PORTFOLIO

International Pension Planning — Puerto Rico (Portfolio 324)

Tax Management Portfolio International Pension Planning — Puerto Rico, No. 324-2nd, provides a detailed discussion of the legal rules, practices, and principles governing the establishment, qualification, operation, and termination of retirement plans in Puerto Rico (“P.R.”) and the taxation of retirement benefits from qualified and nonqualified plans and equity-based compensation arrangements. 

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DESCRIPTION

Tax Management Portfolio International Pension Planning — Puerto Rico, No. 324-2nd, provides a detailed discussion of the legal rules, practices, and principles governing the establishment, qualification, operation, and termination of retirement plans in Puerto Rico (“P.R.”) and the taxation of retirement benefits from qualified and nonqualified plans and equity-based compensation arrangements. Topics addressed include whether, when, and how to qualify a retirement plan in Puerto Rico, the operational requirements that a plan needs to satisfy to retain its local qualified status, a comparison of the various alternatives an employer may use for offering retirement benefits to its P.R. employees, the application of U.S. laws in the operation of retirement plans in Puerto Rico, the deduction of employer and employee contributions to qualified and nonqualified plans, and the P.R. and U.S. taxation of benefits from retirement plans in Puerto Rico.

The Worksheets to this Portfolio contain, among other things, sample plan and trust documents for the establishment of a profit-sharing plan with a cash or deferred arrangement qualified only in Puerto Rico, and samples of the requests to be filed with the P.R. Department of the Treasury for such plan's initial qualification in Puerto Rico and for the administrative approval of subsequent plan amendments and the termination and liquidation of the plan.

This Portfolio, which is addressed primarily to employee benefits practitioners servicing U.S. and international companies with operations in Puerto Rico, assumes a basic knowledge of U.S. employee benefit rules. Readers of this Portfolio will note that, for the most part, retirement plans and compensation arrangements may be operated in P.R. in the same or similar fashion as they are operated in the United States. Areas where that is not the case are identified and discussed.


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AUTHORS

CARLOS GONZALEZ
Carlos Gonzalez, B.B.A. with a major in accounting, University of Puerto Rico (1991); J.D., University of Puerto Rico (1994); LLM in Taxation with an Employee Benefits Certificate, Georgetown University Law Center (2001). Certified Public Accountant; Member, Georgia, Puerto Rico, and Washington, DC Bar Associations; Professor of benefits & compensation at the University of Puerto Rico Law School; former in-house counsel for tax & benefits for The Home Depot, Inc.; advisor to the P.R. Treasury Department on 2011 Puerto Rico tax reform and the IRS on 2004 Puerto Rico plan initiatives; frequent lecturer and author of various articles on employee benefits in Puerto Rico.

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

A. Interplay of U.S. and Puerto Rico Laws in Regulation of Retirement Plans in Puerto Rico

B. Basic Principles Affecting Operation of Retirement Plans in Puerto Rico

1. Status of Puerto Rico Residents Under U.S. Law

2. Application of U.S. Laws to Qualified Plans in Puerto Rico

a. Impact of Type of Qualification on Application of U.S. Laws

(1) Puerto Rico-Only Qualified Plans

(2) Dual-Qualified Plans

b. Application of ERISA

(1) Title I of ERISA

(2) Title IV of ERISA

c. Application of Code

(1) Plan Qualification Rules

(a) Statutory Rule on Application

(b) Practical Considerations for Application

(2) FICA Tax

d. Other U.S. Laws

e. U.S. Accounting Principles

3. The Puerto Rico Government's Regulation of Qualified Retirement Plans in Puerto Rico

a. Authority to Regulate Local Tax Qualification of Plans in Puerto Rico

b. Overview of PRIRC Sections Governing Retirement Plans in Puerto Rico

II. General Plan Qualification Requirements Under Puerto Rico Law

A. Introduction

1. Favorable Tax Treatment Afforded to Qualified Plans

2. Employers that May Maintain Qualified Plans in Puerto Rico

3. Types of Qualified Plans Allowed Under Puerto Rico Law

a. Pension Plans

b. Profit-Sharing Plans

c. Stock Bonus Plans

B. Specific Puerto Rico Plan Qualification Requirements

1. Proof of Tax Exemption

2. Plan Must Be a Permanent Program

3. Exclusive Benefit Rule and Reversion of Excess Assets upon Termination

4. Funding Vehicles

a. Trust Location

b. Annuity-Funded Plans

5. Requirement of Profits for Establishment of Profit-Sharing Plans

6. Service Crediting and Vesting

7. Nondiscrimination Requirements

a. Applicable Nondiscrimination Tests

b. Basic Nondiscrimination Testing Concepts

(1) Employee Testing Group and Employer Aggregation

(2) Plan Aggregation and Disaggregation

(3) Excludible Employees

(a) Employees Covered by Collective Bargaining Agreement

(b) Nonresident Aliens

(c) Employees Who Do Not Meet Age and Service Requirements

(4) Absence of Leased Employee Requirements

(5) Partners Considered Employees

(6) Definition of Highly Compensated Employee

(7) Definition of Compensation

c. Minimum Coverage Test

(1) In General

(a) Percentage Test

(b) Ratio Test

(c) Average Benefit Percentage (ABP) Test

(d) Absence of Transitional Rule for Corporate Transactions

(e) Absence of Bifurcated Testing for Excludible Group

(2) Examples of Minimum Coverage Test Calculations

(a) Percentage Test

(b) Ratio Test

(c) ABP Test

d. General Nondiscrimination Test on Benefits and Contributions

(1) In General

(2) Cross-Testing

(3) Social Security Integration

8. Limits on Employer Contributions and Plan Benefits

9. Limits on Life, Health and Accident Insurance Benefits

10. Limits on Employee After-Tax Contributions

11. Distributions, In-Service Withdrawals and Participant Loans

a. Distributions

b. In-Service Withdrawals

c. Participant Loans

12. Qualified Domestic Relations Orders

13. Reporting and Disclosure Requirements

a. PRIRC Requirements

b. ERISA Requirements

c. Code Requirements

d. Spanish Translation of Disclosures to Participants

14. Prohibited Transactions

a. General Rule

b. Prohibited Transaction Exemption for Acquisition of Employer Obligations

c. Prohibited Transaction Exemption for Loans of Plan Asset to Employer

d. Prohibited Transaction Exemptions for ESOPs

e. Interplay with ERISA's Prohibited Transaction Provisions

C. U.S. Qualification Requirements Not Present in Puerto Rico

D. Miscellaneous Issues about Establishment of Qualified Plans in Puerto Rico

1. Establishment of Puerto Rico Trust for Puerto Rico-Only Qualified Plans

2. Adoption of Master and Prototype Plans in Puerto Rico

3. Funding Plans with IRAs

III. Additional Qualification Requirements for CODA Plans

A. Introduction

B. Plans Eligible to Maintain a CODA

C. Employee Cash or Deferred Elections

D. Immediate Vesting of Employee Contributions

E. Maximum Service Requirement for Participation

F. Limits on Restrictions on Other Benefits

G. Restrictions on Distributions

1. In General

2. Hardship Withdrawals

a. Serious and Immediate Financial Need

(1) Facts-and-Circumstances Test

(2) Safe Harbor

b. Distribution Necessary to Satisfy Financial Need

(1) Employee Representations

(2) Safe Harbor

c. Limit on Distributable Amount

H. Annual Limit on Pre-Tax Contributions

1. General Limit

2. Catch-up Contributions

3. Excess Deferrals

a. Tax Consequences

b. Correction of Excess Deferrals

(1) General Rules

(2) Income Attributable to Excess Deferrals

(3) Partial Corrections

(4) Coordination with Correction of Excess Contributions

I. Nondiscrimination Requirements; ADP Test

1. General Rule

2. Examples of Application of ADP Test

3. Calculation and Allocation of Excess Contributions

4. Correction of Excess Contributions

a. QNECs & QMACs

b. Recharacterizations

c. Distributions

(1) Timeframe for Completing Distribution

(2) Puerto Rico Income Taxation of Corrective Distributions

(3) Method for Calculation of Income

(4) Forfeiture of Matching Contributions

5. Coordination with Correction of Excess Deferrals

6. Effect of Failure to Correct Excess Contributions

7. Absence of ADP Test Safe Harbors

J. Practical Problems with Operation of Dual-Qualified CODA Plans

IV. Additional Qualification Requirements for Self-Employed Plans

A. In General

1. Self-Employed Individuals

2. Earned Income

3. Owner-Employees

4. Employer

B. Qualification Requirements for Self-Employed Plans

1. Past Service Credits

2. Nondiscrimination in Benefits and Contributions

a. Self-Employed Individuals Are HCEs

b. Contributions Based on Earned Income

c. Reduction in Employees’ Compensation

C. Additional Requirements for Plans Covering Owner-Employees

1. Aggregation of Plans Under Common Control

2. Nondiscrimination in Participation, Benefits and Contributions

3. Contributions Limited to Earned Income

4. Restrictions on Distributions before Age 5912

V. Additional Qualification Requirements for ESOPs

A. Introduction

B. Special ESOP Qualification Requirements

1. Investment in Qualifying Employer Stock

2. Employer Stock Must Be Publicly Traded

3. Diversification of Investments

4. Distribution Requirements

5. Participants’ Repurchase Rights

6. Voting Rights on Employer Stock

7. Restrictions on Allocations to Selling Shareholder

C. Special Tax Benefits Afforded to ESOPs

1. Deduction of Dividends on Employer Stock

2. Deduction for Contributions for Payment of ESOP Loan

3. Deferral of Taxation on Sale of Employer Stock to ESOP

D. Operation of Puerto Rico Qualified ESOPs by U.S. and International Employers

VI. Process for Qualification of Retirement Plans with Hacienda

A. Introduction

B. Filing for Initial Plan Qualification

1. Form of Filing

2. Timing for Completing Filing

C. Filing of Plan Amendments

D. Filing upon Plan Termination

E. Filings for Adoptions of Master and Prototype Plans

F. Filing Fees

1. Plans Other than Self-Employed Plans

2. Self-Employed Plans

VII. Correcting Plan Qualification Failures and Obtaining Private Letter Rulings from Hacienda

Introductory Material

A. Use of Closing Agreements for Correcting Qualification Failures

B. Obtaining Private Letter Rulings from Hacienda

VIII. Deduction of Employer Contributions to Puerto Rico Qualified Plans

A. Puerto Rico Income Tax Deduction

1. Introduction

2. General Requirements for Deductibility of Contributions

a. Ordinary and Necessary Business Expense

b. Trust Established Before End of Taxable Year

c. Plan Qualified in Puerto Rico

d. Contributions of Property

e. Deadline for Completing Contribution

f. Current Deduction of Expenses

g. Deduction of Insurance Premiums

3. Limits on Amount of Deduction

a. Stock Bonus and Profit-Sharing Plans

b. Defined Contribution Pension Plans

c. Defined Benefit Pension Plans

(1) 5% of Covered Compensation Method

(2) Level Percentage of Compensation Method

(3) Normal Cost Method

(4) Contributions Needed to Satisfy Minimum Funding Standards

d. Deduction Limit for Combined Plans

e. Deduction Limit for Self-Employed Plans

(1) Ordinary and Necessary Business Expense

(2) Purchase of Insurance Protection

(3) Calculation of Deductible Amount

4. Documents Needed to Substantiate Deduction on Puerto Rico Tax Return

B. U.S. Income Tax Deduction for Contributions to Puerto Rico Qualified Plans

IX. Tax Exemption on Investment Income Earned by Trust

A. Exemption from Payment of Puerto Rico Income Tax

B. Exemption from Payment of U.S. Income Tax

1. ERISA § 1022(i)(1) Definition of Resident of Puerto Rico

2. Impact on Expatriates Working in Puerto Rico

X. Investment Options Available to Participants in Puerto Rico Qualified Plans

A. Statutory Provisions

B. Options for Offering Same U.S. Investment Alternatives

XI. Taxation of Plan Benefits

A. Puerto Rico Income Taxation

1. General Rule

a. PRIRC Definition of Resident of Puerto Rico

b. Sourcing of Distributions

2. Taxation of Lump-Sum Distributions

a. In General

b. 2006 Special Tax Prepayment

3. Taxation of Payments other than Lump-Sum Distributions

4. Rollovers

5. Distributions of Property/Employer Stock

6. Distributions of Annuity Contracts

7. Taxation of Life Insurance Protection

8. Application of Source Act to Distributions from Puerto Rico Qualified Plans

9. Special Rule for Certain Distributions upon Reductions in Workforce

B. U.S. Income Taxation

1. General Rule

a. Code § 933 Exclusion

b. Code Definition of Bona Fide Resident of Puerto Rico

(1) Physical Presence Test

(2) Tax Home Test

(3) Closer Connection Test

(4) Change in Residence

2. Sourcing of Distributions

a. Contributions Portion

b. Investment Earnings Portion

(1) Trust Funded Plans

(2) Annuity Funded Plans

3. Implementation of Sourcing Rule to Defined Benefit Plans

4. Withholding of U.S. Taxes on Distributions from Dual-Qualified Plans

5. U.S. Taxation on Sale of Employer Stock by Puerto Rico Participants

XII. Application of Title IV of ERISA to Pension Plans in Puerto Rico

XIII. Comparison of Puerto Rico-Only and Dual-Qualified Plans

Introductory Material

A. Puerto Rico-Only Qualified Plans: Advantages and Disadvantages

B. Dual-Qualified Plans: Advantages and Disadvantages

1. Regular Dual-Qualified Plans

2. ERISA § 1022(i)(2) Dual-Qualified Plans

XIV. Asset Transfer from Dual-Qualified Plan to Puerto Rico-Only Qualified Plan

A. Historical Reasons for Transfers

B. IRS Position on Transfers

1. U.S. Tax Consequences of Transfers

2. Conditions for Transfers

a. Transferor Plan: Dual-Qualified Plan

b. Transferee Plan: P.R.-Only Qualified Plan

c. Transfer of Assets

C. Final Observations and Pending Issues

1. Types of Plans Eligible for Transfers

2. Different Treatment for Voluntary Rollovers

3. ERISA § 1022(i)(2) Dual-Qualified Plan Not Needed for Transfer

XV. Nonqualified Retirement Plans and Equity-Based Compensation Arrangements

A. General Rules

1. Use of U.S. Tax Rules and Plans in Puerto Rico

2. Overview of Puerto Rico Tax Rules

a. Employee's Realization of Taxable Income

(1) Nonqualified Retirement Plans

(2) Equity-Based Compensation Arrangements

b. Employer's Deduction of Compensation Expense

3. Puerto Rico Registration of Employer Securities

4. Use of Payroll Deductions for Purchase of Employer Stock

5. Application of Source Act

B. Nonqualified Retirement Plans

1. Deferred Compensation Arrangements

a. 2006 Special Transitory Provisions

2. Excess Benefit Plans

C. Equity-Based Compensation Arrangements

1. Stock Option Plans

a. Introduction

b. Qualified Stock Options

(1) Tax Treatment of Qualified Stock Options

(a) Puerto Rico Income Tax

(b) FICA Tax

(2) Conditions for Classification as Qualified Stock Option

(a) Optionee: Employee or Director

(b) Written Plan Terms

(i) Total Number of Shares

(ii) Eligible Employees or Directors

(c) Shareholder Approval of Plan

(d) 10-Year Limit for Option Grants

(e) 10-Year Limit on Exercise Period

(f) Options Nontransferable to Third Parties

(i) General Rule

(ii) Exercise of Options by Optionee's Estate or Heirs

(g) Restrictions on Discounted Exercise Price

(h) Exercise of Option on Termination of Employment or Directorship

(i) $100,000 Initial Exercise Limit

(j) Timing for Determining Compliance with Qualification Requirements

(k) Filing of Plan with Hacienda

(3) Allowable Provisions

(a) Cashless Exercise of Options

(b) Restrictions on Right to Exercise and Receive Stock

(c) Combination of Qualified Options, Nonqualified Options, and Restricted Stock

c. Nonqualified Stock Options

2. Stock Purchase Plans


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Plan Document for the ABC Corporation of P.R. § 1165(e) Plan

Worksheet 2 Trust Agreement for the ABC Corporation of P.R. § 1165(e) Plan

Worksheet 3 Custodial Services Agreement for the ABC Corporation of P.R. § 1165(e) Plan

Worksheet 4 Request for Hacienda Favorable Determination Letter on Initial Qualification of the ABC Corporation of P.R. § 1165(e) Plan

Worksheet 5 Minimum Coverage Form for Qualification of the ABC Corporation of P.R. § 1165(e) Plan

Worksheet 6 Request for Hacienda Favorable Determination Letter on Amendment to the ABC Corporation of P.R. § 1165(e) Plan

Worksheet 7 Request for Hacienda Favorable Determination Letter on Termination of the ABC Corporation of P.R. § 1165(e) Plan

Worksheet 8 Request for Hacienda Favorable Determination Letter on Initial Qualification of the ABC Corporation of P.R. Incentive Stock Option Plan

Worksheet 9 [Reserved]

Worksheet 10 Form 480.31 - Deposit Coupon of Tax Withheld at Source - Nonresident

Worksheet 11 Form 480.5 - Summary of the Informative Returns, and Instructions

Worksheet 12 Form 480.7C - Informative Return - Retirement Plans and Annuities

Worksheet 13 Schedule F - Corporation and Partnership - Deductions for Contributions to Pension or Other Qualified Plans

Worksheet 14 Schedule H - Individual - Income from Annuities or Pensions

Worksheet 15 [Reserved]

Worksheet 16 Circular Letter No. 99-01 - Procedure for the Request and Issuance of Rulings and Administrative Determination Letters

Worksheet 17 Sample Hacienda Favorable Determination Letter on Plan Qualification

Worksheet 17A Form 480.70 (OE) - Informative Return for Income Tax Exempt Organizations, and Instructions

Worksheet 18 T.D. 7859, 47 Fed. Reg. 54298 (12/2/82)

Worksheet 19 Chart Comparing Plan Qualification Requirements Under the Code and the PRIRC

Worksheet 20 ERISA § 1022(i)

Bibliography

OFFICIAL

Treasury Rulings:

Notices & Releases:

DOL Opinions:

PBGC Opinions:

Cases U.S.:

Cases P.R.:

UNOFFICIAL:

Books:

Tax Services:

Tax Management Portfolios:

Articles:

2003

2004

2005