PAY 4% TAX RATE ON ACTIVE INCOME AND NO TAX ON PASSIVE INCOME…
Dear Clients, Colleagues, and Friends,
The just-released version of this Client Alert mandates a correction. Only Resident Aliens of Puerto Rico qualify for estate tax treatment, not United States citizens, as erroneously reported. (Occasionally we get it wrong and when we discover our mistake, we immediately rectify.)
This is not a typo. Yes, you can reduce the tax on your active income to 4% and eliminate the tax on your passive income, including short and long term capital gains, by becoming a resident of Puerto Rico. Puerto Rico is only a 2 hour plane ride to Miami and 4 hours to New York.
This week there was quite the buzz in the financial news when it was reported the famous hedge funds manager, John Paulson, and his $9.5B hedge fund investment, might be going to Puerto Rico and becoming a resident to take advantage of their recent tax law changes. Doing so would allow Paulson and other US investors and business owners the ability to reduce the tax rate on their active income to 4% and to reduce the tax on passive income (including short term and long term capital gains) to zero tax. You read this right – 4% on active income and zero tax on passive income.
Puerto Rico’s politicians believe they can spur investment and economic activity in Puerto Rico by changing their tax code. Puerto Rico passed a series of reforms, including the Individual Investors Act (Act 22-2012 and 138-2012), which qualified anyone who has not been a resident of the territory in the past 15 years but establishes residency in Puerto Rico before the end of 2035. To qualify for the exemptions granted under the Act, every Resident Individual Investor (a tax resident qualifying under the Act) must meet certain statutory requirements, including requesting a tax exemption decree from the Secretary of Economic Development and Commerce.
Generally, to qualify for the zero capital gains tax, you must not have been a resident of Puerto Rico at any time during the 15 years preceding the effective date of the Act, January 17, 2012, and become a resident on or before December 31, 2035. For Puerto Rico and US tax purposes, to qualify for residency status, you must:
Reside in the country for at least 183 days during the calendar tax year;
Puerto Rico must be considered your “tax home,” i.e., principal place of business; and
Meet the Closer Connection Test, i.e., voter’s registration, driver’s license, residence, spouse and minor children reside and attend school
The Puerto Rico tax rules would be particularly attractive for the active investor who is generating short term capital gains and the day trader who is constantly churning his or her accounts.
For the taxpayer that has operating companies in the United States but wishes to reduce the taxes on their operating businesses and convert taxable income to non-taxable dividends, one would become a resident of Puerto Rico, establish a local company to provide management and consulting services to their US based companies, withdraw a taxable salary of up to $250,000 from the new company, and then receive dividend distributions for the remaining profits tax free. The company would only be subject to a 4% Puerto Rico income tax. This structure could be used by taxpayers that render services to clients in the United States, such as money managers and other providers of financial services.
The Puerto Rico exemption is worthless if federal income taxes must be paid on the interest, dividends, and capital gains exempt from Puerto Rico income taxes. However, pursuant to the IRC, the Puerto Rico source income of bona-fide residents of Puerto Rico is not subject to United States federal income tax, and the capital gains and dividends from the Puerto Rico service company constitute Puerto Rico source income exempt from United States federal tax. Thus, the interplay between the Puerto Rico exemptions and the IRC exemption of Puerto Rico source income result in these extraordinary tax savings. It’s all legal and permitted by Puerto Rico law and the IRC.
Like everything tax related, you must be careful to meet the requirements for these extraordinary tax benefits. For more details, feel free to contact the Jeffrey M. Verdon Law Group, LLP.
Jeffrey M. Verdon, Esq.
Jeffrey M. Verdon Law Group, LLP
For more information about any of the information discussed in this Client Alert, or any other income or estate tax planning or asset protection planning assistance, please contact the Jeffrey M. Verdon Law Group, LLP at firstname.lastname@example.org or 949-263-1133.