I must admit – when we first heard about the new Puerto Rico tax incentives back in 2012, we didn’t think they would last. That’s because the potential benefits were so good, we assumed pressure from Washington would eventually shut it down.
We were wrong – 12 years later, the tax incentives are still here.
Yes, the rules have tightened up quite a bit. And both the Puerto Rican authorities and the IRS regularly audit people who use the rules to dramatically reduce their tax burdens.
But, if you are able to follow the rules, and can sort through the mountain of misinformation regarding this program, there’s a big opportunity here. In some cases, you can reduce your tax bill by 100%(!) on certain types of income.
In this article, we’ll take a close look at how Puerto Rico’s tax incentive programs work. We’ll explain what you need to do, how much tax you could actually save, and how to make sure you stay compliant with all the rules and regulations.
How Can Puerto Rico Offer Such Tax Incentives?
Puerto Rico can set its own tax policy because of Section 933 of the US Tax Code. It specifically excludes “income derived from sources within Puerto Rico” from certain types of income tax for an individual who is a “bona fide resident of Puerto Rico.”
In other words, the US authorities have given the power to Puerto Rico to tax their residents as little or as much as they want. Since 2012, they’ve decided to offer a very low tax regime to try and get wealthy Americans from the mainland to move themselves and their businesses there.
Why Did Puerto Rico Introduce Tax Incentives?
In 2012, Puerto Rico was facing some major challenges – a long-lasting economic recession, high unemployment, and growing public debt. The government hoped that by offering these tax breaks, they could attract more investment and economic activity to the island.
They were willing to give up tax revenue in exchange for having wealthy mainlanders move in, spend money in the local economy, and hopefully hire some locals as well.
What Are Puerto Rico’s Tax Incentives’ Packages?
The incentives enacted in 2012 consisted of personal and business incentives. The personal tax incentives were contained in Act 22. The business tax incentives were contained in Act 20. In 2019, the Puerto Rico Legislative Assembly enacted Act 60 to replace both Act 20 and 22. Act 60 was amended in 2021 and again in 2022.
The incentives can be used individually or as part of a more holistic package. Here’s how they work…
#1: Puerto Rico’s Personal Tax Incentives
Key benefits include:
- Individuals moving to Puerto Rico can apply for a Resident Individual Investor decree. It offers a 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 are eligible for a 5% tax rate after ten years of residency.
A Resident Individual Investor decree is valid until December 31, 2035.
To take advantage of these benefits, you must:
- Spend at least 183 days per year in Puerto Rico and make it the “center of your vital interests.”
- Buy a residential property within 2 years of arrival.
- Donate $10,000 or more to a local charity each year.
- Pay a $5,000 annual renewal fee to keep the tax incentives in place.
- Generate no more than $3,000 in earned income from US sources. Earned income is pay for personal services, such as wages, salaries, or professional fees.
Understanding Physical Presence Rules
To pass the presence test and prove you really live in Puerto Rico you only need to meet one of five rules set by the IRS.
Two rules are about how many days you’re in Puerto Rico:
- Be in Puerto Rico for at least 183 days in one tax year. Any part of a day you’re there even for a short time counts as a full day.
- Be in Puerto Rico for at least 549 days over the current tax year and the last two adding up to at least 60 days each year.
The other three rules are about not having strong ties to the US:
- Stay in the US for no more than 90 days in a tax year.
- Earn up to $3,000 in the US and spend more days in Puerto Rico than in the US in a tax year.
- Have no significant connections to the US during the tax year.
#2: Puerto Rico’s Business Tax Incentives
These rules give a Puerto Rican business providing “export services” the opportunity to apply for a decree offering several tax incentives. The decree is valid for 15 years, with a possible 15-year extension.
Key benefits include:
- 4% tax rate on corporate profits for qualifying export services businesses.
- Tax-free dividends remitted to owners of a qualifying export services business if they are bona-fide residents of Puerto Rico.
To avoid any issues with the IRS, a US owner of such business must move to Puerto Rico and follow the same physical presence rules as an individual investor resident there. In addition, you must:
- Pay yourself a reasonable salary based on the value of the services you provide for the company. On that salary, you’ll pay local tax at a rate up to 33% and federal Social Security tax of 12.4% on the first $147,000 (for tax year 2022) of your salary. You must also pay federal Medicare tax of 2.9% of your salary, with no cap.
- Maintain records to demonstrate your continuing eligibility for the export services tax incentives.
- File a Puerto Rico income tax return, a declaration and reconciliation statement of income tax withholding, and a municipal tax return.
WARNING: You will be audited.
For obvious reasons, the tax authorities in Washington are not thrilled with the idea of losing tax revenue to Puerto Rico.
So they’ve become quite strict on making sure you follow the residency requirements to a fault. Because the authorities will check.
There are two audits you can expect:
- At a local (Puerto Rico) level, anyone who moves to the island to take advantage of the Act 60 program will be audited regularly. For the business tax incentives, you can expect an annual audit.
- Back on the mainland, the IRS is in the process of auditing every US citizen who has applied for personal tax incentives package.
It’s very important you document your compliance. If you make a mistake, you may face a big tax bill.
Puerto Rico’s Tax Incentives and the IRS
In 2020, Congress asked the IRS to review the tax incentives offered by Puerto Rico.
The IRS examined the tax returns of 166 US citizens who had relocated to the island and submitted a report to Congress analyzing their findings.
They found that in the 5 years before moving, these individuals had paid a total of $252,300,000 in income taxes. Once they moved to Puerto Rico, they paid none.
Based on these findings, the IRS prepared a list of taxpayers benefitting from the incentives. And it began an “outreach” program requesting information from them. That effort is ongoing. If you’ve applied for either or both incentives, you received one of these letters. And there’s a 100% chance that you’ll be audited for compliance, if you haven’t been already.
Still, there was nothing the IRS could do directly to shut down the program. Congress would have to do that. And despite howls from congressional Democrats about how the tax incentives are diminishing the US tax base, there’s no sign that Congress will act.
You Can’t Escape Tax Entirely
The Act 60 provisions only cover certain income generated a certain way.
We’ve already mentioned the need to pay yourself a salary and the taxes associated with that. Puerto Rico also has a Value Added Tax (“sales and use tax“) on the island of 11.5%, which can be reduced to 4% for certain professional and B2B services.
With few exceptions, the Act also only covers income from sources inside Puerto Rico. Income from sources off island will still be subject to a maximum 40.8% federal income tax and up to 33% in Puerto Rico income tax. And unlike the federal income tax, this top rate of 33% kicks in at a pretty low threshold of $61,500.
In other words, if you’re thinking about making the move, it’s very important you take stock of your situation and plan ahead properly. Otherwise, you might not get the benefits you want.
Who Are the Puerto Rico Tax Advantages Best For?
Focusing exclusively on the comparison between US federal tax obligations on the mainland and in Puerto Rico under Act 60, let’s refine the scenarios to consider how certain situations can result in lower federal income tax due to the unique tax treatment of Puerto Rico under the US tax code.
You’ve probably got a pretty good idea by now that the Puerto Rico tax opportunities aren’t for everyone. So who would benefit the most, and who wouldn’t?
Here are a few scenarios based on our experience in the field. For these scenarios, we compare just the federal income tax savings versus Puerto Rico income tax savings under this program.
Case Study #1:
Software Development Company Relocates to Puerto Rico
Scenario: Susan, a software developer from the mainland US, relocates her entire operation to Puerto Rico, including the establishment of bona fide residency for tax purposes. At the same time, she applies for an Export Services Decree. The company generates $1 million in annual profits.
Mainland US Taxation: Before moving to Puerto Rico, Susan operated her business as a C corporation. On the mainland, the federal corporate income tax rate is 21%. The company would owe $210,000 in federal corporate income taxes.
Puerto Rico Act 60 Taxation: Under Act 60, the company would be subject to a 4% corporate tax rate in Puerto Rico, with no federal corporate income tax on this Puerto Rican source income. The company would owe $40,000 in taxes under Puerto Rico’s jurisdiction.
Savings: The company saves $170,000 in taxes by operating under Puerto Rico’s Act 60 instead of mainland US federal tax rates.
Verdict: With proper planning, highly worth considering.
Note: This analysis doesn’t include a calculation of Susan’s personal tax situation. But it’s worth noting that there is a requirement for the export services business to pay Susan a “reasonable salary” which is subject to Puerto Rican tax at a top rate of 33%. Still, her tax liability isn’t likely to exceed what she would have paid on the same income in the US.
Case Study #2:
Investment Income for a Puerto Rico Resident
Scenario: Paul, an individual investor from the mainland moves to Puerto Rico and applies for a Resident Individual Investor decree. He invests in local Puerto Rican businesses and real estate, generating $500,000 in annual investment income.
Mainland US Taxation: On the mainland, this investment income could be subject to tax at a top rate of 35%, resulting in a tax bill exceeding $150,000.
Puerto Rico Act 60 Taxation: Under Act 60, Paul could qualify for 0% tax on Puerto Rican source income if he meets the requirements we’ve described. Hence, the tax could be $0 on this income.
Savings: Paul could save more than $150,000 in tax each year on his investment income by taking advantage of Act 60’s tax incentives.
Verdict: With proper planning, highly worth considering.
Case Study #3:
Export Services Company Based in Puerto Rico
Scenario: Ted, an entrepreneur, applies for an Export Services Decree for his digital marketing services company. He then establishes the company in Puerto Rico and relocates there. The company generates $2 million in annual revenues from outside Puerto Rico with profits of $800,000 per year.
Mainland US Taxation: Before relocating to Puerto Rico, Ted operated his business as a C corporation. If based on the mainland, his company’s $800,000 net income would be subject to the federal corporate income tax rate of 21%, resulting in $168,000 in federal taxes.
Puerto Rico Act 60 Taxation: Under Act 60, Paul’s company could be eligible for a 4% corporate tax rate on its export services income, with no federal income taxes on this income, resulting in a tax bill of $32,000.
Savings: The company could achieve tax savings of $136,000 by operating under Puerto Rico’s Act 60.
Verdict: With proper planning, highly worth considering.
Note: Again, this analysis doesn’t include a calculation of Paul’s personal tax situation. He will have some personal tax liability in Puerto Rico, but it’s likely to not be more than what he would have paid on the same income in the US.
Who Would Not Benefit from Act 60?
As mentioned, if you can’t:
- Move to Puerto Rico.
- Have your income generated from Puerto Rican sources (for the personal tax incentives) or from export services (for the business tax incentives).
… you can’t benefit from the Act 60 provisions.
Here are a few scenarios that might look good on paper but wouldn’t hold up to any sort of audit.
#1: Mainland Consultant with Puerto Rican LLC
A consultant living on the mainland who sets up a company in Puerto Rico without moving there would still be subject to US federal taxes on their worldwide income, with no benefits from Act 60.
Reason for failure: They didn’t meet the residency requirements.
#2: Mainland-Based E-Commerce Business
An e-commerce business based on the mainland that simply registers in Puerto Rico without relocating operations or the owner becoming a bona fide resident.
Reason for failure: The business isn’t generating export services income and the owner doesn’t meet residency requirements.
#3: Investor in Puerto Rican Securities from the Mainland
A mainland investor earning dividends from investments in Puerto Rican securities would still be subject to US federal taxes on these dividends, with no tax advantages under Act 60.
Reason for failure: The personal tax incentives are only available to a bona fide resident of Puerto Rico.
Still Interested in Moving to Puerto Rico?
If you are interested in taking advantage of the Puerto Rico tax incentives, it is recommended that you:
- Visit Puerto Rico to see if you can see yourself living there.
- Talk to people who have already taken advantage of the incentives to understand their experiences with local tax authorities and the IRS.
- Consult with professionals who understand this opportunity and can give you a clear idea of what you will pay to stay on the mainland versus how much you could save by moving.
Need Help?
Over the past 40+ years, we’ve helped thousands of clients build better wealth protection plans. Part of that is to look for legal ways to minimize your tax burden.
Since 2012, Puerto Rico has offered a very attractive program to Americans looking to reduce their tax bill. But, it’s not something you should try to do on your own.
Done well, it can indeed lower your taxes. But if not done in full compliance with the regulations, it could attract unwelcome attention.
If you’re wondering if it’s right for you, please get in touch to see if our services can help you on your way.
It starts with a free, no-obligation consultation with one of our Associates. You can do that here.
