One of the advantages of being around as many years as I have is a long memory.
And, during my entire 30-year career, Congress has been trying to figure out the best way to help the struggling economies of the US territories: Guam, Puerto Rico, the US Virgin Islands, and the Northern Mariana Islands.
Puerto Rico, which in the last year has exploded into prominence as a “tax haven” for wealthy Americans and businesses, is a great example. The island became a US possession in 1898 after the Spanish-American War. Ever since, Congress has been trying to figure out how best to deal with its persistent poverty.
For more than a century, Congress has tried direct aid, industrial incentives, and tax breaks to revive Puerto Rico’s economy. As the political winds shift in Washington, DC, these incentives have come and – inevitably – gone. The result: Unemployment is nearly 14%, and the average per capita income is about half that of Mississippi. Crime is rampant, with a murder rate six times that of the mainland. Puerto Rico has a public debt exceeding $70 billion, and its municipal bonds have been downgraded to junk status. Deposits in local banks have fallen 30% since 2005. It’s no wonder that nearly 5 million Puerto Ricans now live on the mainland, versus the 3.6 million still residing on the island itself.
The first tax incentives for Puerto Rico came into effect in 1921, and in 1976, Congress gave US companies the ability to operate in Puerto Rico tax-free. Hundreds of companies – most prominently those in the pharmaceutical sector – moved to Puerto Rico. But by the mid-1990s, these incentives were costing the US Treasury billions of dollars in tax payments. So in 1996, Congress repealed this incentive. Easy come, easy go.
Today, the main federal tax incentive for Puerto Rico provides that bona-fide residents of the territory need not pay income tax on “income derived from sources within Puerto Rico.” By itself, this exemption isn’t particularly noteworthy, because Puerto Rico taxes are much higher than those of any US state, with a top rate of 33%.
However, the exemption opens the door for local tax incentives. And Puerto Rico responded in 2012. Anyone who becomes a bona-fide resident of Puerto Rico is now eligible for the following benefits, courtesy of a new law, Act 22:
- 100% tax exemption from Puerto Rico income taxes on all 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.
The law is ideal 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) on passive income and want to reduce their federal tax liability. If you reside in Puerto Rico and live off your portfolio income, you pay zero tax in the US or Puerto Rico.
Puerto Rico guarantees these provisions will remain in place until the end of 2035.
Tax Breaks for Businesses, Too
Additional tax breaks exist for companies as well, although it’s not possible to operate a business completely tax-free.
To qualify for these business tax incentives, you need to form a Puerto Rican company. You must be an employee of that company and pay yourself a salary of $250,000 or one-third of your profits, whichever is smaller. On that income, you must pay local tax at a top rate of 33%, Medicare tax of 2.9%, and Social Security tax of 12.4% on the first $117,000 of your salary.
So, unless your business generates at least $250,000 in annual profits, there’s no real benefit to this strategy. Income above this threshold, however, is subject to only a 4% corporate income tax. You can take these profits in the form of a tax-free dividend. The total tax on income above this threshold, therefore, is only 4%.
Tax Nirvana… or Not?
No doubt, these are some mouth-watering incentives. When these incentives came into being, a media frenzy followed, with headlines like “Puerto Rico Rolling Out the Welcome Mat for Millionaires.”
My biggest concern about these incentives was – and continues to be – that they’re in the “too good to be true” category. The incentives exist only because the US Tax Code exempts Puerto Rico source income from federal taxes. Congress could change or amend this status anytime.
This fact hasn’t stopped some promoters from claiming that, since the incentives are part of Puerto Rican law, Congress can’t do anything about them.
That's simply not true and no matter what the aforementioned promoters say, the Federal Government can and will take action if and as desired.
There are already rumblings in Congress that Act 22 threatens to erode the US tax base. There would likely be little political opposition on the mainland to shutting down or restricting these tax benefits.
Should you relocate to Puerto Rico? Sure. If you’d benefit from these tax breaks, I don’t see much downside. Keep in mind that to qualify for them, you must be physically present in Puerto Rico for at least six months each year. And while English is the language of business on the island, most of the locals speak Spanish.
But remember, when too many people start exploiting a loophole to save on federal taxes, the loophole usually closes. It’s happened before in Puerto Rico – and it could happen again.
Correction: Dividends and interest are only tax-free to a bona-fide new resident of Puerto Rico if they come from a Puerto Rican source, such as interest on a CD at a Puerto Rican bank or a dividend from a Puerto Rican corporation. Otherwise, this income is subject to US federal income tax.
The 100% tax break on capital gains applies only for gains that accrue after you become resident in Puerto Rico.