Transfers from dual-qualified plans to Puerto Rico-only qualified plans must be made before January 1, 2011, to avoid qualification and tax problems.


As a result of a recent U.S. Internal Revenue Service (IRS) Revenue Ruling (Rev. Rul. 2008-40), employers that maintain plans intended to be qualified both in the United States and in Puerto Rico (dual-qualified plans) should consider whether to continue to maintain these plans as dual-qualified in the future or split them up between separate U.S.-only and Puerto Rico-only qualified plans.

Rev. Rul. 2008-40 holds that an employer maintaining a dual-qualified plan cannot transfer the assets and liabilities of that plan to a Puerto Rico-only qualified plan on or after January 1, 2011, without triggering taxation of the U.S.-source income portion of the transferred assets. Moreover, such a transfer could be treated as an impermissible distribution resulting in disqualification of the plan making the transfer. This result causes significant problems for employers maintaining dual-qualified plans and, therefore, as explained below, employers should consider taking steps to split up their dual-qualified plans into separate, stand-alone U.S.-only and Puerto Rico-only plans.

New IRS Ruling Reverses Prior Position

Importantly, the Ruling reverses the IRS’s position articulated in several private letter rulings where the IRS had approved these plan-to-plan transfers without adverse tax or qualification results. Recognizing that this is a new position, the IRS provided limited transition relief that permits transfers from dual-qualified plans to Puerto Rico-only qualified plans prior to January 1, 2011, without triggering the taxation and disqualification problems described above. Consequently, assets transferred during the transition period that are attributable to participant or employer contributions for services performed in Puerto Rico by bona fide Puerto Rico residents will be treated entirely as income from sources within Puerto Rico, and thus exempt from U.S. taxes.

Employers maintaining dual-qualified plans are not required to make these transfers. Instead, they may continue to maintain dual-qualified plans after the expiration of the transition period. However, these employers would then have to address the difficulties of maintaining dual-qualified plans (particularly dual-qualified 401(k) plans).

Dual-Qualified Plan Issues

An employer maintaining a dual-qualified plan must make sure that the plan involved complies with the technical qualification and nondiscrimination testing rules of both the U.S. Internal Revenue Code and the Puerto Rico tax code requirements for qualified plans. The challenge with maintaining such a dual-qualified plan is that the qualification rules in Puerto Rico are not the same as in the United States, and it is not always easy to meet both rules at the same time. For example, one way to cure a nondiscrimination testing failure in the Puerto Rico equivalent of a section 401(k) plan is to refund discriminatory excess amounts to highly compensated employees. These distributions, however, could violate U.S. rules that would prohibit these distributions, particularly where the U.S. 401(k) nondiscrimination test is otherwise met without making those distributions.

Separately, dual-qualified plans present significant tax issues even upon regular, properly made distributions. Distributions from dual-qualified plans are generally subject to double taxation, i.e., Puerto Rico taxes on the full amount of the payment, plus U.S. taxes on the U.S.-source portion of the payment. For example, in dual-qualified defined contribution plans such as 401(k) or profit sharing plans, the portion of the payment that represents earnings that have accrued over the years in the U.S.-based trust is treated as U.S.-source income. As a result, the earnings portion of the payment to Puerto Rico employees is taxed twice, both in Puerto Rico and the United States. Although theoretically Puerto Rico residents may recoup some or all of the dual taxation through claiming foreign tax credits on their tax returns, in reality these tax credits are rarely claimed by most rank-and-file Puerto Rico taxpayers.

A third technical issue for dual-qualified plans relates to rollovers. The dual taxation of payments from dual-qualified plans creates enormous complexities for Puerto Rico taxpayers wishing to roll over their plan distributions to another employer’s plan or an IRA. The portion of a distribution from a dual-qualified plan that is Puerto Rico sourced income generally can be rolled over to a Puerto Rico-based IRA (or Puerto Rico-qualified plan of another employer) but not a U.S.-based IRA (or U.S.-only qualified plan of another employer). Similarly, the U.S.-sourced income from a dual-qualified plan can only be rolled to U.S.-qualified IRAs or employer plans.

Solving the Problem During Transition Period

By maintaining a Puerto Rico-only qualified plan separately from the U.S.-qualified plan, an employer can avoid these and other complexities. Therefore, employers maintaining dual-qualified plans may wish to consider using the transition relief provided in Rev. Rul. 2008-40 and splitting those plans into separate U.S.-only and Puerto Rico-only qualified plans before January 1, 2011.