6 REASONS THE PUERTO RICO TAX INCENTIVES AREN’T ALL THEY’RE CRACKED UP TO BE
Lots of offshore gurus are pushing Puerto Rico these days. As usual, the picture isn’t quite as rosy once you dig below the surface.
Time to pull the shovel out on all this Puerto Rico hype. Let’s get down below all the fancy marketing to look at how the Puerto Rico tax incentives actually work in the real world.
As you’ll see, living in Puerto Rico turns out to be a great deal for hedge fund managers, full-time traders, and certain other high net worth professionals. But for most expats and digital nomads, simply living outside the US entirely provides a much better tax deal.
THE BASICS
As a US citizen, you’re subject to US tax on your worldwide income, whether you live inside the US or outside the US. Of course, there are lots of tax incentives available for expats, like the foreign earned income exclusion, foreign tax credit, and the ability to operate a business through a non-US corporation.
However, if you become a
“bona fide resident of Puerto Rico,” you’re no longer subject to US federal income tax
on your Puerto Rico source income. Instead, you’re only subject to Puerto Rican income tax on that income.
Then, Puerto Rico has enacted several tax incentives, the two most popular of which are as follows:
Under Act 20, a Puerto Rican corporation that’s engaged in certain types of service businesses only pays Puerto Rican tax of 4%.
Under Act 22, you can pay 0% on certain dividends and capital gains you realize while you’re a bona fide resident of Puerto Rico.
Let’s get into the details and see why the deal here may not be as sweet as it looks on the surface.
1.
THE PUERTO RICO INCENTIVES ONLY WORK IF YOU LIVE IN PUERTO RICO
Some offshore gurus claim that you can take advantage of Act 20 benefits while you live in the US. They say you can form a Puerto Rican corporation, hire employees in Puerto Rico, and operate your business from your home in the US.
The idea here is to only pay US tax on a salary you take from the company, while the company’s income is taxed only at the 4% Puerto Rican tax rate.
This doesn’t work. Suggesting that it does is horrible advice. Just really really bad, even by the usual standards of offshore gurus.
The problem is that this advice looks only at the Puerto Rican tax consequences. It doesn’t consider the broader US tax consequences of this arrangement as a whole.
Here’s how the full tax consequences would really work in this fact pattern:
For purposes of the US tax rules, a Puerto Rican corporation is a non-US corporation. So, it’s subject to the same general US tax rules that apply to a corporation formed anywhere else outside the US.
A non-US corporation that is “engaged in a trade or business in the United States” (or “ETBUS” for short) is subject to US tax.
Generally, a non-US corporation is ETBUS only when it has its own people on the ground in the US operating its business. Click here for an article that goes into more detail on this issue.
Then, a non-US corporation that’s ETBUS is subject to US tax on its income that’s “effectively connected” with the conduct of business in the US. In the fact pattern discussed above, there would need to be an allocation to determine how much of the company’s income is attributable to your work in the US and how much is attributable to the employees down in Puerto Rico.
The part of the income attributable to work in the US would be subject to US tax at graduated rates up to 35%.
Then, if the non-US corporation removes that income from the US, the amount removed would also be subject to the branch profits tax at 30%. Assuming that the income tax applies at the full 35% rate, the combined rate is 54.5% (which is 35% plus 30% of the remaining 65%).
So, if you live in the US and you operate a business that you hold through a Puerto Rican corporation, that Puerto Rican corporation is ETBUS and therefore subject to US tax (at a very high rate) on at least a portion of its income.
To avoid this,
you would need to move to Puerto Rico to operate your business. By doing that, your corporation would
no longer have “people on the ground” in the US and therefore wouldn’t pay US tax on its income.
2. NO REALLY, YOU DO HAVE TO ACTUALLY MOVE YOUR LIFE TO PUERTO RICO
Sometimes you’ll see offshore gurus say that you only need to spend at least 183 days per year in Puerto Rico. That’s true. It’s also incomplete.
To no longer be subject to US tax and take advantage of the Puerto Rico tax incentives for a taxable year, you must be a “bona fide resident” of Puerto Rico for that entire taxable year. In addition to being in Puerto Rico for 183 days, you must also pass two additional tests:
You must not have a “tax home” outside of Puerto Rico, and
You must not have “closer connections” to any place other than Puerto Rico.
Your “tax home” is basically the locus of your economic activity. If you work in an office, that’s your tax home. So, you can’t be commuting back and forth between Puerto Rico and your office—you need to move the office to Puerto Rico.
Then, to pass the “closer connections” test,
you need to move the rest of your life to Puerto Rico as well. This test looks at a long list of factors to determine the place in the world that is really home for you. Some of these factors are as follows:
The location of your permanent home;
The location of your family;
The location of personal belongings, such as automobiles, furniture, clothing, and jewelry;
The location of social, political, cultural, professional, or religious organizations with which you have a current relationship;
The location where you conduct your routine personal banking activities;
The place where you conduct business activities (other than those that go into determining your tax home);
The location of the jurisdiction in which you hold a driver’s license;
The location of the jurisdiction in which you vote;
The location of charitable organizations to which you contribute; and
The country of residence you designate on forms and documents.
The IRS doesn’t specifically require that you get a Puerto Rican flag tattooed on your shoulder, but it certainly couldn’t hurt.
I had a client who wasn’t favorably impressed on his first trip to Puerto Rico, so he asked if he could buy a boat and anchor it just inside Puerto Rico’s territorial waters. Well, it would be pretty hard to meet the above factors in that case.
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