Can you spend half the year on a Caribbean island while legally avoiding virtually every U.S. federal and state tax?
Yes. Puerto Rico has become the answer to that question.
The island is an unincorporated territory of the United States. Puerto Ricans have been U.S. citizens since 1917, which means the island’s residents, like the citizens of the 50 U.S. states, can move freely across their borders. However, as residents of an unincorporated territory, Puerto Ricans generally do not pay federal income taxes. If a person is a bona fide resident of Puerto Rico, the Internal Revenue Service cedes jurisdiction.
In 2012, the island enacted incentives built into Puerto Rican tax law to promote foreign investment. Those incentives were formerly known as Act 20 and Act 22. In 2019, those tax laws were folded into the Puerto Rico Incentives Code Act, also known as “Act 60”. Act 60 is not part of U.S. tax law; it is Puerto Rican tax law. These tax avoidance provisions have made Puerto Rico a tax haven for business owners and wealthy Americans.
A U.S. business or business owner benefits from moving to Puerto Rico because of the flat four percent corporate tax rate. Puerto Rico’s four percent tax rate compares to the 40 percent or more that many business owners pay in the United States. Additionally, all capital gains accrued after qualifying for Act 60 are 100 percent exempt from taxes. That’s a zero percent tax rate on Act 60 gains when you sell your business.
Chapter 3 of Act 6, formerly known as Act 20, is a business provision. A Chapter 3 company is located in Puerto Rico and can provide services or sell products to people outside of the territory. The business must directly employ at least one full-time employee in Puerto Rico, who may be the business owner. That means you don’t have to move your entire business — or even a large part of it — to benefit from Act 60.
Chapter 3 taxes corporate profits at four percent and fully exempts taxes on dividends paid from profits sourced from Puerto Rico. “Sourced” is a term frequently used in Act 60. It means you must be located in Puerto Rico, but you can sell your products or services to customers who don’t live there. Qualifying businesses are given up to 100 percent tax exemption for the first five years of operations. Business owners are allowed 90 percent tax exemptions on personal property.
Chapter 2, originally known as Act 22, shields Americans who become Puerto Rican residents from interest and dividend income taxes and capital gains. They are subjected to the same flat four percent income tax. Chapter 2 isn’t a loophole to Chapter 3, but it does allow business owners to benefit from Puerto Rico’s tax benefits even if their company doesn’t qualify.
So what’s the catch?
Act 60 is not part of U.S. tax law. It is Puerto Rican tax law. If you are a Puerto Rican citizen, you must apply and be approved. If accepted, the initial decree will be granted for 15 years. It may be extended for an additional 15 years.
Your primary work location must be in Puerto Rico to satisfy Chapter 3. Within two years, you’ll have to buy a home in Puerto Rico. The territory wants your help increasing its tax revenue, but the IRS will enforce Section 933 of the tax code, which lets Puerto Rico collect tax revenue from their residents. The enforcement of Section 933 means you must be a bona fide resident of Puerto Rico. You can use five tests to meet the physical requirements to claim residency, but you should plan on spending at least 183 days there.
Not all income will qualify for the four percent tax rate. Deferred income — payments due before you move to Puerto Rico — are not exempt. Salaried income paid by U.S-based businesses is also not exempt, but that’s more of a classification choice than an obstacle.
Most people don’t want to move their entire business, so they just move themselves. The company pays you as a 1099 worker to consult from under the shade of a palm tree. If you’ve been a resident of Puerto Rico for the entire taxable year, the income you derive from sources within Puerto Rico is not included as part of your income for U.S. tax purposes.
You can’t move to Puerto Rico and immediately sell your business tax-free. You’ll have to arrive there and start the clock then. Suppose you started your business in the U.S. and live in Massachusetts. Your cost basis is $1 million, and the company value is $11 million today. You read this article and took advantage of Act 60. You make the move and are sitting on a Puerto Rican beach. To simplify the math, assume your business remains valued at $11 million.
You keep running your business for a while and benefit from paying the flat four percent Puerto Rico business income tax instead of 43 percent in U.S. federal and state income taxes. Later, you sell your company for $20 million. You will owe U.S. federal capital gains taxes on the $10 million gain that occurred while living in Massachusetts (the $11 million value minus $1 million cost basis).
The capital gain increase of your company while you were in Puerto Rico was $9 million (the $20 million sale price minus the $11 million valuation when you qualified for Act 60). Instead of paying the U.S. Treasury $1.8 million, which would be its 20 percent share of that gain, you keep it all.
Keep in mind many sales are comprised of an earn-out. If you still lived in one of the 50 states, the earn-out would be taxed up to 37 percent federally, plus state rates. Under Act 60, those payments would be taxed at four percent flat. The acquirer of your firm wants to push as much of the purchase price to an earn-out because they can deduct the cost. A buyer’s deduction is your ordinary income, taxed at 37 percent. However, if your income tax rate has dropped to four percent, and theirs hasn’t, you can arbitrate that difference and negotiate a higher sales price.
On average, the cost of living in Puerto Rico isn’t much different than residing in the states; it’s about 10 percent less expensive. If you consider cost-of-living adjustments, other offshore options are available. These include the Virgin Islands, Costa Rica, Ecuador, Nicaragua, Thailand, Mexico, Panama, Argentina, Trinidad, Romania, Chile, Poland, Brazil, Malaysia, and Greece.
With so many choices, quality of life may mean more to you than tax incentives or cost. Spend some time, and maybe company money, exploring your options before committing.
This article first appeared in the Berkshire Eagle on May 19, 2023.