Tax Havens: Establishing Residency in Puerto Rico and the Potential Benefits of IRC Section 933

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Many high net worth individuals are increasingly flocking to states like Florida or Nevada due to their lack of a state income tax. However, under the provisions of IRC Sec. 933, a move to a U.S. territory, like Puerto Rico, may offer even more lucrative tax incentives than a zero income tax state. The potential tax benefits for U.S. high net worth individuals who establish residency in Puerto Rico are too great to ignore.

Requirements for IRC Sec. 933

IRC Section 933 allows U.S. individuals to exclude income that is Puerto Rico sourced from being subject to U.S. federal tax. To qualify for the income exclusion under this code section, the individual must pass two tests:

The individual must qualify as a bona fide resident of Puerto Rico for the entire taxable year.
The income must constitute Puerto Rico source income under the US Internal Revenue Code.

For the residency test, under IRC Section 937, a bona fide resident of Puerto Rico is an individual who:

Is physically present in Puerto Rico for at least 183 days during the taxable year.
Does not have a tax home outside of Puerto Rico during the taxable year.
Does not have a closer connection to the United States or a foreign country than to Puerto Rico.

Sec. 933 Income Sourcing Rules

Compensation

Generally, income earned as wages or compensation for services is taxable where the service is being performed. If the services are performed in Puerto Rico, the income will be subject to Puerto Rico taxation, and if performed in the U.S., it will be subject to U.S. federal taxation, regardless of the residency status of the individual.

Interest

Interest income from bank accounts, bonds, and notes are taxable in the source in which it arises from. For example, interest income earned from a savings account established within a Puerto Rican bank would be taxable under Puerto Rico. Interest income earned from a U.S. bank or U.S. trade, or business is deemed to be sourced within the U.S. and therefore taxable under U.S. federal taxation.

Dividends

Like interest income, the taxability of dividend income is determined by the payer’s country of incorporation. Dividends paid from a U.S. corporation are U.S. source income, and dividends paid from a Puerto Rican corporation are Puerto Rico source income. Since the taxability of interest and dividends is determined by the source of the payer, an example of how a taxpayer can benefit from this rule is by moving a certificate of deposit within a US bank to a certificate of deposit with a Puerto Rican bank.

Sale of personal property and securities

The tax treatment of sales of property is straightforward. For sales of real property, taxability is determined by where the property is located. For sales of personal property, it is determined by the residency of the seller.

Generally, income from the disposition of marketable securities and other investments is sourced to the country of residence. However, there is an exception with marketable securities that have appreciated in value since the day an individual established residency in Puerto Rico.

Gains on the sale of investment property are subject to special sourcing rules if they meet each of the following two criteria:

For the tax year in which the source of the gain must be determined, the taxpayer is a bona fide resident of the relevant territory
For any of the 10 years preceding that year, the taxpayer was a citizen or resident alien of the United States (other than a bona fide resident of the relevant territory).

These individuals will be subject to the special sourcing rule as not all gains will be excludable under Section 933. Under Section 1.937-2(f), gain on the sale of investment property that was owned prior to the individual becoming a bona fide resident of Puerto Rico, and the individual was a U.S. citizen and not a bona fide resident of Puerto Rico during any of the 10 years preceding the sale, would not be excludable from U.S. federal taxes under Section 933.

For example, say a taxpayer held stock with a cost basis of $1,000, then established residency in Puerto Rico when the FMV of the stock appreciated to $2,000, and then later sold the stock as a Puerto Rican resident for $4,000. In this situation, the taxpayer would have a total capital gain of $3,000. But only $1,000 of the gain – the portion of the gain that is allocable to the period prior to the individual establishing residency in Puerto Rico, would only be subject to U.S. federal taxes.

If a taxpayer meets these criteria, gains from the disposition of the property will be treated as U.S. sourced income for purposes of Sec. 933. See Treas. Reg. 1.937-2(f)(1) and the Example 1 in Treas. Reg. 1.937-2(k).

Exception to the special sourcing rule

A taxpayer may make an election under Treas. Reg. 1-937-2(f)((1)(vi)(A) to treat a portion of the gain as attributable to within the possession. This election is considered to be made if the taxpayer reports the gain attributable to the possession holding period on their Puerto Rican tax return. The possession holding period is the length of time between the taxpayer’s initial day of Puerto Rican residency, up until the date of disposition.

The gain measured during this holding period is the amount which would be included on the Puerto Rican tax return should a taxpayer elect to do so. In the case of marketable securities, the gain attributable to the possession holding period is determined by the change in FMV of the security on the first of the possession holding period to the day of disposition.

In the case of property other than marketable securities, the portion of the gain attributable to the possession holding period is determined by multiplying the total gain on disposition by the possession holding period over the total holding period.

Income from flow-through entities such as partnerships and corporations

The taxability of income from flow-through entities as a partner or shareholder is determined by the source of the income.

Deductions

According to IRS Publication 1321, deductions which do not apply to one specific type of income, must be allocated between the Puerto Rican sourced income, and U.S. income. Common examples of these types of deductions include the standard deduction, alimony payments, and certain itemized deductions.

In order to figure out the allowable amount of deduction a taxpayer may claim on their U.S. tax return, multiply the gross deductions by the following ratio:

_____________Gross income subject to U.S. income tax____________

Gross income from all sources (including the Sec. 933 excluded income)

No Application to Other Taxes

It is important for taxpayers to understand that Sec. 933 only applies when figuring their U.S. income tax liability. The provisions of this code section do not apply to other types of tax including Social Security, Medicare, and Self-Employment Tax. Court cases have determined that even when a taxpayer has earned income performed within Puerto Rico, such income is still subject to self-employment tax. The same is true for W-2 earners in having their wages subject to FICA taxes.

Conclusion

Many American taxpayers have moved to zero income tax states as a tax haven, but moving to Puerto Rico can have greater potential tax benefits for the reasons discussed in this article. By establishing residency and moving their business operations to Puerto Rico, taxpayers can benefit greatly by taking advantage of the income exclusion rules under IRC Section 933, and favorable tax rates such as corporate tax rates.

Evolved is a tax compliance and advisory firm with offices in New York City, Philadelphia and Stamford, serving clients nationally throughout the US. We provide tax provision, private equity and venture capital services alongside advisory for high net-worth tax and family office tax.