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Puerto Rico Plans--Taxes on Lump-Sum Distributions Likely to be
Reduced
By Carlos Gonzalez-Padro,
Esq.
The Home Depot, Atlanta, GA
A recently-introduced bill, Puerto Rico House Bill No. 3750 (HB
3750), would set a 10% tax rate on lump-sum distributions. This 10%
rate would apply to all plans qualified in Puerto Rico, whether
defined benefit or defined contribution, qualified only in P.R. or
dual qualified, or funded with a P.R. trust or a U.S. trust, and
regardless of whether they invest in P.R. property.
On August 10, 2007, P.R. House Representatives Antonio
Silva-Delgado and Hector Ferrer-Rios introduced HB 3750. In its
relevant part, HB 3750 would amend Section 1165(b) of the Puerto Rico
Internal Revenue Code of 1994 (PRIRC) to provide that lump-sum
distributions to participants or beneficiaries from retirement plans
qualified in P.R. are considered a long-term capital gain. In turn, HB
3750 would amend PRIRC Section 1014(a) to provide that long-term
capital gains pay local income taxes at the lower of: (i) the
taxpayer's ordinary income tax rate (from 7% to 33%, depending on the
taxpayer's taxable income); or (ii) a 10% rate. Because the 7%
ordinary tax rate jumps to 10% at only $2,000 of taxable income, for
most participants and beneficiaries these changes would effectively
mean that their lump-sum distributions would be taxed at a flat
10%.
HB 3750 would also require trustees and paying agents of retirement
plans qualified in P.R. to withhold and remit to the Puerto Rico
Department of the Treasury (commonly known by its Spanish name as
“Hacienda”) 10% of the taxable amount of any lump-sum
distributions to participants or beneficiaries. The taxable amount is
the entire amount distributed less the portion thereof, if any,
attributable to employee after-tax contributions. In the case of U.S.
plans that have also been qualified in P.R. (i.e., dual-qualified
plans), the withholding requirement only applies to distributions to
P.R. participants and beneficiaries, not U.S. participants and
beneficiaries.
For these purposes, lump-sum distributions are distributions of a
participant's or beneficiary's entire plan account completed within a
single taxable year (generally, the calendar year) following the
participant's separation from service with the participating employer.
It is not necessary that the lump-sum distribution be completed in a
single payment, nor that the account be distributed during the same
taxable year in which the participant separated from service. Most
retirement plans in operation on the island, however, require that
lump-sum distributions be made in a single payment.
This author has been informed by various sources that HB 3750 is
likely to be approved before the end of the year.
HB 3750 would be a noticeable improvement from the current rules on
P.R. income taxation of lump-sum distributions. Lump-sum distributions
are presently subject to a 12.5% tax rate and income tax withholding
at source. Beginning January 1, 2008, the 12.5% rate is set to
increase to 20%. Lump-sum distributions from retirement plans (or in
the case of defined contribution plans, of participant accounts) that
during the two-year period prior to distribution have invested at
least 10% of their assets in certain types of property located in P.R.
will remain subject to the 12.5% rate. In practice, however, few plans
and participant accounts satisfy the requirement of having invested
10% of their assets in P.R. property. Thus, unless HB 3750 becomes law
before year's end, the tax rate on lump-sum distributions from most
plans will increase from 12.5% to 20%.
Also, HB 3750 does not follow the practice that has been in place
since 2002 of establishing different tax rates on lump-sum
distributions depending on the location of the underlying trust and
investments, and whether the distribution is completed during special
window periods. As indicated above, HB 3750 would have the 10% rate
apply to lump-sum distributions from all retirement plans qualified in
P.R.
It should be noted that HB 3750 does not purport to change the P.R.
income tax rules on distributions other than lump-sums (e.g.,
installments, annuities, in-service withdrawals, and deemed
distributions resulting from defaulted loans). These forms of payment
are taxed at the ordinary income tax rates and are not subject to an
income tax withholding at source.
Sponsors of retirement plans in P.R. should consider contacting the
trustee or paying agent responsible for distributions to confirm that
they are aware of these potential changes and, if and when HB 3750
becomes law, withhold 10%, rather than 12.5% or 20%. Human resources
and employee benefits personnel and/or third-party administrators
responsible for benefits communications should also be made aware of
this potential change, so they can correctly address questions
participants and beneficiaries may have on the subject.
For more information, in the Tax Management Portfolios, see
Gonzalez-Padro, 324 T.M., International Pension Planning -- Puerto
Rico, and in Tax Practice Series, see ¶5510, Qualified
Retirement Plans -- Overview.
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