Puerto Rico Tax Incentives: the Ultimate Guide to Act 20 and Act 22
In old-world Italy, insolvent money changers would suffer the fate of having their changing tables broken in half. Thus was born the Italian term banca rotta, the root of the English word bankrupt.
Today, money changers are not the only ones with broken tables; even sovereign nations have suffered the fate of bankruptcy. However, some have weathered the calamity better than others while certain countries manage to escape entirely unscathed.
Of course, no one truly “escapes” bankruptcy, they merely delay the inevitable. When you’re a rich imperialist country that once controlled the world currency market, you can kick the can down the road for decades before the real day of reckoning.
When you’re a sunny island outpost of that imperialist power, you may not be so lucky.
Such is the case for Puerto Rico.
Completely bankrupt and scrambling for money, Puerto Rico has done what many countries do when trying to boost their economy, they have created attractive tax incentives to encourage foreign investment.
Puerto Rico’s main focus has been to draw in US corporations and investors seeking tax relief from US citizenship-based taxation.
As an unincorporated US territory, Puerto Rico can offer US citizens several tax advantages that other countries cannot and they have pushed these advantages hard to paint their bankrupt country as a tax haven paradise for US citizens.
This has created quite the buzz in the six years since the program first began, with folks viewing Puerto Rico as an alternative to citizenship renunciation for tax-weary Americans.
But don’t believe all the hype.
While Puerto Rico may be the solution for a small group of people, it is not the ultimate remedy that many claim it to be.
The available programs have many strings attached and, if those requirements don’t fit perfectly into your business and lifestyle plans, you are better off staying away.
While tax rates in the United States are not as high as in many other developed countries, they continue to create a substantial tax burden for US citizens. The larger burden is that, unlike citizens from almost every other country on earth, US persons are subject to US tax on their worldwide income regardless of where they live.
There are numerous tax benefits for expats like the Foreign Earned Income Exclusion, tax credits, and foreign corporations. However, the new Trump tax reform severely limits the extent of many of those benefits to the point that it is now practically impossible to reduce your tax bill to zero by living overseas.
But even before the tax reform changed the rules of the game, there were many US citizens who found it difficult to pack up and leave the only country they had ever known.
They still wanted a more tax-friendly environment, however, so these entrepreneurs and investors often resorted to domestic tax relief options. For years, successful Californians have flocked to Nevada and wealthy New Yorkers have migrated to Florida to enjoy zero state income tax.
Moving to Miami or Las Vegas doesn’t sound that intimidating. The Vegas-to-LA drive is a comfortable, if not boring four-hour stretch, and getting from the Sunshine State to the Big Apple only requires a short, albeit potentially bloody United flight.
However, moving to Florida does nothing to eliminate the much bigger tax burdens of US residents: federal income, Social Security, and Medicare taxes.
Moving to a state with zero income tax may save you a few percentage points but, in the end, the federal government will still have full claim to its share of your hard-earned money.
Enter Puerto Rico.
Puerto Rico’s treasury has long been running on empty and, thanks to the global financial crisis, unemployment rates climbed from their already dismal 10% in 2008 to 17% in 2010.
So, beginning in 2012, Puerto Rico used their special status within the United States to create unique tax incentives that would lure successful employers down to the island to bring capital and create jobs.
Currently, the agreement between Puerto Rico and the United States government allows American investors and corporations (that are willing to relocate to Puerto Rico and establish their bona fide residence there) to only pay Puerto Rico tax on most forms of income.
Because Puerto Rico has a special status within the United States, folks who take advantage of Puerto Rico’s programs can enjoy huge exemptions on federal income tax and reduce their tax rate by as much as 90%.
The two most popular programs offered by the Puerto Rican government are Act 20 and Act 22.
Act 20, also known as the Export Service Act, targets certain service businesses by offering incentives such as a low 4% corporate income tax to qualifying corporations that relocate to the jurisdiction.
Act 22, or the Individual Investors Act, targets high net worth investors with the promise of 0% tax on interest, dividends and capital gains obtained while residing in Puerto Rico as a bona fide resident.
The main catch to these programs is the bona fide residence requirement. You must relocate your center of life to the island and spend at least half the year (183 days) in Puerto Rico in order to qualify.
By becoming a bona fide resident of Puerto Rico, you will no longer be subject to US federal income tax on your Puerto Rico source income as you are now subject to Puerto Rican income tax laws. This, of course, is the main draw of both programs.
While the requirement for bona fide residence is much more lenient than the bona fide residence test under the Foreign Earned Income Exclusion, too many have taken this leniency as a sign that they can fudge the lines and basically live in the US full-time while still qualifying for Puerto Rico’s tax incentives.
No matter how many offshore tax gurus tell you that this is possible, don’t believe them!
This will not work.
The rules may be more favorable overall, but they are still rules and they must be followed. Failing to meet the requirements for the Puerto Rican bona fide residence test can cost you dearly and nullify every effort made to take advantage of these tax incentives.
As long as that is perfectly clear to you, we can now dive in and examine each program in detail.
Act 20 – The Export Service Act
The main premise of the act is incredibly straightforward: set up a Puerto Rican company, establish an office in the country and hire a Puerto Rican worker(s), and qualify to pay only 4% corporate tax on any Puerto Rico-sourced income.
Of course, the devil is in the details, so let’s break this down into parts.
Set Up a Puerto Rican Company
First and foremost, your company must be incorporated in Puerto Rico. If you already have a US company, you do not need to sell your business assets to the new Puerto Rican company in order to make the transition. Instead, you can do a tax-free reorganization of the company to a Puerto Rican corporation.
Since only service-based companies qualify for Act 20’s incentives, you will not need to set up a structure other than a Puerto Rican corporation. However, not all businesses will qualify.
Act 20 clearly stipulates that benefits will only apply to businesses that provide services from Puerto Rico to outside markets. Once again, let’s break down that definition:
1. Provide services: Act 20 only applies to service-based businesses. These services include but are not limited to:
- Advertising and public relations
- Auditing services
- Call centers
- Commercial art and graphic design
- Computer software development
- Economic services
- Electronic data processing centers
- Engineering and architectural services
- Information systems and other technological services
- Investment banking and other financial services
- Legal, tax, and accounting services
- Managerial and human resource services
- Marketing services & consulting
- Medical, hospital and laboratory services
- Research and development
- Scientific or environmental services
- Shared service centers
- Voice and data telecommunications (between persons located outside of Puerto Rico)
2. From Puerto Rico: The business must clearly and unequivocally offer their services from Puerto Rico.
This means that many businesses that are commonly run by expats and digital nomads will not qualify. For example, drop-shipping, Amazon FBA, SaaS, app businesses, online ad arbitrage, affiliate marketing, niche websites and e-commerce sold from a personal website will not qualify since the source of the service provided is questionable.
You may be working from an office in Puerto Rico to run your FBA business, but the service (which is actually a product) is technically provided in the United States.
3. To outside markets: Your business cannot be involved in activities with a nexus in Puerto Rico.
This means that you cannot conduct a trade or business providing services to the Puerto Rican market. These activities include but are not limited to:
- Puerto Rican real estate
- Legal counsel provided within Puerto Rico concerning Puerto Rican law
- Lobbying on the laws and regulations of the Puerto Rican government
- Services provided to Puerto Rican residents and local entities
Establish an Office in Puerto Rico and Hire a Puerto Rican Worker(s)
One of the big qualifiers under Act 20 is to have Puerto Rican people working for you. (Remember, the Puerto Rican government created this tax incentive to address the 17% unemployment rates.) Previously, you were required to hire at least five individuals, but that number has been reduced to one in some cases.
In regards to establishing an “office”, you can work from home and so can your employee if that is what you prefer, but your employee(s) must have full social security benefits and all related employee coverage, including full taxation.
For $10 an hour, you likely won’t be hiring high-level employees, but you also shouldn’t hire a stooge who is sitting in a broom closet doing nothing. They have to be doing real work. If the Puerto Rican government decides to audit you, they will want to see the work that your Puerto Rican employees are actually doing.
Qualify to Pay 4% Corporate Tax
To qualify for the 4% corporate tax, you must apply for a tax concession and obtain a tax exemption decree. The decree lasts for a 20-year term with the possibility of a 10-year extension. All tax benefits will be secured during that term.
Again, the 4% tax can only be applied to business income that is Puerto Rican-sourced. If you live and operate your business in the US, your Puerto Rican corporation, while foreign, could technically be engaged in a US trade or business for US tax purposes and subsequently become subject to high US tax rates on a portion of its income.
If you can avoid doing this and you meet all other qualifications, you will actually qualify for more than the 4% fixed corporate income tax rate. For example, in the case of services that are considered strategic to Puerto Rico, the corporate tax rate could be reduced to 3%.
You will also enjoy 100% tax exemption on distributions from earnings and profits (i.e., 0% dividend tax).
For example, if your Puerto Rican company makes $100,000, it should pay you a reasonable salary – say $60,000 – for which you would pay the full Puerto Rican personal income tax (which is much higher than the 4% corporate tax and includes Social Security and Medicare taxes).
The $40,000 left after taxes is only taxed at the 4% rate and then you can take the rest out of the company as a dividend that is 100% exempt from tax.
Certain businesses will also have 100% tax exemption from personal and real property taxes for the first five years and 90% tax exemption thereafter.
All businesses will benefit from a 60% tax exemption on municipal taxes. And, if your business operates in the industrial development zones of the smaller islands of Vieques and Culebra, your business will receive a 90% tax exemption on municipal taxes.
The Impact of the Trump Tax Reform
It used to be that you could set up a Puerto Rican company under Act 20, qualify for the 4% corporate tax, and then qualify as a Puerto Rican non-resident, thereby exempting yourself from all personal income tax requirements in Puerto Rico.
However, the Trump tax reform changes all of this due to the introduction of the GILTI – The Global Intangible Low-Taxed Income – a new tax law that targets US corporations that own Controlled Foreign Companies (CFCs) for US tax purposes.
Under GILTI, the minimum tax for any US-owned CFC is 10.5%. So, even though Puerto Rico will only charge you 4% corporate tax, the US will take another 6.5% from your CFC if you are a US person.
The only way to get around this and to reduce the rate to the 4% offered through Act 20 is to become a bona fide resident of Puerto Rico. If your business is majority owned by a Puerto Rican bona fide resident (you), it will no longer be considered a US-owned CFC and you will receive all the advantages described above.
The good news is that US citizens can use Act 20 to avoid the new CFC rules and all GILTI implications (even if they own 100% of the shares in their company) if they become a bona fide Puerto Rican resident.
The catch is that you have to become 100% compliant with Puerto Rico’s bona fide residence provisions, which means spending at least 183 days in Puerto Rico every year and moving your center of life to the island.
Act 22 – The Individual Investors Act
Because of the incentives provided, Act 22 is an attractive offer for traders, crypto investors, and anyone looking to sell a business or who has a large amount of passive income or capital gains from any source.
Establishing Bona Fide Residence
You must be a bona fide resident of Puerto Rico for an entire tax year before you can receive the benefits offered under Act 22.
This does not necessarily mean that you have to be in Puerto Rico beginning January 1st but that you must spend 183 days or more in Puerto Rico between January 1st and December 31st of any given tax year.
If you decided to move to Puerto Rico in November of this year, for example, you wouldn’t qualify for the Act 22 benefits until 2020 because you would not have spent enough time in Puerto Rico in 2018 to receive the benefits in 2019. Therefore, the 2019 tax year would be the first full taxable year for which you could claim residence, qualifying you for the 0% dividend tax in 2020.
But it’s not just about the number of days you spend in the country. People think they can spend 183 in Puerto Rico and 182 in Los Angeles and qualify as a bona fide Puerto Rican resident.
That’s not going to work.
It’s not just a numbers game, you also have to prove that Puerto Rico is your center of life. And that means that you really have to move there. You can spend time in the US, but you cannot spend more time in the US than in Puerto Rico and you must always come back to Puerto Rico.
The same can be said of travel to anywhere else in the world. You may be a nomad bouncing around or you may be quasi-nomadic and go to Asia for a month and then Russia for a month, but you always go back to Puerto Rico. It is the center of your operations.
If you have other homes, you have to prove that your Puerto Rican home is more significant than all the rest. You can prove that Puerto Rico is the center of your life by building the case for two specific arguments:
- You have no other tax home outside of Puerto Rico
- You have no closer connections to any other place
1. No Other Tax Home
Your tax home is the center of all your economic activity. Your office is your tax home, which means that if you’re commuting between Puerto Rico and your office back in the US or any other location, Puerto Rico won’t really be considered your tax home.
You must move your office to Puerto Rico.
And, while you can technically still have bank accounts in the US, it will not help your case if you run all of your financial activity through those accounts. You need to show every economic connection possible to Puerto Rico, including movement through your Puerto Rican bank accounts.
2. No Closer Connections
You can build the argument that you have no closer connections to any other place by showing evidence that you have moved the rest of your life to Puerto Rico. This evidence can include having a permanent home in Puerto Rico, moving your family and personal belongings to the country, and establishing social, political, cultural, professional and religious ties in Puerto Rico.
You should also obtain a Puerto Rican driver’s license, declare Puerto Rico as your official country of residence on all forms and documents, and register to vote in Puerto Rico. In fact, voter registration is not even an option. You have to vote in Puerto Rico to truly make your case.
Time Spent Outside of Puerto Rico
A lot of people will argue that, as long as you spend 183 days in Puerto Rico each year, you can spend the other 182 days in the United States. This is a risky move that could cost you tens of thousands in taxes.
It’s not worth the risk.
Remember, you are building your case to prove that you have moved your whole life to Puerto Rico. Yes, you can spend time in the US, but plan on a few months a year, not a full six months.
Either live in Puerto Rico or don’t do it. I can’t emphasize that enough. Do NOT cut corners.
Now, let’s go back to the original terms of Act 22 and focus on how the tax incentives work once you have established your bona fide residence. The big draw of Act 22 is the 0% tax applied to all capital gains earned during your bona fide residence in the country.
Here’s where a lot of people get confused. They think that they can simply move down to Puerto Rico and then sell their business or their crypto investments without having to pay any capital gains.
That’s not how it works.
Remember, it is 0% on capital gains earned during your bona fide residence in Puerto Rico.
This means that only Puerto Rican capital gains can be taxed at the 0% rate, requiring a pro-rata allocation of any assets that you owned prior to establishing your bona fide residence in Puerto Rico. Only the portion of the appreciation that accrues while you’re a bona fide resident of Puerto Rico is considered Puerto Rican source.
For example, if you have held crypto for a year before you decide to move to Puerto Rico and you then live in Puerto Rico for another two years before selling your crypto investments, you will have to pay regular US capital gains tax on a third of that amount.
Only the amount that accrued while a bona fide resident qualifies for the 0% rate.
The same applies to anyone looking to sell a business. If a guy came to me today who was considering moving to Puerto Rico to take advantage of Act 22 in order to sell his business and evade the capital gains tax, I would have to give him some bad news.
If he has owned his business for long, his time spent in Puerto Rico would barely make a dent. If he wants to sell the moment he establishes his bona fide residence, he’s not going to get any tax relief at all. He is going to pay tax in the US for all the time that he ran that business in the US.
Act 22 is better suited for someone who wants to sell their business or assets in five years. It’s not for someone trying to pull a fast one and evade taxes altogether.
It is also important to note that it doesn’t matter if you’ve been offshore. The pro-rata allocation is based on the time that you were a US person versus a bona fide Puerto Rican resident.
If you have been living as a nomad offshore and you move to Puerto Rico, become a bona fide resident, and later sell your business, the time you spent offshore utilizing the Foreign Earned Income Exclusion still counts as being a US person. You would still be subject to the full capital gains tax with the pro-rata deal.
For instance, if you’ve owned your business for five years while traveling as a nomad, decide to move to Puerto Rico, and then sell your business five years later, you will pay tax on half the capital gains in the US and half in Puerto Rico at the 0% rate.
You only get an exemption on what you earn while a bona fide resident of Puerto Rico, which is why, as always, it’s worth getting off your tuchis and doing something today.
What’s Wrong With the Puerto Rican Tax Haven?
Puerto Rico’s programs are the number one area where I see people cutting corners. People try to pull every scam in the book. I hear it all the time and see comments on my blog from readers arguing that you can just pretend that you’re living in Puerto Rico and still get the benefits.
And the fact that so many people try to cut corners with these programs could jeopardize their longevity. As someone who insists on doing everything 100% legal, the amount of corner cutting in Puerto Rico is a clear sign to someone like me to just stay away.
Most of the people I’ve met who are following the requirements still seem to be flying by the seat of their pants a little bit. Overall, it feels like Puerto Rico’s programs attract the wrong people and the amount of fraud taking place is a clear sign that the program won’t hold.
After all, Act 20 and Act 22 were brought into existence by the stroke of a pen and they can be gone just as fast. Technically, once you have secured a decree, your personal benefits will be guaranteed for the next 20 years, but all it takes is for the US government to come in and declare that the party is over for those benefits to go away.
The problem is that Puerto Rico is ultimately accountable to the US government. If you’re going to move, move somewhere good. Don’t settle because you’re afraid of some monster under the bed outside of the United States. If you can move to Puerto Rico, you can move to Panama or anywhere else on earth.
My key is to live somewhere not under the control of Washington, DC.
I don’t mean to say that living in Puerto Rico is a horrible idea, but why live in a bankrupt country under the thumb of the US government – a country that has a long history of excessively demanding tax laws – when you have so many other good options?
The idea that the US government would be excited to see its own citizens take their money and flee to Puerto Rico, a US territory, all while standing idly by and doing nothing is silly.
That is why the idea of moving to Puerto Rico with the goal to save on taxes is troubling to me.
Do you want to go to a country that rolls out the red carpet only when it gets desperate, or because it’s the way they do business? I’d rather trust my money and my business to a place that wants me, but doesn’t need me.
My biggest beef with the program though is that it is undeniably subject to change. In fact, I suspect that if Puerto Rico’s programs gain any kind of momentum, they are going to be dead.
Like so many things, the IRS and Congress will let Puerto Rico attract a few rich people until it gets out of hand and then the tax incentives will be targeted and the programs will disintegrate. We have already seen this process begin with the introduction of the GILTI.
And then there’s the potential that Puerto Rico could become an actual US state. While it’s a long shot, that would be the quickest way to kill the program. Just one year ago (2017), Puerto Rico held the latest in a long string of votes on the issue of statehood.
While the odds of Puerto Rico becoming a state are low, the uncertainty reminds me that the best way to distance yourself from the IRS isn’t to go hang out in a US enclave with a tax policy that could fall apart tomorrow.
Who Does Puerto Rico Help?
Act 20 is the less attractive option simply because, if you’re a business owner and you want to set up a bona fide residence somewhere, there are a lot better places than Puerto Rico where you could establish residence, pay zero tax, and still spend 120 days on average in the US.
If that’s the case, why would you want to be tied down to Puerto Rico?
However, if you want to be in Puerto Rico and you have large capital gains, then Puerto Rico is a better option because even the Foreign Earned Income Exclusion won’t protect you from taxes on passive income and Puerto Rico can.
If you’re making big money, Puerto Rico can also offer more relief than the $104,100 exemption on active income available through the FEIE because you can take all the money out of your business tax-free (after the 4% corporate tax, of course) instead of keeping it all in your business.
Puerto Rico may also be a good option for folks who are hesitant to renounce their US citizenship or who cannot renounce yet because they do not have a second passport. Depending on your second passport strategy, Puerto Rico could serve as a midway jumping off point as the time you spend there while obtaining your second passport could reduce your overall tax liability before renouncing.
But you have to really commit to living in Puerto Rico to make this work.
Going Offshore Works Better For Most People
For most expats and digital nomads, remaining outside the United States and utilizing the Foreign Earned Income Exclusion with an offshore structure is the better option.
You will have the freedom to be more nomadic and you will not have to deal with the requirements of staying in one place and providing evidence of your tax home and closer connections.
Even if you prefer setting up a bona fide residence somewhere so that you can spend more time in the United States, you can become a bona fide resident in Malaysia or Panama or Georgia and still get great tax benefits, Then, when you want to change your bona fide residence to another location, you can do so with proper notice without sacrificing those tax benefits.
Once you liberate yourself and become open to the notion of doing business ANYWHERE, why go somewhere with as many limitations and drawbacks as Puerto Rico? There are legal ways for US citizens and residents to reduce their US tax obligations by setting up companies and living overseas – Puerto Rico is not your only option.
For example, if you make $150K net profit and you set up an offshore company, the first $104,100 would be exempt from tax under the Foreign Earned Income Exclusion, and the next $50,000 would be subject to 10.5% GILTI, which is very similar to what you would get in Puerto Rico.
At those rates it’s better to use a foreign structure instead of a Puerto Rican structure because the cost of living is much higher in Puerto than in many other countries where you could be spending your time, you won’t have the obligation to be in one place, and there are fewer commitment costs (i.e., no need to buy real estate, hire employees, etc.)
Renouncing Is the Only Legal Out
If your goal is to completely exit the US tax system, the only legal out is through citizenship renunciation. And, depending on your net worth and your individual situation, you may get more benefits in terms of selling your assets, a company, cryptocurrencies, etc. by renouncing.
I have spoken to several former US citizens who considered moving to Puerto Rico but ultimately decided to renounce US citizenship; none of them regret their decision and they are happy that they solved their problem rather than merely reduced it.
At my core, I am a pragmatist who believes in finding opportunities to legally lower or eliminate tax. However, I also believe that when the ship is sinking, you shouldn’t simply go up to a higher deck.
If you’re making the kind of money where Puerto Rico’s tax incentives help, spend the $100,00 and buy a St. Lucia passport and renounce. I’m not saying that renouncing US citizenship is the only option besides moving to Puerto Rico, but if you believe that the tax obligations and investment restrictions on US citizens are draconian, it’s time to jump ship.
It’s Worth a Call
For my money, becoming tax resident in Puerto Rico to cut your US tax bill is the right choice for a very small percentage of the population seeking friendlier shores.
For the average entrepreneur, Puerto Rico never made a lot of sense.
Set aside the potential risks, the paperwork, and the fact that you still do need to pay some tax to take advantage of the program. You also need to live in Puerto Rico. Like really, truly live there.
I’ve spoken to several people who were sold on the program by some fancypants tax guru in a skyscraper, and none of them were ecstatic with their choice.
Treating symptoms rather than causes isn’t good in medicine, and it isn’t good when deciding to go offshore either. Finding a solution that gives you the end result you want – from a better, cheaper lifestyle to lower taxes – generally means looking beyond shiny objects like Puerto Rico.
The entire goal of internationalization is to protect yourself from threats from insolvent nations like the United States. Fleeing to a territory of the United States to solve your tax problems seems like a precarious situation, at best.
My five magic words are not “go where you’re treated a little bit better”; they are “go where you’re treated best.”
Still, there may be some unique cases where Puerto Rico really is the best option for you.
That is why it’s worth getting on a call with someone who’s not trying to sell you Puerto Rico or any particular strategy. Puerto Rico could work for a limited number of people who understand the law and who are actually willing to follow it, but there are a lot of potential minefields and you will need to work with someone who is willing to walk you through them rather than turn a blind eye to the many issues that could come up with Puerto Rico’s tax incentives.
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