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.

Written by Stewart Patton

Time to get 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 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:

  1. Under Act 20, a Puerto Rican corporation that’s engaged in a service business and has at least 5 employees in Puerto Rico only pays Puerto Rican tax of 4%.
  2. Under Act 22, you can pay 0% on certain dividends and capital gains you realize while living in 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 5 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:

To avoid, this, you simply have 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:

  1. You must not have a “tax home” outside of Puerto Rico, and
  2. 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 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.

3. There’s no telling when the party will be over

The special rules in Puerto Rico are simply a matter of Puerto Rican law, which can be changed with the stroke of a pen.

Let’s look at Puerto Rico and take a guess at how long these tax incentives will stick around:

  1. Puerto Rico has a mountain of debt, which has tripled in the last 15 years.
  2. Puerto Rico has defaulted on interest payments on that debt.
  3. Puerto Rico is fighting in the US Supreme Court to be allowed to declare bankruptcy so it can reorganize its debt.
  4. All the while, rich gringos are walking around the island and paying no or very little tax.

It’s pretty hard to imagine this situation staying the same for the long haul. It’s pretty easy to imagine a politician riding into office on a wave of “let’s stick it to the gringos.”

Also, there’s some potential for Puerto Rico to become an actual state instead of simply remaining a territory of the United States (although by all accounts this is a long shot). If that happens, then living in Puerto Rico will be the same as living in Florida as far as tax is concerned—no more Act 20 or Act 22.

4. Act 20 only works in narrow circumstances

Lots of stuff you read about Act 20 just says you must “start a business” and have 5 employees. That’s true, but (as always) there’s more to the story.

The 4% tax rate only applies to income from “eligible services” the Puerto Rican corporation provides to nonresidents and foreign entities. Eligible services include:

Some of my expat and digital nomad clients do things that could fit under one of these categories, but the majority don’t. For example, here’s a list of businesses that many expats and digital nomads do that simply won’t work for an Act 20 business:

5. Act 22 works in even narrower circumstances

Act 22 is billed as “move to Puerto Rico and pay no tax on capital gains.” Just like with Act 20, that’s sort of true, but it’s more complicated than that.

I routinely get calls from entrepreneurs about to exit who’ve bought their ticket to San Juan. They ask whether they can sign the Purchase and Sale Agreement right when they hit the tarmac or whether they should actually sleep a night in Puerto Rico first.

Well, unfortunately, it doesn’t work quite like that.

First, remember that you must be a bona fide resident of Puerto Rico for an entire taxable year before you get these benefits at all. So, you must meet the tax home test and the closer connection test, starting on January 1 of the year you realize the capital gain (and then for the whole rest of that year as well).

Then, the capital gain must be Puerto Rican source capital gain. When you own stock of a company other than a Puerto Rican company, generally only the portion of the appreciation that accrues while you’re a bona fide resident of Puerto Rico is Puerto Rican source.

So, if you’ve held stock for 19 years, then you become a bona fide resident of Puerto Rico for one year, only 5% of your gain on sale gets the benefit of the 0% capital gain rate. You have to pay regular ol’ US capital gain tax on the rest. If you stay in Puerto Rico for another twenty years (and Act 22 sticks around), you’ll only get the 0% rate on 50% of your gain.

6. Lots of sharks in these waters

Any time a new tax reduction strategy comes along, you can bet the sharks will start circling, looking for weaknesses and ways to make things easier. That’s happening in Puerto Rico in spades.

The 5 employees thing, for example. You can join a “partnership” that shares the services of 5 employees, thus allowing your Puerto Rican corporation to sorta look like it kinda meets the requirements.

Is that what Puerto Rico intended here? Absolutely not.

Also, I’ve heard promoters brag about how they’re running all sorts of investments made by resident Americans through Puerto Rican companies, all in an effort to produce Puerto Rican source income on exit. But, they’re forgetting that a Puerto Rican company is a non-US company and therefor subject to the Subpart F rules, passive foreign investment company rules, specialized reporting for offshore companies, etc.

These schemes and scams are of course harmful for those who participate in them, but the harm goes further than that. They threaten the long-term viability of the Puerto Rican tax incentives for those who actually play by the rules.

Going fully offshore works better for most people

If you’re a hedge fund manager or other professional with a big office who’s making millions in fees for your services, Puerto Rico’s a pretty sweet deal (for as long as it lasts).

For the 99% of expats and digital nomads who do consulting on their own or have the sorts of businesses that don’t work for Act 20, just living outside the US offers a much better deal.

Download this FREE REPORT to discover common (and costly) expat tax myths.


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Stewart Patton