By Jeffrey M. Verdon, Esq., Travor Moses, Esq. & Fernando Goyco-Covas, Esq.
Puerto Rico’s politicians have aimed to spur investment and economic activity in Puerto Rico by changing their tax code. These series of reforms, including the Individual Investors Act (Act 22-2012 and 138-2012), now mean that Puerto Rico offers the potential for exceptionally advantageous United States and Puerto Rican income tax exemptions which, as long as certain requirements are met within the United States Internal Revenue Code of 1986, as amended (the “IRC”),[i] can provide remarkable income tax relief to a wide universe of US citizens, residents, and even non-resident aliens. With the proper planning, a taxpayer is able to reduce the tax on his or her active income to 4% and to completely eliminate the tax on passive income, including short and long term capital gains, by becoming a resident of Puerto Rico. Puerto Rico is only a two hour plane ride from Miami, and four hours from New York, so with recent increases in federal tax rates for income, capital gains, and qualified dividends for higher income taxpayers, calling Puerto Rico home may never have been more inviting.
There are generally four categories of individuals that should consider benefitting from the advantageous tax treatment that moving to Puerto Rico can afford, assuming certain requirements are met. The first category encompasses United States citizens and United States residents who have income that is mostly derived from capital gains. For these high net worth individuals, active traders in securities, and hedge fund owners, just to name a few, moving to Puerto Rico would result in an exemption from the maximum federal marginal income tax rate of 43.4% on short term capital gains (39.6% + 3.8% tax on “net investment income”) and the 23.8% on longer term capital gains.[ii]
The second category of individuals that ought to consider moving to Puerto Rico are service providers who can render such services from Puerto Rico to their non-Puerto Rican clients. Individuals such as money managers can organize a Puerto Rican corporation or limited liability company in order to gain the favored tax treatment of a foreign entity that will not be subject to federal income tax. The dividends that are distributed from that entity to the individual would constitute Puerto Rican source income exempt from federal income tax and Puerto Rican income tax, so long as the services are rendered from Puerto Rico.
Furthermore, the entity would qualify for a reduced 4% Puerto Rican income tax rate due to a tax exemption grant under either the Act to Promote the Exportation of Services (the “Export Services Act”) or the Act to Regulate the International Financial Center (the “IFC Act”). The individual must receive an arm’s length salary for his or her services to the entity that would be exempt from the 39.6% maximum federal marginal income tax rate, but would be subject to the maximum 33% Puerto Rico marginal income tax rate. It may also be possible to limit the salary requirement to the lesser of $250,000 annually or 30% of the earning and profits of the Puerto Rico entity in order to maximize the amount of tax exempt dividends.
The third category consists of business owners with operations outside of Puerto Rico. These individuals may also form a Puerto Rico corporation or limited liability company in order to reap the federal income tax savings. To do so, such individuals will provide management services from Puerto Rico to their offshore business. Managing the business as such from Puerto Rico would allow the entity to receive the previously mentioned 4% corporate income tax rate under the Export Services Act, and the dividends would be exempt from United States and Puerto Rico income tax, so long as the services are rendered from Puerto Rico.
The arm’s length salary requirement would be applicable to owners that render services to the Puerto Rico entity. The amount of tax savings hinges on the fees that may be charged by the Puerto Rico entity to its affiliate for the services rendered in Puerto Rico. Such fees must be arm’s length fees (i.e. the fees that would be paid by the affiliate to an unrelated third party for the same services) that pass muster under Section 482 of the IRC.
The fourth category involves aliens that move to Puerto Rico, as the United States and Puerto Rico income tax exemption are available to these individuals as well. By investing $500,000 in Puerto Rico, non-resident aliens may obtain a permanent residence visa, and resident aliens who are “green card” holders may move to Puerto Rico without the need of a visa or other residency permit. An alien domiciled in Puerto Rico on his or her date of death will be treated as a nonresident, non-citizen for United States federal estate tax purposes. Therefore, pursuant to the situs rule of the IRC, the only assets that will be subject to the United States estate tax are assets of his or her estate located in the United States (excluding Puerto Rico). Further, if the alien becomes a United States citizen based solely upon his or her Puerto Rico residency and is domiciled in Puerto Rico on the date of death, only the assets of his or her estate located in the United States (excluding Puerto Rico) will be subject to United States estate taxes.
Rules & Analysis
Puerto Rico’s changing tax code applies to taxpayers who have not been residents of the territory in the past fifteen years and establish residency in Puerto Rico before the end of 2035. To qualify for the exemptions granted under the Act, every Resident Individual Investor (a tax resident qualifying under the Act) must meet certain statutory requirements, including requesting a tax exemption decree from the Secretary of Economic Development and Commerce.
Section 933 of the IRC discusses certain items that will not be included in gross income and are therefore exempt from U.S. federal income tax. The general rule is that any individual who is a bona fide resident of Puerto Rico during the entire taxable year will be exempt from income derived from sources within Puerto Rico.[iii] Therefore, interest, dividends, and capital gains will be exempt from federal income tax if the following two requirements are met: 1) the individual meets the requirements of Section 937 to become a bona fide resident of Puerto Rico during the entire taxable year, and 2) the interest, dividend, and capital gains are from sources within Puerto Rico pursuant to the IRC source of income rules.
Requirement #1: Bona Fide Resident of Puerto Rico
Section 937 of the IRC defines a bona fide resident as an individual that a) is present at least 183 days during the taxable year in Puerto Rico, b) does not have a tax home outside of Puerto Rico during the taxable year, and c) does not have a closer connection to the United States or a foreign country than to Puerto Rico.[iv] These three requirements harbor complex subtleties that can be found within the Code and Federal Regulations, the details of which should be referenced by the conservative practitioner in order to ensure effective tax status.
If an individual meets the presence, tax home, and closer connection tests, then that individual is a bona fide resident of Puerto Rico and will not be subject to United States income tax on income that is derived from sources within Puerto Rico. Before getting into a discussion of what “income derived from sources within Puerto Rico” means, it is important to note that the United States Internal Revenue Service (“IRS”) must be notified when an individual becomes or ceases to be a bona fide resident of Puerto Rico.[v] This will be done via IRS form 8898, which is due the same date the individual’s U.S. income tax return is due.
Requirement #2: Income Must be Sourced from within Puerto Rico
Once it is clear that an individual meets the bona fide resident of Puerto Rico test, in order to be exempt from US Federal Income Tax, he or she must also show that the source of that income is derived from Puerto Rico.[vi] Generally, the rules are similar to the rules for determining whether income is income from sources within the United States or is effectively connected with the conduct of a trade or business within the United States are used in order to determine whether income is sourced from Puerto Rico.[vii] The IRC further notes that any income treated as income from sources within the United States or as effectively connected with the conduct of a trade or business within the United States shall not be treated as income from Puerto Rico.[viii] There are specific source of income rules that apply to each of the various forms of passive investments. Again, the IRC and Federal Regulations should be consulted for a complete understanding in order to effectuate the taxpayer’s intended results.
- Interest and Dividend Income: IRC Sections 862(a)(1) and (2) discuss when interest and dividends will be treated as income from sources within the United States. Generally, interest from the United States or the District of Columbia, and interest on bonds, notes, or other interest bearing obligations of non-corporate residents or domestic corporations (corporations organized in the United States or under the laws of the United States or any State) shall be treated as income form sources within the United States.[ix] In regard to dividends, amounts received as such from a domestic corporation and certain foreign corporations engaged in business in the United States will generally be treated as income from sources within the United States.[x] Therefore, interest and dividends received from Puerto Rico residents and corporations organized under the laws of Puerto Rico will be Puerto Rico source income.[xi] However, this is so only to the extent of and subject to the applicability of the Conduit Rule and the 10% Shareholder Rule, the details of which should be consulted but which are beyond the scope of this article.
- Capital Gains: Generally, capital gains from the sale, exchange, or other disposition of securities by a bona-fide resident of Puerto Rico are from sources within Puerto Rico.[xii] However, gains from the sale of securities owned by the individual prior to becoming a bona-fide resident of Puerto Rico (“Pre-Residency Securities”) will either constitute income from sources outside of Puerto Rico (unless a certain 10 year rule is met), or the portion of the gain attributable to the period prior to bona-fide Puerto Rico residency will be from sources outside of Puerto Rico, and the portion attributable to the period after bona-fide residency will be from sources within Puerto Rico.[xiii] Accordingly, capital gains from the sale, exchange or other disposition of securities acquired after the individual becomes a bona-fide resident of Puerto Rico will be from sources within Puerto Rico and exempt from Puerto Rico and United States income tax, whereas capital gains from the sale, exchange or other disposition of Pre-Residency Securities will generally be subject to Puerto Rico and United States income tax. However, the portion of the capital gains attributable to the holding period of Pre-Residency Securities commencing after the date that the individual becomes a bona fide resident of Puerto Rico may be from sources within Puerto Rico and thus exempt from such taxes.
In conclusion, for someone who is able to meet the requisite tests, Puerto Rico provides the ability to retain your passport while gaining the benefit of very significant income tax savings. The rules for qualification of these tax benefits are complicated and should not be attempted without the guidance of local counsel. For those interested in exploring this further, we recommend the local lawyer, Fernando Goyco-Covas, of Adsuar Muñiz Goyco Seda & Perez-Ochoa P.S.C., who can help guide you or your clients through the maze of residency rules to ensure compliance with the U.S. and Puerto Rican laws.
[i] Unless otherwise noted, hereinafter the references to section(s) shall refer to section(s) of the IRC.
[ii] Not including state income tax rates.
[iii] IRC §933(1).
[iv] IRC §937(a).
[v] Treas. Reg. §1.937-1(h).
[vi] IRC §933(1).
[vii] IRC §937(b)(1).
[viii] IRC §937(b)(2).
[ix] IRC §861(a)(1).
[x] IRC §862(a)(2).
[xi] Treas. Regs. §§1.937-2(g), 1.937-2(i).
[xii] IRC §865(g)(1), §865(g)(2), IRS Notice 89-40, 1989-1C.B. 681, and are generally from sources within Puerto Rico pursuant to the interplay of Section 1.937-(2)(b) and 1.937-2(f)(2)(ii) of the section 937 Treasury Regulations and Section 865(a)(1).
[xiii] Treas. Reg. §1.937(2)(f).
ABOUT THE AUTHORS
Jeffrey M. Verdon, Esq., is the managing member of his law firm of Jeffrey M. Verdon Law Group, LLP located in Newport Beach, California. Jeff’s law practice concentrates on comprehensive estate planning, including asset and lifestyle protection for affluent families and business owners throughout the United States.
Fernando Goyco-Covas is the founding partner of the Puerto Rico law firm of Adsur, Muniz, Goyco, Seda & Perez-Ochoa, P.S.C. and has more than 30 years of experience in tax, mergers and acquisitions and corporate matters.
Travor Moses, Esq., is the in-house counsel to Perian Management Company and practices in the areas of taxation, asset protection and general business matters. He received his Juris Doctorate degree from University of California, Hastings College of the Law and received his LL.M. (Estate Planning) from the University of Miami School of Law.