution to a nonqualified plan, subjecting Puerto Rican employees to U.S. taxation on the deemed distribution.
The transfer also could disqualify the U.S. plan if in-service distributions were not otherwise permitted. In Revenue Ruling 2008-40, the IRS offered relief to employers, permitting the transfer of assets between a U.S. and a Puerto Rican Trust without any adverse consequences until Dec. 31, 2010.
Although the beneficial relief from the Revenue Ruling 2008-40 transfer was to expire, the good news for employers is that in Revenue Ruling 2011-1, the transition relief was extended for one year, until Dec. 31, 2011. Accordingly, employers may transfer assets from a U.S. 401(k) plan to a 1165(e) plan without adverse consequences to participants.
Furthermore, distributions from the Puerto Rican Section 1165(e) plan, in the future, will receive favorable taxation in Puerto Rico and not be subject to U.S. taxation.
As a result of this extension, the perfect solution for employers discovering Puerto Rican employees in U.S. plans is to establish a Section 1165(e) plan, transfer the assets from the U.S. plan to a Puerto Rican Section 1165(e) plan and eliminate any historical problems.
However, before transferring any assets it would still be prudent to consider administrative issues, such as the existence of excess deferrals over the Puerto Rican Code limitations in a U.S. plan, and the possible dual status of a U.S. plan.
All retirement plans subject to ERISA are required to file an annual Form 5500. Issues for employers to consider when maintaining Section 1165(e) plans and dual plans are as follows:
* Section 1165(e) plans that are qualified in Puerto Rico and not the U.S. should include on Line 7, under plan characteristic "Codes", Code 3C, reflecting that the plan is not intended to be qualified in the U.S. under Section 401 of the U.S. Code.
* U.S.-based plans that cover Puerto Rican employees and are qualified under both the U.S. Code and the Puerto Rican Code should use Code 3J, reflecting that they are dual plans.
* Plans governed by Section 1165(e) are also required to file a Form 480.70 with the Hacienda.
U.S. employers will have different reasons for providing comparable benefits to employees in the United States and Puerto Rico.
Regardless of the overall compensation and benefit structures of an employer, 2011 is the perfect year to evaluate whether changes should be made for Puerto Rican employees due to the new 2011 Puerto Rican Code.
More importantly, U.S. employers should review where benefit statements are being mailed in 2011, to determine if a transfer under Revenue Ruling 2008-40 should be considered.
Contributing Editor Frank Palmieri, CPA, JD, LL.M (Taxation) is a partner with the law firm of Palmieri & Eisenberg, with offices in Princeton, N.J., and Alexandria, Va. He is a national speaker and writer on employee benefits issues and is a fellow in the American College of Employee Benefits Counsel.
