By Stephen Douglas, Russ Hall and Lourdes Martinez
Puerto Rico has revised its tax code, and the new code makes several noteworthy changes to the rules for qualified retirement plans. These include new limits on benefits, contributions and compensation that may be taken into account; higher deduction and employee pretax contribution limits; and revisions to nondiscrimination requirements. The changes affect retirement plans that are qualified under the laws of Puerto Rico.
Most of the new rules took effect retroactively on January 1, 2011, although some are delayed until January 1, 2012. (Except as expressly indicated below, the 2011 effective date generally applies to the rules summarized in this article.) Future guidance should shed light on whether the effective date is determined on a plan year, employer tax year or some other basis, and perhaps provide transition relief as well.
Sponsors of Puerto Rican qualified plans must amend their plans to reflect new limits on benefits, contributions and compensation. Sponsors will also need to consider the higher available limits on certain contributions, i.e., on pretax contributions by participants and employer deductible contributions. Finally, sponsors will need to assess the impact of these changes on their plans' nondiscrimination tests.
Limits on compensation
For the first time, the Puerto Rican tax code will limit the compensation that can be taken into account in determining benefits under or contributions to retirement plans (as well as for purposes of nondiscrimination tests). The limit is $245,000, which is the same as the current U.S. limit. However, the Puerto Rican limit does not appear subject to an automatic cost-of-living adjustment (COLA) (except for plans qualified under the laws of the United States as well as Puerto Rico). This change becomes effective January 1, 2012.
Limits on benefits and contributions
The revised tax code also will begin to impose individual limits on the benefits that can be accrued under defined benefit (DB) plans and on the contributions made to defined contribution (DC) plans. The basic limits for both DB and DC plans — the dollar and percentage of compensation — are the same as the limits for 2011 under U.S. Internal Revenue Code (IRC) section 415. So for DB plans, the limits are $195,000 and 100% of average compensation (whichever is less), and for DC plans the limits are $49,000 and 100% of compensation (whichever is less). However, the Puerto Rico dollar limits do not receive automatic COLAs, and it isn't clear whether or how frequently the Puerto Rico legislature will revise them. The new limits take effect January 1, 2012, so sponsors must amend their plans by then.
With the advent of the new compensation limits described above — if the experience of U.S. plans is a guide — this change may not affect many plan participants, although given the absence of COLAs, the limits will cast an increasingly wide net over time.
Pretax contribution limits
The limit on pretax elective contributions to 401(k)-type plans remains $10,000 for 2011 but will rise in future years — to $13,000 for 2012 and $15,000 for 2013 and later years. Likewise, the limit on catch-up contributions (available to participants age 50 and older) remains $1,000 for 2011 but increases to $1,500 for 2012 and later years. Even when fully phased in, these limits are lower than the comparable U.S. limits and — unlike the limits under U.S. law — are not linked to an automatic COLA.
Sponsors will presumably want to incorporate these higher contribution limits into their plans for 2012. However, they should consider the possible implications for actual deferral percentage (ADP) test results if they expect those individuals classified as highly compensated employees (HCEs) to take advantage of the higher limits in disproportionate numbers.
It's likely that the different contribution limits as well as other differences (e.g., potentially different pool of HCEs under Puerto Rican and U.S. law — see below) between the U.S. and Puerto Rican rules will continue to discourage sponsors from covering employees residing in Puerto Rico and the United States under a single 401(k)-type plan.
Deduction limits
The new tax code increases the maximum limits on deductible plan contributions. Specifically, the rules allow deductions for contributions necessary to satisfy the minimum funding requirements of the Employee Retirement Income Security Act (ERISA) (the same minimum applying to U.S. qualified plans). The code increases the maximum limit on deductible contributions to DC plans from 15% to 25% of compensation. However, as under current law, when an employer maintains both a DB plan and a DC plan, the total deduction (for both plans) is still limited to 25% of aggregate compensation.
These higher limits are welcome, as they reconcile the earlier gap between ERISA's minimum funding requirement and the deduction limits.
Nondeductible contribution tax
Plan sponsors whose plan contributions exceed the deduction limits described above will be subject to a new 10% tax. Sponsors will want to keep this tax in mind as they develop their DB plan funding strategies, especially because the Puerto Rican deduction limits remain lower than those under U.S. law (where contributions to enable a DB plan to reach up to a 150% funded level are deductible). This is especially important in deciding whether to make a nondeductible contribution to avoid ERISA benefit restrictions based on a plan's funded status.
As under U.S. law, the tax will continue to apply each future year to a previous-year nondeductible contribution until it is deductible under ordering rules set forth in the statute. Thus sponsors must maintain accurate records of their deductible and nondeductible contributions.
Under previous law, an individual was classified as an HCE for nondiscrimination testing purposes if his or her compensation was in the highest one-third of all non-excludible employees. The 2011 Code defines HCEs using a number of absolute thresholds. Like the U.S. definition, one HCE category includes employees whose pay exceeded $110,000 in the preceding year (the current threshold under U.S. law). The amount does not appear to be subject to an automatic COLA, with one exception. In a dual-qualified plan (i.e., a plan that meets the tax qualification rules in both the United States and Puerto Rico), both the U.S. dollar limit with its automatic COLA and the top-paid group election, if applicable, appear to be substituted for this part of the definition. Like U.S. law, the Puerto Rican definition includes 5% owners. However, the Puerto Rican definition also includes other categories, specifically officers and the HCE's spouse or dependent(s).
The new HCE definition might be helpful in minimum coverage testing, as it could increase the percentage of non-highly compensated employees (NHCEs). It is less clear how this change will affect ADP testing of a 401(k)-like plan (called an "1165(e) plan" in Puerto Rico, although it will now find its statutory home in section 1081.01 of the 2011 Code).
While the Puerto Rican HCE definition has moved closer to the U.S. definition, differences remain. The potential differences in HCEs may still discourage employers from using a single, dual-qualified 401(k) plan to cover their employees in both the United States and Puerto Rico, as it would still be possible to have an ADP testing failure in one jurisdiction that would be impossible to correct through a refund of excess contributions under the other jurisdiction's laws.
Nondiscrimination testing — testing population
Under Puerto Rico law, members of a controlled group of corporations (or certain other entities) used to have some flexibility in deciding whether to perform the minimum coverage and nondiscrimination tests on the basis of all employees in the controlled group. The new code requires controlled group members to use all employees within the controlled group for these tests. Aggregation is also required with respect to certain "affiliated service groups," which is defined similarly under U.S. law.
This new "controlled group" definition is quite similar to the U.S. version. So, for example, it appears to force a sponsor to take the U.S. employees of the sponsor or its affiliates into account as well as the employees located in Puerto Rico. For companies that cover their entire Puerto Rico workforce under a single plan or plans, this change should not be especially disruptive where the vast majority of controlled group HCEs are in the United States. However, it may pose challenges for controlled groups that provide different qualified plan coverage to different segments of their Puerto Rican workforce.
Nondiscrimination testing — M&A relief
The current minimum coverage requirements (generally similar to those under U.S. law) have been augmented with a special transition rule for sponsors involved in a merger, acquisition or similar transaction. The new provision is similar to that under the U.S. tax code — a plan must meet minimum coverage rules immediately before the transaction and must avoid any significant changes during the transition. This change should generally be useful to sponsors involved in an acquisition, divestiture or similar transaction.
ADP testing failures
A new 10% tax will apply to sponsors of 401(k)-type plans that fail the ADP test for a plan year unless the sponsor corrects the failure by the date its tax return is due. This sponsor-focused tax sanction should further encourage sponsors to perform accurate ADP tests in a timely manner. The deadline to avoid this employer-level tax will generally be earlier than the prior-law deadline of 12 months after the close of the plan year to which the test relates.
Determination letters
The requirement to obtain a determination letter as a condition of plan qualification has been codified, effective as of January 1, 2012. The deadline to request such a determination is the due date of the sponsor's tax return for the first tax year in which the plan covered any participants. Plan sponsors should verify that they have obtained a determination letter for the plan from Hacienda (the Puerto Rican equivalent of the IRS). It remains to be seen whether, given this newly codified requirement, Hacienda will change its current willingness to grant "retroactive" determination letters without any sanctions to employers that are late in seeking such approval.
Other changes
The 2011 Code also changes the tax treatment of distributions from qualified plans. Among other changes, a 10% withholding tax is required on the taxable portion of any partial/periodic distributions. Previously, withholding was required only for lump-sum distributions.
In March, the Hacienda issued guidance granting relief from the 10% withholding tax for 2011 payments made upon separation from employment in the form of an annuity or other periodic payments (e.g., payments made during a fixed period of time in substantially similar amounts). This relief exempts the first $23,500 paid to a participant who is 60 or older and the first $19,500 paid to a younger participant. Other distributions to which the 10% withholding rate generally applies, such as an ad hoc, in-service withdrawal of less than the entire balance, are subject to the new withholding requirement as of January 1, 2011 (for calendar-year taxpayers).
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