Are You Ready to Become a Vulture Capitalist?
For the last month, I’ve watched the recovery efforts in Puerto Rico in the wake of hurricanes Irma and Maria.
It’s a horrifying picture. Even with billions of dollars in aid pouring in, more than 80% of the island’s residents have no electricity. Nearly one-third lack safe drinking water. Food and medicine are in short supply. More than 90% of roads remain impassable. And it’s projected that 100,000 residents of the island’s 3.4 million residents will leave, many of them permanently.
In the meantime, the island’s external debt has ballooned to nearly $75 billion. That’s more than $22,000 for every person on the island. What’s more, Puerto Rico partially defaulted on repayments before the storm hit.
In short, Puerto Rico isn’t a place I’d ordinarily consider taking up residence or starting a business. But these aren’t ordinary times, and the tax advantages the government of Puerto Rico extends to bona fide residents are compelling.
Puerto Rico is a US territory. Under the Internal Revenue Code, the island has more latitude than states regarding how income is taxed. Federal tax incentives for US territories have come and gone over the years, but at present, the main one for Puerto Rico is Section 933 of the Internal Revenue Code. Bona fide residents of the territory don’t pay income tax on “income derived from sources within Puerto Rico.”
By itself, this exemption is a nonstarter, because Puerto Rican income taxes are much higher than those of any US state. The top rate is 33%. And at 11.5%, sales taxes are also higher than any US state.
However, the exemption opens the door for local tax incentives. And Puerto Rico responded in 2012, in the form of Act 20 and Act 22.
Act 20 provides significant tax benefits for companies that generate Puerto Rico-source income. To qualify, you must form a local company with at least five employees and pay yourself a reasonable salary. You can be one of the five employees. You don’t need to live in the territory to qualify for these incentives, but if you do, the tax on your salary is subject to Puerto Rican income tax at a top rate of 33%. You must also pay Medicare tax of 2.9%; and Social Security tax of 12.4% on the first $127,200 of your salary.
If you meet these requirements, your profits are subject to only a 4% corporate income tax in Puerto Rico. There’s no federal tax on this income. The government of Puerto Rico guarantees this tax rate for 10 years.
In addition, anyone who becomes a new bona fide resident of Puerto Rico is eligible for the following benefits, courtesy of Act 22:
100% exemption from Puerto Rico income taxes on all Puerto Rico-source dividends and interest payments
100% exemption from Puerto Rico income taxes on all short- and long-term capital gains accrued since becoming resident in the territory
The law seems perfect for wealthy US citizens or green card holders who are now paying federal income taxes as high as 39.6% (plus the 3.8% Obamacare tax) and want to reduce their federal tax liability on passive income. Best of all, Puerto Rico guarantees that these provisions will remain in place until the end of 2035.
To qualify for benefits under Act 22, you must actually relocate to Puerto Rico. And you must satisfy the definition of a “bona fide resident” for each year you seek to obtain them. That means:
You must be physically present in Puerto Rico at least 183 days annually
You must not have a “tax home” other than Puerto Rico
You must not have a closer connection to the US or a foreign country than to Puerto Rico.
You can see why some entrepreneurs might find these incentives mouthwatering. But when these incentives came into effect a few years ago, I predicted that Act 22 wouldn’t last. I believed that Congress wouldn’t permit a direct erosion of the US tax base with this type of incentive. If Act 22 wound up taking too much revenue away from the US Treasury, I thought Congress would amend or repeal Section 933.
These predictions had a greater chance of becoming a reality if Hillary Clinton had won the last election. Clinton supports extending the same right to declare bankruptcy that mainland cities enjoy to US territories like Puerto Rico. I foresaw a deal where Puerto Rico was allowed to declare bankruptcy and renegotiate its debts in exchange for ending its tax incentives.
As well, I thought that existing Puerto Rico residents, already suffering under a burden of soaring taxes, crumbling infrastructure, and shrinking pension benefits wouldn’t tolerate these incentives.
Act 20 is another matter. Since its incentives apply to local businesses that employ local residents, I believed then – and now – that they have staying power.
The election of Donald Trump and a Republican-controlled Congress has changed my thinking about Act 22. A Republican administration is not likely to challenge tax incentives enacted by individual states or territories. And while the crumbling pre-hurricane infrastructure made living in Puerto Rico a daily challenge, a couple of our more adventurous clients successfully relocated there.
But Irma and (especially) Maria changed things once again. Puerto Rico’s infrastructure has effectively been destroyed. Everything needs to be rebuilt: power plants and distribution networks, cellular networks, roads, bridges, and hospitals to name just a few.
And for adventurous entrepreneurs, unprecedented opportunities await, with business profits sheltered by Act 20 and individual tax liabilities tempered by Act 22.
As liberal journalist Bill Moyers puts it, “Vulture capitalists circle above Puerto Rico.”
Well, yes. And capitalism is exactly what Puerto Rico needs to rebuild. Construction, engineering, telecommunications expertise, renewable energy knowledge, medical services – just about any skill you might have is in short supply.
If you’re interested in taking advantage of these incentives, the biggest obstacle is the “physical presence” requirement to qualify for them. Essentially, Puerto Rico must be your “center of vital interests.” You must spend 183 days or more on the island annually, and no more than 90 days on the US mainland each year.
The IRS relaxed the physical presence requirements after hurricanes Irma and Maria. Essentially, if you live in Puerto Rico but were forced to evacuate, the days spent off-island would still be considered days of physical presence. The same rule applies if you were off-island when the storms hit and were unable to return.
However, since Puerto Rico has its own tax system, individuals and companies seeking to qualify for Act 20/22 incentives must abide by similar physical presence requirements. And while local tax authorities have yet to provide similar relief from these requirements, I expect that they will.
If you’re interested in taking the plunge, I highly recommend you travel to Puerto Rico and assess the territory for yourself. Living on the island wasn’t for the faint-of-heart before the hurricanes hit. There’s even more of a frontier atmosphere now.
And as always, if you’re one of our Inner Circle clients, get in touch with us at email@example.com if you’d like us to introduce you to professionals who can help you qualify for the Act 20/22 incentives.
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