In response to the earthquakes that since January 6, 2020, have shaken Puerto Rico, on February 18, 2020, the Puerto Rico Department of the Treasury (known by its Spanish name as “Hacienda”) issued Circular Letter of Internal Revenue Number 20-09 (CL 20-09) to allow Puerto Rican participants in qualified retirement plans to receive, under favorable tax terms, distributions of the money they may need to help recover from the damages they and/or their close relatives sustained as a result of the earthquakes. Adoption of the disaster relief afforded by CL 20-09 is optional. Plan sponsors have full discretion to decide whether to allow these distributions in their retirement plans, and that decision has no impact on the qualification of the plan under Puerto Rico’s tax laws.
Distributions Eligible for Favorable Tax Treatment
Lump-sum distributions after separation from service and/or in-service hardship withdrawals (collectively, “disaster-related distributions” or “DRDs”) paid between February 20, 2020, and June 30, 2020, (the “eligible period”) to the Puerto Rican participants in a retirement plan qualified in Puerto Rico, whether a Puerto Rico-only qualified plan or a dual-qualified plan, defined benefit or defined contribution, are eligible for the favorable tax treatment described below under “Favorable Tax Treatment on Disaster-Related Distributions.” These DRDs are available provided that (1) the participant is a resident of Puerto Rico throughout 2020 (an “eligible individual”), and (2) the participant requests the payment for the purpose of accessing resources needed to help cover losses or expenses incurred or to be incurred as a result of the earthquakes (“eligible expenses”). Monthly pensions, annuities, and periodic installments do not qualify as DRDs, because these forms of payment cannot be requested, processed, and disbursed in full within the eligible period.
To be eligible for a DRD, the participant must be a resident of Puerto Rico throughout 2020. The plan administrator, trustee, recordkeeper, and/or other service provider responsible for processing benefit payments (collectively, the “administrator”) is not responsible for verifying whether a participant who requests a DRD is a resident of Puerto Rico. If in the sworn statement submitted as part of the application process the participant represents that he or she is a resident of Puerto Rico throughout 2020, the administrator can safely rely on the representation. The qualification of the plan will not be adversely affected if it turns out that the eligible individual is not a resident of Puerto Rico.
Eligible expenses are all those expenses that an individual incurs or will incur to cover losses or damages sustained, and the cost of unforeseeable expenses and necessities incurred, as a result of the earthquakes. These include expenses incurred for assessing or repairing damages to a residence, business establishment, or car; repairing or replacing furniture and other household items; purchasing food, clothing, fuel, and even an electric power generator; and paying for medical expenses and the costs of temporary accommodations. The eligible expenses may be incurred by the eligible individual or his/her spouse, descendants, or ascendants (e.g., an participant may request a DRD to access money needed to repair his/her mother’s house).
While eligible distributions must be completed by June 30, 2020, it is not necessary that the underlying expenses be incurred by that date. An eligible individual may request and receive a hardship distribution to compensate for eligible expenses to be incurred after June 30, 2020. As part of the application process, the eligible individual does not have to provide the administrator with a detailed listing or written evidence of the eligible expenses. The administrator can safely rely on the eligible individual’s representations about the nature and amount of the eligible expenses, and the qualification of the plan will not be adversely affected if the eligible individual uses the money for other purposes.
Favorable Tax Treatment on Disaster-Related Distributions
The taxable portion of DRDs (i.e., all the money distributed, except for the portion attributable to employee after-tax contributions, if any) is taxed as follows: (1) the first $10,000 is tax-free and exempt from Puerto Rico income tax withholding at source, and (2) the next $90,000 is subject to both a flat tax of 10 percent and a 10 percent Puerto Rico income tax withholding at source (i.e., the amount withheld at the time of payment covers the entire tax liability that the eligible individual will owe when he/she files the corresponding Puerto Rico income tax return). DRDs are deemed to come first from the taxable portion of the participant’s account (i.e., pre-tax money), and then from the nontaxable portion of basis on the account (i.e., after-tax money), if any.
An eligible individual may receive several DRDs during the eligible period, either from the same or various retirement plans and/or Puerto Rico individual retirement accounts (IRAs). However, in the aggregate, DRDs cannot exceed $100,000, and only the first $10,000 will be tax-free and exempt from income tax withholding at source.
DRDs must be reported to Hacienda by e-filing local Form 480.7C by February 28 of the year immediately following the year of distribution through Hacienda’s online portal, called the Sistema Unificado de Rentas Internas (SURI). A hardcopy of Form 480.7C must be mailed to the eligible individual by the same February 28 due date. The 10 percent Puerto Rico income tax withheld at source on DRDs must be electronically deposited with Hacienda through SURI by the 15th day of the month immediately following the month of distribution. Even if related to the earthquakes, lump-sum distributions and hardship withdrawals in excess of $10,000 that are not subject to the 10 percent Puerto Rico income tax withholding at source do not qualify as DRDs. Therefore, the Puerto Rico participant would not be able to take advantage of the favorable tax treatment described above, and the administrator responsible for processing the distribution could be liable to Hacienda for an under-withholding violation.
Removal of Restrictions on Hardship Withdrawals
DRDs are automatically considered a form of bona fide hardship withdrawal for purposes of the local restrictions on distributions from employer-sponsored retirement plans, and their completion has no impact on the local qualification of the plan. Active participants who receive a DRD are not subject to a temporary suspension of their future elective deferrals or any other kind of employee contributions to the plan.
To request a DRD, the eligible individual must provide the administrator with a sworn statement or affidavit that includes the following information:
- Name, postal address, and the physical address of the individual’s primary residence.
- A certification or representation that the individual will reside in Puerto Rico throughout 2020.
- A certification or representation that the DRD will be used to cover eligible expenses.
- The amount and payment date of the DRDs the individual previously received from another retirement plan or IRA (i.e., to corroborate that, in the aggregate, the individual does not receive DRDs in excess of $100,000, and that only the first $10,000 of all DRDs is exempt from the 10 percent Puerto Rico income tax withholding at source). If the individual has not received other DRDs, the sworn statement should include a certification or representation to such effect. Based on the information on the sworn statement, the administrator must withhold Puerto Rico income tax at source on DRDs in excess of $10,000, and limit total DRDs to a maximum of $100,000.
- Acknowledgement of the individual’s responsibility for payment of any additional taxes owed if the requirements of CL 20-09 are not met. Examples of these requirements include: the individual is not a resident of Puerto Rico throughout 2020, does not use the money to cover eligible expenses, receives more than $100,000 in DRDs from retirement plans and/or IRAs, or receives more than $10,000 that is exempt from income tax withholding at source.
Consistent with the terms of the plan document or the administrative guidelines for the plan, as part of the application process the administrator may also request documents or information, but the furnishing of a sworn statement is necessary in order for a DRD to be eligible for the favorable tax treatment. The eligible individual may furnish the sworn statement to the administrator by mail, electronically, or in person, as the administrator may determine (i.e., a hardcopy is not mandatory).
Plan sponsors have full discretion to determine whether, and to what extent, to allow DRDs in their qualified retirement plans. For example, a plan sponsor may allow for DRDs, but limit them to an amount below $100,000, or restrict the eligible expenses that would qualify for a distribution. Retirement plans that provide for DRDs must be amended accordingly by December 31, 2020. Generally, these amendments are not filed with Hacienda for their administrative review and approval.