Be careful with the 2017 version of Puerto Rico’s Act 20 tax holiday

On July 11, 2017, the Governor made some major improvements to Puerto Rico’s Act 20 tax holiday. These revisions made Puerto Rico’s Act 20 “untouchable.” No offshore jurisdiction can come close to the tax deal being offered by this US territory.

Puerto Rico’s Act 20 tax holiday gives your business a 4% tax rate, guaranteed for 20 years. This means you can cut your corporate tax from 35%, plus your state, to 4% by moving your business to Puerto Rico. Dividends paid from a Puerto Rico Act 20 company to a resident of Puerto Rico are tax free.

And only Puerto Rico can offer this tax deal to US citizens. Here’s why:

If you move you and your company from California to Panama, you’ll pay Federal income tax on your profits after taking the Foreign Earned Income Exclusion.

If you move you and your company from California to Puerto Rico, you’ll pay 4% in corporate tax after your salary. For more, see: Panama vs. Puerto Rico (this article was written before the law changes).

• Unlike income earned in a foreign country, income earned in Puerto Rico is excluded from Federal income tax under IRC 933.

However, small business owners must be careful with the 2017 version of Puerto Rico’s Act 20 tax holiday. These law changes make it tempting to try and cheat the system. But rest assured, if and when the IRS catches up with you, they’ll be hell to pay.

If you’re going to use Puerto Rico’s Act 20 tax holiday, be ready to defend it from the US IRS. Expect an audits and for Uncle Sam to take a closer look at these amazing tax deals. Hire a professional to plan and document your Act 20 income and get an opinion letter if you will have any US source income / transfer pricing issues (if any work to generate the money will be done in the United States, you have US sourcing issues).

For an article describing the modifications to Puerto Rico’s Act 20 tax holiday, see: Changes to Puerto Rico’s Act 20 and Act 22.

Here’s why you should  be careful with the 2017 version of Puerto Rico’s Act 20 tax holiday.

To explain why these changes create risk for the small business owner, we need to cover a bit of history. Puerto Rico passed Act 20 in 2012 with the requirement that each business employ a minimum of 3 people on the island. In 2015, the minimum number of employees was increased from 3 to 5.

The purpose of Puerto Rico’s Act 20 is to bring jobs to the island. The territory’s is bankruptcy and in dire need of outside investment. See: How to benefit from Puerto Rico’s bankruptcy (note that this article was published before these changes were announced).

In July of 2017, the government eliminated the employee requirement for most types of businesses. You can now open a business with one employee and qualify for Act 20.

I’m a fan of the employee requirement because it protects the business owner from getting into trouble with the IRS. It protects the business owner from her worst enemy… herself. Here’s why:

Only Puerto Rico sourced income is eligible for the Act 20 tax rate of 4%. Puerto Rico sourced income is business profits earned from work performed in Puerto Rico. If some of the work to generate the income is performed in the United States and some in Puerto Rico, you must allocate profits between these two jurisdictions. PR sourced income is taxed at 4% and US sourced income is taxed at 35% plus your state.

If you shutdown your company in the United States, and move you and your business to Puerto Rico, 100% of your future  profits will be Puerto Rico sourced income. All of the work to earn the money will be done in Puerto Rico, so all income is PR sourced for tax purposes.

Or you might live in the US and set up an independent division in Puerto Rico…

Let’s say you live in the US and set up a division in Puerto Rico. Money you earn from work in the US is US sourced and taxable by the IRS. Likewise, any profits generated by the group in Puerto Rico is Puerto Rico sourced and taxable at 4%.

You can hold PR sourced income inside your Puerto Rico Act 20 company tax deferred. Setting up a division in Puerto Rico while you (the business owner) remains in the United States, gets you tax deferral at 4%. Moving you and your business to Puerto Rico gets you tax free after paying 4% on your corporate profits.

That’s easy enough, but some will try to push the envelope….

And here’s the risk to small businesses: You’re a one man shop operating from California. You want to live in California and move some of your income to Puerto Rico. You set up an Act 20 company on the island and hire one person.

This one employee is basically a personal assistant. They pay the bills, do a little accounting, book your travel, etc. They’re not adding significant value to the product or service being sold. The only reason you hired them is so you can run some of your sales through the Puerto Rican company to get the tax deferral.

Such an employee doesn’t generate any Puerto Rico sourced income. They’re a minor expense for your US business, but won’t help you move a bunch of cash out of the US and into an Act 20 company.

I know a lot of people will try this! They’ll setup sham companies with one or two low level employees and shift millions of dollars of income out of the US and into Puerto Rico. Eventually the IRS will come in and smash all of these businesses.

When a Puerto Rico Act 20 company required 5 employees, no one would bother to hire unproductive workers.  When you needed 5 full time employees, the cost of a fake business was just too high for most players hoping to game the system.

With 5 full time employees, only companies making money from these workers, and thus generating Puerto Rico sourced income, could afford to set up on the Island.  With only one employee required, just about anyone can afford to play in the sandbox.

Here’s my take on how to use the 2017 version of Puerto Rico’s Act 20 tax holiday:

1. If you move to Puerto Rico, and become a resident by spending at least 183 days a year on the island, you can set up an Act 20 business with only 1 employee (yourself). 100% of the work to generate the business income should be done in Puerto Rico.  
2. If you will remain in the United States, and set up a division for tax deferral, plan on having at least 5 employees.

For those building a division of a US company in Puerto Rico, the benefit of the change in the law is that you can grow at whatever pace you like. You’re no longer required to hire 3 employees and then 2 more in a year.

But, don’t get it twisted. Only income from work performed in Puerto Rico creates PR sourced income. If 95% of the work to earn that money is done in California, and 5% in Puerto Rico, then you have very little PR sourced income.

And this allocation of income is done on a qualitative basis, not by hours worked. If you have a team of 50 highly paid programmers in California, and a group of 50 call center workers in Puerto Rico earning minimum wage, the majority of your income is US source.

As I said, setting up a division in Puerto Rico gets you tax deferral. Moving you and your business gets you tax free after the 4% corporate rate. The opportunities available in Puerto Rico for those willing to relocate are incredible and can’t be matched by any foreign country.

And these benefits don’t stop with Act 20. If you move to the island, buy a home within 2 years, and otherwise qualify under Act 22, you’ll pay zero capital gains tax. Act 22 eliminates capital gains tax on assets acquired after you move to Puerto Rico (does not include real estate in the United States).

While there are risks of abuse with Puerto Rico’s Act 20, the benefits are significant for those willing to do put in the time and do it right.

I hope this article on why you should be careful with the 2017 version of Puerto Rico’s Act 20 tax holiday has been helpful. For more information on how to setup your business in Puerto Rico under Act 20, or to negotiate an Act 22 decree, please contact us at info@premieroffshore.com or call us at (619) 550-2743. All consultations are free and confidential.