Recently, the IRS announced a new campaign intended to identify individuals who failed to include income on U.S. tax returns based on their recent relocation to Puerto Rico. The announcement is related to Act 22, which seeks to attract new residents to Puerto Rico by providing a total exemption from Puerto Rico income taxes on all passive income once an individual becomes a resident of Puerto Rico. 

While the focus of these IRS investigations is on individuals, the IRS is also looking into sham corporations used to benefit from Act 22’s tax advantages. This is only the most recent effort by the federal government to crack down on those seeking to take advantage of illegal tax havens outside the continental United States. 

What Is Act 22?

Individual Investors Act (Act 22) was passed by Puerto Rican lawmakers in an attempt to attract new, high-income residents. The Act allows qualifying residents to claim a number of tax advantages upon becoming a bona fide resident of Puerto Rico, including:

Capital Gains Exemptions:

• All accrued capital gains income after becoming a resident is exempt from any tax imposed by Puerto Rico.

• All unrealized capital gains income that was accrued but unrealized before becoming a Puerto Rican citizen is subject to a lower tax rate. 

Passive Income Exemptions:

• All new residents’ dividend and interest income is exempt from Puerto Rican income tax.

• All interest and dividend income that constitutes a “source of income” is exempt from federal income taxation under Section 933 of the IRS Tax Code.

To establish residence under the Act, someone must create a presumptive residence in Puerto Rico, live there for at least 183 days of the year, and cannot have a home outside Puerto Rico. Additionally, a resident cannot have a “closer connection” to any other U.S. state or country than the connection they have to Puerto Rico. 

Since the Act’s passage in 2012, more than 4,000 individuals and corporations have relocated to Puerto Rico. Presumably, many of these relocators did so to take advantage of Act 22’s tax benefits. 

The IRS’s Problem with Act 22

While the IRS does not take issue with those who legally relocate to Puerto Rico to take advantage of the benefits provided by Act 22, it announced its intent to look into whether recently relocating parties are complying with their federal tax obligations. There are several scenarios the IRS has expressed concern over:

1. Individuals who excluded income that is subject to federal tax; 

2. Individuals who fail to report all income to the IRS and reported in only to Puerto Rico as exempt income; and

3. Individuals who falsely claim to be bona fide residents of Puerto Rico.

The IRS efforts come in the wake of much broader concerns over wealthy individuals taking steps to avoid their federal tax obligations. Indeed, Treasury Secretary Janet Yellen recently explained that, if left unaddressed, the tax gap could expand to $7 trillion annually. 

Proving Puerto Rican Residence

As the IRS continues to investigate tax violations related to Act 22, more about the extent of the agency’s investigation in these cases is becoming known. Many of the IRS investigations relate to the false claim that someone is a bona fide resident of Puerto Rico. 

Taxpayers may think that leasing a home or apartment on the island is sufficient to establish a residence in the eyes of the IRS. However, this is not the case; the IRS will consider all surrounding circumstances when determining whether a would-be taxpayer meets the definition of a “bona fide resident.” 

As federal defense attorney Nick Oberheiden explains, 

“To establish residence in Puerto Rico, it is not enough to spend the required 183 days per year on the island in a leased or rented home. The IRS is going to look to see whether a taxpayer moved their family to the island. Are they involved in local clubs? Do their children go to school in Puerto Rico? Did they purchase a vehicle in Puerto Rico or move their important personal belongings there? All of these questions are relevant in the IRS’s eyes. Those who half-heartedly relocate to Puerto Rico to benefit from Act 22’s tax advantages are at risk of incurring the wrath of the IRS.”

The IRS indicated that it will pursue investigations and enforcement through examinations, outreach, and soft letters. Soft letters fall short of a total IRS tax audit but involve some of the same review procedures. However, while incurring tax liability is certainly a concern, the real threat is if the U.S. Department of Justice decides to get involved by bringing tax evasion charges against those found to have withheld or failed to report taxable income. 

Notably, in 2020, the Department of Justice indicted the head of BDO Puerto Rico’s Tax Division for allegedly violating the rules of Acts 20 and 22. The special agent overseeing that case explained, “Federal and Puerto Rican tax laws have been put in place to invigorate the economy and provide financial relief to Puerto Rico. 

IRS Criminal Investigation will vigorously pursue any individuals and professionals that fraudulently enrich themselves by abusing government tax incentive programs.” While it may be too soon to tell whether individuals face a similar fate, the possibility should certainly be on their radar.