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Action Required for Retirement Plans Covering Puerto Rico Residents

An eight-year transition period for U.S. tax-qualified retirement plans covering Puerto Rico residents is set to end in 2015.  Employers that cover Puerto Rico residents under U.S. tax-qualified plans should consider spinning off the Puerto Rico portion of the plan in 2015, to avoid subjecting Puerto Rico residents to U.S. federal income tax.

Background.

 Tax-qualified retirement plans covering Puerto Rico residents are subject to both ERISA and tax-qualification requirements.  There are two alternatives for tax qualification.  Alternative 1 is for the plan to be “dual-qualified,” under both the Puerto Rico tax code and the U.S. Internal Revenue Code.  Alternative 2 is for the plan to be qualified under the Puerto Rico tax code but not the U.S. Internal Revenue Code.

In general, Puerto Rico residents are not required to pay U.S. federal income tax on income from sources within Puerto Rico.  Most compensation that a Puerto Rico resident earns by working in Puerto Rico is Puerto-Rico-source income, and is exempt from U.S. federal income tax.  In contrast, however, investment income from a retirement trust maintained outside Puerto Rico is not Puerto-Rico-source income, even if the employee earned the retirement benefits by working in Puerto Rico.  Accordingly, if a Puerto Rico resident participates in a retirement plan whose trust is in the U.S. mainland, the employee will have to pay U.S. federal income tax on part of his or her benefit, even if the employee never set foot outside Puerto Rico.

To avoid this result, a plan’s trust must be located in Puerto Rico, so that the trust’s investment earnings will be Puerto-Rico-source income.  For most employers with dual-qualified plans that cover a large number of employees who are not Puerto Rico residents, moving the trust to Puerto Rico is not a practical option.  A more efficient way to avoid U.S. federal income taxes on benefit payments to Puerto Rico residents is to provide benefits for Puerto Rico residents in a separate plan with a Puerto Rico trust.

In 2008, the IRS announced a transition period during which employers with U.S.-based dual-qualified plans could spin off the part of the plan covering Puerto Rico residents into a separate plan with a Puerto Rico trust.  If the spinoff is completed by the end of the transition period, trust earnings accumulated in the U.S. trust before the spinoff will be treated as Puerto-Rico-source income.  In addition, the spinoff will not be treated as a distribution even if the spinoff plan is tax-qualified only in Puerto Rico.  In contrast, if a spinoff occurs after the transition period, Puerto Rico residents will have to pay U.S. federal income tax on earnings from before the spinoff, and a spinoff to a plan that is not tax-qualified under the U.S. Internal Revenue Code will be treated as a distribution.  If any of the Puerto Rico employees are still actively employed by the company at the time of the spinoff, this treatment might automatically result in disqualification of the transferor plan.

Action Required in 2015.  

For plans that participate in a qualified group trust, the transition period will end December 31, 2015.  (For plans that do not participate in a qualified group trust, the transition period ended December 31, 2012.)  This means that employers with dual-qualified plans covering Puerto Rico residents might wish to spin off the Puerto Rico part of the plan and establish a separate Puerto Rico trust by the end of the year.

The separate Puerto Rico plan will need to be qualified under the Puerto Rico tax code.  Dual-qualification will not necessarily be required, but might be desirable because qualification under the U.S. Internal Revenue Code provides tax-advantages that might not be available for a plan that is qualified only under the Puerto Rico tax code.  For example, maintaining a dual-qualified plan will protect Puerto Rico residents from federal employment tax; avoid adverse federal income tax consequences for Puerto Rico residents who sometimes work outside of Puerto Rico; and ensure that the employer’s contributions to the trust are deductible under the U.S. Internal Revenue Code.

Many plan sponsors that establish separate trusts in Puerto Rico will want to continue investing their assets in qualified group trusts in the U.S. mainland (such as a master trust maintained by a large employer or a collective trust).  The IRS has ruled that group trusts may accept these investments.

The IRS’s guidance did not address the tax consequences to the investing plan and its participants, however.  For example, the guidance left open the possibility that earnings from investing in a U.S. group trust will be treated as U.S.-source income, therefore subjecting Puerto Rico residents to U.S. federal income tax.  We have discussed this issue informally with Treasury and IRS officials, and have been told that earnings from a U.S. group trust will not be treated as U.S.-source income if the following conditions are satisfied:

  • The plan either (1) is dual-qualified or (2) covers only residents of Puerto Rico;

  • The plan’s trust is located in Puerto Rico;

  • All contributions are made to the trust in Puerto Rico; and

  • All distributions are made from the trust in Puerto Rico.

Employers that provide retirement benefits to employees in Puerto Rico should review their plans and determine the best course of action before the December 31 deadline.

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