Global Report: New Requirements Impact Retirement Plans Qualified Under Puerto Rico Tax Code

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1 Global Report: New Requirements Impact Retirement Plans Qualified Under Puerto Rico Tax Code April 2011 On January 31, 2011, the Puerto Rico legislature adopted a new tax code that substantially affects how qualified plans operate in Puerto Rico. The new tax laws affect plans that are tax-qualified under the Puerto Rico tax code as well as plans that are dual qualified under both the U.S. and Puerto Rico tax codes. From a plan sponsor s perspective, there are a number of plan provisions that must be addressed from a documentation standpoint and in terms of how the plan is administered and communicated to plan participants. Plan Changes Effective January 1, 2011 Partial Distributions Distributions other than total distributions or loans to participants payable with respect to any participant or beneficiary, such as partial distributions made after the participant s separation from service and withdrawals made before the separation from service, are subject to an income tax withholding rate of 10% on the amount not previously subject to taxation. Asset Reversions A Puerto Rico qualified plan will not fail to be qualified if it allows for a reversion of assets to the employer if done in compliance with Section 403(c) of ERISA. Thus, a Puerto Rico qualified plan may now allow contributions to be returned to the employer due to a mistake of fact or law, if conditioned upon deductibility or on the initial qualification of the plan. Controlled Groups Mandatory Aggregation For purposes of determining coverage and nondiscrimination testing, all employees of all corporations or partnerships or other persons who are members of a controlled group of corporations or partnerships or of an affiliated service group are deemed to be employees of the same employer. Copyright 2011 Aon Hewitt Inc 1

2 Controlled Group All defined benefit and defined contribution plans maintained by the same employer are required to be grouped and considered as a single defined benefit or defined contribution plan. Coverage Testing Corporate Acquisitions If by reason of a corporate acquisition or spin-off transaction, an entity becomes or ceases to be a member of the employer s controlled group, any plan covering the employees of such entity or any member of the employer s controlled group are deemed to comply with the coverage testing requirements for the period beginning on the day on which the composition of the employer s controlled group changes and ending on the last day of the first plan year beginning after such change ( transition period ), provided that (i) the plan has complied with the minimum nondiscrimination coverage testing requirements immediately prior to the change in controlled group composition, and (ii) plan coverage does not otherwise change significantly during this transition period. Twenty Percent Capital Gains Tax on Lump-Sum Distributions To the extent that the participant receives a lump-sum distribution (a total distribution within one tax year) due to separation from service for any reason or upon termination of the plan (without regard to a separation from service), the amount of such taxable distribution is considered a long-term capital gain subject to a capital gains tax withholding rate of 20%. New 10% Withholding Obligation Any person that makes distributions other than total distributions or loans to participants, such as partial distributions made after the participant s separation from service and withdrawals made before the separation from service, must deduct and withhold an amount equal to 10% of the amount that is in excess of the amounts attributable to after-tax contributions. Note: On March 1, 2011, the Puerto Rico Treasury issued Administrative Determination which granted limited relief from the 10% withholding rules with respect to annuity and periodic payment distributions. In 2011, trustees and paying agents may exclude from the 10% withholding obligation the first USD 23,500 paid to a participant who is at least age 60, and the first USD 19,500 paid to participants under age 60. This exemption must be reissued annually by the Puerto Rico Treasury in order to continue to apply. Partial Rollovers Participants may now rollover partial or total distributions or just the pretax portion of a distribution from a qualified trust following the participant s separation from service. The distribution may be rolled over to a Puerto Rico individual retirement account or annuity or to a Puerto Rico qualified retirement plan. Elective Deferrals and Individual Retirement Account Limitation Participants may now make contributions to a Puerto Rico individual retirement account in addition to the qualified plan elective deferral limit. The Puerto Rico tax code repealed the offset of individual retirement account contributions to the elective deferral limit. Liability for Withholding An employer that maintains or sponsors the plan under which the trust is created is jointly liable for the failure to comply with the tax withholding and reporting obligations imposed on the withholding agent or paying agent. Copyright 2011 Aon Hewitt Inc 2

3 New Definition of Highly Compensated Employee For purposes of the qualified plan requirements under Puerto Rico tax laws, the term highly compensated employee means: (i) an officer; (ii) a shareholder holding more than 5% of the voting shares or total value of all classes of stock of the employer; (iii) an employee who in the preceding tax year had compensation from the employer in excess of USD 110,000; and (iv) the spouse or dependent (within the meaning of Section (c)(1) of the Puerto Rico tax code) of an individual described in (i), (ii), or (iii) above. Note: When a Puerto Rico qualified plan also is qualified under the U.S. tax code, the provisions of Section 414(q)(1)(b) of the U.S. Internal Revenue Code of 1986, as amended (setting forth the compensation amount for a highly compensated employee), apply in lieu of the provisions of the Puerto Rico tax code s compensation limit of USD 110,000. This will become more significant in subsequent years since, unlike the U.S. tax code, the Puerto Rico tax code does not provide for any cost of living adjustments to the compensation amount in subparagraph (iii). Failure to Correct ADP Test Results in a Timely Manner If a Puerto Rico qualified plan subject to ADP testing does not correct (by way of distributions or other approved methods) excess contributions no later than the last day for filing the income tax return of the employer maintaining or sponsoring the plan, including any filing extension, for the tax year of the employer during which the excess contributions were made, the employer will be subject to a tax equal to 10% of the uncorrected excess contributions. Tax on Excess Nondeductible Contributions In the case of any retirement plan qualified under the Puerto Rico tax code, a tax is levied equal to 10% of contributions not deductible under the plan (determined at the end of the employer s tax year). This tax applies even if the nondeductible contribution is not claimed as a deduction on the employer s income tax return. The tax must be paid by the employer making the nondeductible contribution. Note: For purposes of determining the amount of nondeductible contributions for a tax year, contributions made under the condition that they be deductible and returned to the employer no later than the last day for filing the employer s income tax return for the tax year during which the contribution was made, including any extension allowed by the Treasury Secretary, will not be included to the extent timely returned. Increase to Employer Deductible Contributions In the case of a profit sharing or stock bonus plan, the limit on deductible employer contributions will be determined in the tax year in which paid and limited to an amount not exceeding 25% of the compensation otherwise paid or accrued during the tax year to all employees under the defined contribution pension plan. For defined benefit plans, the deductible contribution amount may be determined using a level cost method, 5% compensation method, normal cost method, or by determining the amount needed to satisfy the ERISA minimum funding standards. Note: Puerto Rico only qualified plans and dual qualified plans are both subject to Title I of ERISA. Copyright 2011 Aon Hewitt Inc 3

4 Form 5500 Filing The Puerto Rico tax laws have added a provision granting the Puerto Rico Treasury the authority to require the filing of IRS Form 5500 in lieu of filing the PR Form (OE) (Informative Return for Tax Exempt Organizations) for those plans that are subject to ERISA. Note: The PR Form (OE) continues to be required until such time as the guidance is issued by the Puerto Rico Treasury. Plan Changes Effective January 1, 2012 Elective Deferrals and Catch-Up Contributions To the extent that an employee has elected to contribute to a cash or deferred arrangement, the contributions cannot exceed the following amounts: Tax Year Beginning On or After Maximum Annual Amount January 1, 2011 USD 10,000 January 1, ,000 January 1, 2013 (and thereafter) 15,000 Note: If the employee participates in two or more plans, such plans should be treated as if they were one for the purpose of determining the amount of the above limitation. An additional contribution is permitted for participating employees in a plan that contains a cash or deferred contribution agreement, known as catch up, if at the close of the plan year the employee has reached age 50. The additional contribution cannot exceed the amounts set forth below: Tax Year Beginning On or After Maximum Additional Catch-Up Amount January 1, 2011 USD 1,000 January 1, ,500 Defined Benefit Plans The annual benefit with respect to a participant (expressed as a benefit payable annually in the form of a straight life annuity with no ancillary benefits) cannot exceed the lesser of USD 195,000 or 100% of the participant s average annual compensation for the period of consecutive calendar years (not more than three) during which his or her compensation was the highest. Note: The Puerto Rico tax code does not provide for a cost-of-living adjustment to the USD 195,000 after Copyright 2011 Aon Hewitt Inc 4

5 Defined Contribution Plans The annual contributions of the employer and the participant and other additions with respect to a participant, not including contributions rolled over or transferred from another retirement plan, cannot exceed the lesser of USD 49,000 or 100% of the participant s compensation paid by the employer during the year. Note: The Puerto Rico tax code does not provide for a cost-of-living adjustment to the USD 49,000 after Participant Compensation The maximum amount of annual compensation for a participant that may be considered for purposes of determining contributions or benefits under a Puerto Rico qualified plan and the application of the nondiscrimination tests and benefit and contribution limitations cannot be greater than USD 245,000. Note: The Puerto Rico tax code does not provide for a cost of living adjustment to the USD 245,000 after For dual qualified plans, however, the Puerto Rico tax code provisions will permit additional compensation to be recognized to the extent the Section 401(a)(17) compensation limitation (USD 245,000 for 2011) is increased under the U.S. tax code s cost of living adjustment formula. Qualification Requirements For tax years beginning on or after January 1, 2012, any trust claiming to be tax-exempt under the Puerto Rico tax code must request and obtain a determination letter from the Secretary of the Treasury of Puerto Rico. The determination letter request must be filed no later than the last day to file the plan sponsor s income tax return, including any filing extension. Note: The determination letter filing must cover the tax year of the plan sponsor during which the plan became subject to Puerto Rico tax code qualification requirements. Next Steps for Employers and Plan Administrators Ensure they have applied the new 10% withholding on non-lump sum distributions and confirm that trustees or paying agents have applied such withholding to the extent applicable. Review plan documents and administrative service agreements to reflect the new changes to plans qualified under the Puerto Rico tax code. Note that further guidance is expected during 2011 to clarify many of the new requirements. Review related tax notices, rollover forms, and election forms so that they may conform to the new requirements. Update summary plan descriptions and any related employee communications to reflect the new Puerto Rico requirements. Prepare communications to employees about new regulations, limits, and withholdings. Copyright 2011 Aon Hewitt Inc 5

6 Review most recent Puerto Rico determination letter filing (for dual qualified and Puerto Rico only qualified plans) to confirm plan years covered, consider filing for any period prior to 2012 for which a determination of the plan s tax-exempt status has not yet been issued, and prepare to file for a determination letter with the Puerto Rico Treasury Department for the 2012 plan year. Continue to evaluate the extent to which the assets of an ERISA Section 1022(i)(1) Puerto Rico plan (a separate Puerto Rico only plan qualified under both the Puerto Rico and US tax codes) may remain in a group trust under Revenue Ruling Plan sponsors also will want to consider how best to approach the extended transition period under Revenue Ruling (until December 31, 2011) for assets and liabilities to be transferred from a U.S. qualified plan to a separate plan qualified under the Puerto Rico tax code without adverse tax consequences affecting the qualified status of the plans. * * * Note: Aon Hewitt is not a law firm or a tax advisor and cannot provide legal or tax opinions. Accordingly, nothing in this report is intended to constitute legal or tax advice or to replace the advice of any company s legal or tax counsel. Counsel s advice should be sought before taking any action on matters discussed in this report.. Copyright 2011 Aon Hewitt Inc 6

7 About Aon Hewitt Aon Hewitt is the global leader in human resource consulting and outsourcing solutions. The company partners with organizations to solve their most complex benefits, talent and related financial challenges, and improve business performance. Aon Hewitt designs, implements, communicates, and administers a wide range of human capital, retirement, investment management, health care, compensation and talent management strategies. With more than 29,000 professionals in 90 countries, Aon Hewitt makes the world a better place to work for clients and their employees. For more information on Aon Hewitt, please visit Copyright 2011 Aon Hewitt Inc. This document is intended for general information purposes only and should not be construed as advice or opinions on any specific facts or circumstances. The comments in this summary are based upon Aon Hewitt's preliminary analysis of publicly available information. The content of this document is made available on an as is basis, without warranty of any kind. Aon Hewitt disclaims any legal liability to any person or organization for loss or damage caused by or resulting from any reliance placed on that content. Aon Hewitt reserves all rights to the content of this document. Copyright 2011 Aon Hewitt Inc 7