IRS Focuses on Puerto Rico as a Tax Haven

The Internal Revenue Service (IRS) has begun to focus its resources on identifying tax havens in Puerto Rico. As Washington D.C. tax attorney Kevin E. Thorn, Managing Partner of Thorn Law Group, explains, this has potentially significant implications for U.S. taxpayers who transfer their business to Puerto Rico seeking tax advantages. Kevin E. Thorn warns, that such transfers have triggered many IRS tax audits already, and more may be on the way in the future.

What is the Tax Appeal of Puerto Rico?

Under Internal Revenue Code (IRC) §933, Puerto Rican source income is excluded from U.S. federal tax. Two laws, enacted by Puerto Rico in 2012, introduced major tax incentives to promote foreign investments. These were Act 20 and Act 22. In other words, income made in Puerto Rico receives advantageous tax treatment.

If a United States citizen becomes a bona fide Puerto Rican resident and moves his or her business to Puerto Rico, the income becomes Puerto Rican sourced income. This income benefits from a 4% corporate tax/fixed income tax rate, a 100% exemption on property taxes, and a 100% exemption on dividends from export services.

What is a Bona Fide Resident?

Under Internal Revenue Code § 937, a bona fide resident means a person who is present for at least 183 days during the taxable year in Puerto Rico, who does not have a home outside Puerto Rico during the taxable year and does not have a closer connection to the United States or a foreign country than to Puerto Rico.

Determining Bona Fide Residency Status

Step 1 - Presence Test: An individual satisfies the presence test if he or she was present in Puerto Rico for at least 183 days during the taxable year. When determining if an individual meets the presence test, an examiner must usually also determine the number of days the individual was also physically present in the United States.

Step 2 -Tax Home Test: An individual will meet the tax home test if he or she did not have a tax home outside the specific territory during any part of the tax year. An individual’s tax home is generally his or her regular or principal place of business. If there is no place of business, his or her tax home is in his or her regular place of residence.  

Step 3 - Closer Connection Test: The final requirement that a taxpayer must meet in order to qualify as a bona fide resident of Puerto Rico is that the taxpayer must not have a “closer connection” to the United States or a foreign country than to Puerto Rico during any part of the taxable year. A person will be considered to have a closer connection to the United States or a foreign country than to Puerto Rico if the individual has maintained more significant contacts with the United States or the foreign country. Whether the individual has maintained more significant contacts is determined under a facts-and-circumstances test.

Factors to consider in the Facts and Circumstances test:

• With which organizations is the individual affiliated?
• Where does the person bank?
• Where does the individual conduct business?
• What jurisdiction the individual holds a driver’s license?
• Where does the individual vote?
• Residence mentioned on official forms and documents filed by the taxpayer.

What Incentives Do Acts 20 and 22 Provide?

Act 20 provides incentives to companies exporting services from Puerto Rico. Act 20 applies to any entity engaged in an “eligible service:”

• Which has a bona fide office located in Puerto Rico,
• Performs services for non-resident and/or foreign entities without any nexus to Puerto Rico, and
• Which ensures that the eligible service provided is not related to the conduct of a trade, business or other activity in Puerto Rico.

These incentives provide 4% corporate tax rate, 100% tax exemption on dividends or profit distributions, and 100% exemption on property taxes.

Act 22 is attractive to individual investors and businesses that move to Puerto Rico due to a 100% tax exemption from Puerto Rico taxes on all dividend and interest income and long-term capital gains accrued after becoming a qualifying new resident.  Puerto Rico source passive income is also completely exempt from federal taxation under IRC §933l

IRS Audits

The IRS’ current concern is that wealthy clients and businesses have fraudulently claimed to be bona fide residents of Puerto Rico to avoid United States income tax, leading to a loss of revenue by the United States Treasury. Any individual or business should consult with an experienced international tax attorney before moving any businesses or assets. Establishing Puerto Rican residence is an intricate process that must be followed carefully.

Request a Consultation With Washington D.C. Tax Attorney Kevin E. Thorn

What does this mean for individuals, businesses, or investors who move their businesses to Puerto Rico?

It is clear that the IRS is heavily focused on Puerto Rico as a tax haven and investors and businesses should be very careful when preparing their annual returns because a severe IRS tax audit or IRS investigation could result. To avoid civil penalties and the possibility of criminal prosecution, a taxpayer with concerns regarding their duties to the IRS should consult the Washington D.C. IRS tax lawyer Kevin E. Thorn, Managing Partner of Thorn Law Group, located at 1775 Eye Street NW, Suite 1150, Washington, DC 20006, call 202-349-4033, email ket@thornlawgroup.com or contact us confidentially online today.