IRS Issues Clarification Ruling on Transfers From Dual-Qualified Plans to Puerto Rico-Only Qualified Plans

The Internal Revenue Service has released guidance addressing the tax treatment of benefit transfers from U.S.-qualified plans to non-U.S.-qualified foreign plans and from plans qualified under both U.S. and Puerto Rico law to plans qualified only under Puerto Rico law.

The IRS now considers both of these transfers to be taxable distributions.

To avoid significant compliance challenges, employers maintaining dual-qualified plans should consider taking steps to split up their dual-qualified plans into separate, stand-alone U.S.-only and Puerto Rico-only plans before 1 January 2011.

Ruling Reverses IRS' Prior Position

Under IRS Rev. Rul. 2008-40, employers maintaining dual-qualified plans cannot transfer plan assets and liabilities to Puerto Rico-only qualified plans on or after 1 January 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 ruling reverses the IRS' position set out in several private letter rulings wherein the IRS approved these plan-to-plan transfers without adverse tax or qualification results. The recent ruling clarifies the treatment of transfers from U.S. plans to foreign plans and is a change in position concerning transfers from dual-qualified plans to Puerto Rico plans.

Recognising that this is a new position, the IRS has provided limited transitional relief that permits transfers from dual-qualified plans to Puerto Rico-only qualified plans before 1 January 2011. Therefore, 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 will be exempt from U.S. taxes.

Employers Would Face Difficulty in Maintaining Plans

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.

Maintaining a dual-qualified plan is not simple. 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. This is particularly difficult as the qualification rules for both jurisdictions differ.