One of the American tax system’s many oddities is the way the country deals with US territories: Guam, the Northern Mariana Islands, the US Virgin Islands, and Puerto Rico.
Because these are territories and not states, they aren’t fully part of the federal tax system. Congress has granted them considerable freedom to partially disengage from this system and create their own tax incentives.
Take Puerto Rico, for instance. Shortly after American forces took over the island following the Spanish-American War in 1898, Congress enacted the first of many direct aid packages and tax incentives to the territory to spur economic growth. Today, the main federal tax incentive is Section 933 of the Tax Code, which excludes “income derived from sources within Puerto Rico” from personal income tax while an individual is a “bona fide resident of Puerto Rico.”
By itself, this exemption isn’t particularly noteworthy, because Puerto Rican taxes are much higher than those of any US state. The top rate is 33% on income exceeding $61,500 annually.
However, Section 933 opens the door for local tax inducements. In 2012, Puerto Rico’s Legislative Assembly enacted a package of reforms consisting of personal and business incentives. Any individual who became a bona fide resident of Puerto Rico after the enactment was eligible for the following benefits, courtesy of Act 22:
100% tax exemption from Puerto Rico income taxes on all Puerto Rican-source dividends and interest payments.
100% tax exemption from Puerto Rico income taxes on all short- and long-term capital gains accrued since becoming resident in the territory. Capital gains accrued before becoming resident would be eligible for a 5% tax rate after ten years of legal residency.
The law seemed perfect for wealthy US citizens or green card holders who were then paying federal income taxes as high as 39.6% (plus the 3.8% Obamacare tax) and wanted to reduce their federal tax liability on passive income. Best of all, Puerto Rico guaranteed these provisions would remain in place until the end of 2035.
Another incentive enacted in 2012 was Act 20, the “Export Services Act.” It gave eligible companies incorporated in the territory a special corporate tax rate of only 4% and a 100% personal exemption on dividends or profit distributions. What’s more, you would pay no federal tax on the dividend since it was from a Puerto Rican source. Your total tax liability would be 4%.
To receive these benefits, you didn’t even need to reside in Puerto Rico. But this provision became less attractive once Congress enacted President Trump’s landmark tax reform act at the end of 2017. Now, the only way to still take advantage of these incentives is if you reside on the island.
Then in 2019, the Puerto Rico Legislative Assembly enacted Act 60 to replace both Act 20 and 22. Bona-fide residents of Puerto Rico can still obtain a 100% tax exemption through 2035 from local income taxes on dividends, interest, and capital gains generated after becoming a bona fide resident of Puerto Rico. But you must now make annual donations of $10,000 or more to a local charity (up from $5,000) and purchase a personal residence within two years of qualifying for the incentives. The Act 20 incentives remain in place, but under the new law, the government will audit export service businesses at least every two years.
Since these incentives came into being, more than 2,300 wealthy Americans and 1,900 businesses relocated to Puerto Rico through the end of 2019. Even more have moved to the island since Joe Biden’s inauguration a year ago, perhaps because of the tax increases his administration promised.
Congress, IRS Promise Crackdown
When Puerto Rico’s tax incentives came into effect, we were skeptical of their staying power. We thought either Congress or Puerto Rico itself would shut them down. That hasn’t happened (yet), but the IRS is now crashing the party. In February 2021, it announced a “campaign” focused on the US taxpayers who have reduced their tax burden by claiming benefits under the 2012 tax incentives. The FBI also arrested a Puerto Rico CPA named Gabriel Hernandez, who stands accused of wire fraud in connection with an allegedly fraudulent tax exemption application for an IRS undercover agent posing as a wealthy client.
At the request of Congress, the IRS also prepared a list of taxpayers benefitting from the incentives. And the agency has started an “outreach” program requesting information from them. The focus is to determine whether those who migrated to Puerto Rico to take advantage of the incentives properly sourced income to the territory and if they met the residence requirements.
To qualify for the individual income tax exemptions the territory offers, you need to satisfy the IRS definition of a “bona fide resident” of Puerto Rico. That means you must be physically present in the territory for at least 183 days annually; not have a closer connection to any other state or country than to Puerto Rico; and make the island the center of your social, political, cultural, and religious activities.
The focus of the IRS campaign, unsurprisingly, is to determine if the thousands of individuals and companies that relocated to Puerto Rico complied with the rules. For instance, they’ll be investigating if their children are enrolled in local schools or if they sold their home on the mainland. Or whether they moved their personal belongings to Puerto Rico, along with other steps a taxpayer would take to make the territory the center of their lives.
In 2005, the IRS used a similar strategy to crack down on high-net-worth taxpayers who relocated to another American territory: the US Virgin Islands. At the time, the USVI offered a tax incentive amounting to an effective 3.5% income tax rate.
The IRS investigation into the USVI began with the arrest of one of the proponents of its tax incentive for failing to meet the program’s residency requirements. It also warned others against making false claims about what income qualified for the program’s tax benefits and about its residency requirements. It then began intensive audits of hundreds of purported USVI residents.
If you relocated to Puerto Rico to take advantage of these incentives, we suggest getting your tax house in order. If you played by the rules, you have nothing to worry about, other than a potentially time-consuming audit. But if you didn’t, and need professional assistance, you’ll be well-advised to retain a tax professional familiar with the applicable rules.