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.
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, under a law referred to as Act 60 (formerly Act 20 and Act 22), Puerto Rico has enacted several tax incentives, the two most popular of which are as follows:
- a Puerto Rican corporation that’s engaged in certain types of service businesses only pays Puerto Rican tax of 4%.
- you can pay 0% tax 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 Actually Live in Puerto Rico
Some offshore gurus and Puerto Rico promoters claim that you can take advantage of Act 60 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 other than the special rules related to Puerto Rico, 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 outside the US.
- A non-US corporation that is “engaged in trade or business within 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 the trade or business within 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 21%.
- 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%.
- 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 and Puerto Rico promoters 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 at any point in that taxable year, and
- You must not have “closer connections” to any place other than Puerto Rico during that taxable year.
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 immediate 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.
3. There’s no Telling When the Party’s 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:
- Puerto Rico has a mountain of debt, which has tripled in the last few years;
- Puerto Rico has defaulted on interest payments on that debt;
- Puerto Rico fought in the US Supreme Court to be allowed to declare bankruptcy so it can reorganize its debt; and
- 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.
Before moving to Puerto Rico, you would have a “decree” from the Puerto Rican government that is meant to secure your right to Act 60 benefits. However, a contract signed with a government is a very different thing than a contract signed with a private party.
4. Act 60 for a Business Only Works in Certain Circumstances
Lots of stuff you read about Act 60 just says you must “start a business” in Puerto Rico. 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:
- Research and development,
- Advertising and public relations,
- Graphic design,
- Architectural design,
- Legal services,
- Electronic data processing,
- Computer program development,
- Voice and data telecommunications,
- Call centers,
- Centralized management services,
- Storage and distribution,
- Hospital and laboratory services, and
- Financial services.
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 60 business:
- Any sort of ecommerce business (drop-shipping, Amazon FBA, selling on your own site),
- Most SaaS businesses,
- Most app businesses,
- Online ad arbitrage,
- Niche websites, and
- Affiliate marketing.
5. Benefits for Capital Gain Work in Even Narrower Circumstances
Act 60 is billed by some promoters as “move to Puerto Rico and pay no tax on capital gains.” Just like with Act 60 for your business, that’s 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. There’s a special exception that will allow you to use the Puerto Rico tax benefits immediately upon moving there in certain circumstances, but this exception requires you to live in Puerto Rico for at least 3 years.
Then, the capital gain must be Puerto Rican source capital gain. When you own stock of a private company other than a Puerto Rican company, only a portion of your gain is Puerto Rican source. That portion is the amount of time you are a bona fide resident of Puerto Rico divided by the total amount of time you’ve held the stock.
So, if you’ve held stock of a private company 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 US capital gain tax on the rest. If you stay in Puerto Rico for 19 years (and Act 60 sticks around), you’ll 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.
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. If you’ve talked to a promoter and they haven’t mentioned these things . . . well, that’s a problem.
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 May Work Better
If you’re a hedge fund manager or other professional with a big office who’s making millions in fees for your services, or you trade financial assets or cryptocurrency full-time, Puerto Rico’s a pretty sweet deal. Living outside the US entirely wouldn’t be better in your situation.
For those expats and digital nomads who do consulting on their own or have the sorts of businesses that don’t work for Act 60, just living outside the US entirely provides a much better deal.
Ready to become an expert on this stuff? Click here to take the US Tax Masterclass for Americans Abroad (absolutely free).