In February, Puerto Rico enacted new legislation that will require changes to tax-qualified retirement plans covering Puerto Rico employees, including both Puerto Rico-only and dual-qualified (US and Puerto Rico) retirement plans. Act No. 9-2017 (the 2017 Act) revises a number of Puerto Rico qualified retirement plan rules including contribution limits, rules related to nondiscrimination testing and employer deductions for retirement plan contributions. Questions remain about how and when to implement these changes, but the 2017 Act became effective immediate upon enactment, so plan sponsors should be prepared for the possibility of mid-year 2017 changes to their retirement plans.
Retirement Plan Changes
Following are some of the significant amendments the 2017 Act makes to the requirements applicable to tax-qualified retirement plans under the Puerto Rico Internal Revenue Code of 2011 (the PR Code):
- Contribution Limits for Defined Contribution Plans. The PR Code previously provided for an annual contribution limit tied to Section 415 of the US Internal Revenue Code of 1986, as amended (the US Code), which limits a participant’s annual allocations, including both employee and employer contributions, to the lesser of the annual limit for the year published by the IRS under US Code section 415(c) ($54,000 for 2017) or 100 percent of the participant’s annual compensation. The 2017 Act replaces this limit with a new formula limiting total annual allocations (other than rollover contributions) on behalf of a participant to the lesser of $75,000 (which does not appear to have a cost of living adjustment), or 25 percent of Net Income (“Net Income” is not defined, so it is not clear what types of income are included).
- Definition of Highly Compensated Employees. Prior to the 2017 Act, the PR Code’s definition of highly compensated employees included officers, shareholders holding more than 5 percent of the voting shares or total value of all classes of employer stock as well as employees with compensation from the employer in excess of $110,000 (or, for dual-qualified plans, the dollar amount under US Code Section 414(q)(1)(b)). The 2017 Act (1) removes officers from the definition of highly compensated employee, (2) expands the 5 percent ownership rule to include ownership of the capital or interest in the gains of an employer that is not a corporation, and (3) revises the compensation threshold to $150,000 (which does not appear to be subject to a cost of living adjustment). The new definition of highly compensated employees applies to both Puerto Rico-only and dual-qualified retirement plans, which means that dual-qualified plans are no longer permitted to use the applicable dollar threshold under US Code Section 414.
- Small Employer ADP Safe Harbor. The 2017 Act implements a new type of average deferral percentage (ADP) safe harbor, which exempts eligible plans from the requirement to satisfy the usual ADP nondiscrimination rules. Certain employers whose businesses generate less than $10 million per year in gross income, and who sponsor defined contribution retirement plans with fewer than 100 participants, may be exempt from ADP nondiscrimination testing if the plan sponsor provides all eligible participating employees with a contribution equal to at least 3 percent of their compensation. It is not clear how “businesses” or “gross income” are defined for purposes of evaluating eligibility for the safe harbor; more guidance is needed before plan sponsors should implement this safe harbor arrangement.
- Employer Deductions for Retirement Plan Contributions: Prior to the 2017 Act, the PR Code provided that the maximum deduction for employer contributions to a defined contribution plan could not exceed 25 percent of the compensation paid or accrued to all employees under the plan during the applicable tax year (similar to the rules under US Code Section 404(a)). The 2017 Act retains this 25 percent limit, but also provides that, notwithstanding such limit, all contributions that do not exceed the amended annual contribution limit (described above) are deductible.
The 2017 Act also adds a new chapter to the Puerto Rico Trust Act titled “Retirement Plan Trusts,” which clarifies the rules regarding beneficiaries under retirement plans. Plans qualified in Puerto Rico that are subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA), must provide that the beneficiary of a married participant is the participant’s spouse, and the participant can only designate a non-spouse beneficiary with spousal consent (which is similar to the rules applicable to US qualified retirement plans). In addition, the 2017 Act clarifies that all assets belonging to a retirement plan trust will be exempt from the estate and inheritance provisions of the Puerto Rico Civil Code, and their disposition will be determined under the terms of the documents governing the retirement plan trust. This is a helpful clarification for plan sponsors who previously were concerned about reconciling the ERISA rules with the Puerto Rico Civil Code rules.
Next Steps for Plan Sponsors
The 2017 Act states that its intent is to increase the flexibility of retirement plans and make their establishment and administration less onerous on plan sponsors. For now, however, the 2017 Act raises a number of questions and adds potential complications for plan sponsors to administer their plans. Specifically:
- It is not clear how and when the new rules will apply. Since the 2017 Act became effective when it was signed on February 8, 2017, do plan sponsors need to ensure they comply with the new contribution limits in 2017? If so, how do plan sponsors determine what constitutes an employee’s “Net Income”? In addition, do plan sponsors need to amend their plans in 2017 to reflect the revised definitions of highly compensated employees and new annual contribution limits? More guidance is needed to understand how the contribution limit will be measured and how the nondiscrimination rules incorporating the new highly compensated employee definition will apply.
- Will eligible plan sponsors want to use the new ADP safe harbor? Unlike the US Code, the PR Code did not previously provide a safe harbor exempting eligible plans from ADP nondiscrimination rules. More guidance is needed to determine how “businesses” or “gross income” are defined for purposes of evaluating eligibility for the safe harbor.
We expect to see guidance and further clarification on these issues from the Puerto Rico Treasury Department. For now, plan sponsors should wait for additional guidance. However, since the 2017 Act is effective immediately, plan sponsors should be prepared to consider action in 2017, both with respect to plan administration and the adoption of plan amendments. Further, since the changes to be implemented make significant changes to the rules impacting Puerto Rico employees, plan sponsors should expect that the amendments will be qualification amendments, which will likely require plan sponsors to seek updated qualification letters from the Puerto Rico Treasury.