Did you know that the United States has one of the strictest tax policies in the entire world?
The vast majority of nations require people to pay taxes based on residency. The United States, however, joins Eritrea as one of two nations on the globe that taxes its citizens based on citizenship.
In other words, US citizens have to pay taxes in the US, regardless of whether or not they live and work abroad. This makes the United States one of the only countries to legalize double taxation.
Recently, there has been an increased interest in the potential of Puerto Rico as a tax haven. On paper, becoming a Puerto Rican tax resident seems great. The territory lowered its corporate tax rate to a mere 4%.
However, because the US is so stringent about its taxation rules, many Americans wonder if Puerto Rican tax residency is really a viable option. Can you choose to pay taxes in Puerto Rico? Or, are the rumors all a lie?
Read on to learn everything that you need to know about the so-called “Puerto Rican tax haven.” Who knows? You may even end up becoming a Puerto Rican tax resident.
What Is Puerto Rico?
Puerto Rico is an island located in the Gulf of Mexico. It was inhabited for centuries by an indigenous population, before becoming Spanish territory in 1508. The United States acquired Puerto Rico in 1898.
Because Puerto Rico is part of the United States, there exists a lot of confusion about what exactly the island is. Is it a state? Is it a protected land? Is it a different country?
In short, Puerto Rico is not a different country from the US. As the island is part of the United States, Puerto Ricans have the right to hold an American passport. They can also vote in some US elections.
In turn, Americans can travel freely between Puerto Rico and the US mainland. They don’t need a passport to travel to the island. And they can move to Puerto Rico without undergoing cumbersome immigration processes.
However, in spite of this strong connection. Puerto Rico is not a US state. As a result, Puerto Ricans are exempt from paying several different kinds of federal tax.
Are Puerto Rican Local Taxes Considered State, Territorial, or Federal Taxes?
Because Puerto Rico is not a state, local taxes are not considered “state taxes.” Since the island is not an independent country, it also doesn’t have the power to enforce its own federal taxes.
Instead, Puerto Rican residents pay a special kind of local tax. These taxes are called “Common Wealth Taxes,” and they are paid to the Internal Revenue Code of Puerto Rico.
This local code establishes the rates for territory-wide income taxes, as well as inheritance taxes, gift taxes, and property taxes. The code also includes the high Puerto Rican 11.5% sales tax.
Interestingly, most Puerto Rican residents only pay commonwealth taxes. In other words, the majority of Puerto Rican residents do not have to pay, or even file for, US federal taxes.
Are Puerto Rican Commonwealth Taxes High?
But how do the Puerto Rican tax brackets compare to US federal tax brackets? Does Puerto Rico tax its residents at a higher or lower rate than the US federal government?
The answer to that question depends a lot on how much money you make. However, in general, Puerto Rican taxes are considerably lower than US taxes.
In Puerto Rico, the first $9,000 is completely tax-free. Meanwhile, in the United States, your first $10,000 is taxed at 10%. This is great news for the working class!
However, a lot of middle-class people might find that Puerto Rico taxes them at a higher rate than what they are used to. This is because the highest tax bracket in Puerto Rico starts at just $61,000.
Every dollar of income surpassing this amount is taxed at a whopping 33%.
While this might be shocking for some Americans, others love this policy. The highest tax bracket in the United States pays a federal income tax of 37%. Meanwhile, in Puerto Rico, nobody pays more than 33% in taxes.
In that sense, a lot of wealthy people would benefit from Puerto Rico’s tax policy.
Do Puerto Rican Residents Have to Pay US Federal Taxes?
According to the American Internal Revenue Service (IRS), most Puerto Ricans do not have to pay US federal taxes. In fact, most bona fide residents of the island don’t even have to file for federal income taxes.
This all may sound really exciting. But before you pack your suitcases, you should know that there are some caveats to this rule.
Caveat #1: Where Does Your Money Come From?
Skipping out on federal income taxes might sound appealing. However, in most cases, it’s also illegal.
The “no federal income tax” rule only applies to Puerto Rican residents who earn 100% of their money from local, Puerto Rican sources. In other words, if you live and work in Puerto Rico, you don’t have to pay US federal taxes.
However, Puerto Rican residents who work in the US still have to pay US federal taxes. This means that if you have a restaurant in Dallas, you still have to pay federal taxes. The same is true for freelancers and digital nomads.
It doesn’t matter if you live in San Juan or in Miami. If you earn money from sources in the US, the IRS will be expecting your yearly tax return come April.
Caveat #2: Who Is Your Employer?
If you are a Puerto Rican resident, you might have to pay US federal income taxes. It all depends on who you work for.
Employees of local, Puerto Rican businesses don’t have to pay US federal income taxes. The same is true for employees of large, multi-national companies, like hotels or restaurants.
However, employees of the US government have to file for federal income taxes. It doesn’t matter you are a resident of Puerto Rico or New York. If the US government signs your paycheck, you owe money to Uncle Sam.
Caveat #3: How Bona Fide Is Your Residency, Really?
The United States government loves to tax its citizens. It doesn’t matter where in the world you go. If you are American and earn an income, you have to file taxes.
Because of this policy, the IRS doesn’t love it when Americans go to Puerto Rico for tax purposes. They want to make sure that everyone is really paying the taxes that they owe.
Moving to Puerto Rico for tax purposes can even be considered tax evasion. In fact, the IRS is actively hunting down these “fake Puerto Rican residents” to make sure they are paying their fair share of taxes.
So, how do you know whether or not you qualify as a Puerto Rican resident? Who does the IRS consider Puerto Rican, and who doesn’t have to pay federal taxes?
As the IRS mentions on their website, only bona fide Puerto Rican residents can qualify for federal tax exemption. Bona fide is a Latin term that means “genuine” or “real.”
This means that you can’t just fly down to Puerto Rico for a weekend, rent an apartment, and file for local taxes. In order to file for Puerto Rican residency, you have to authenticate your status as a local resident.
The main way to achieve this is to actually live in Puerto Rico. As the IRS explains in their definition of Puerto Rican residency, residents of the territory spend the whole year there.
So, if you spend the winters in San Juan and the summers in Chicago, you are still a tax resident of Illinois. In order to be considered a Puerto Rican tax resident, you have to live in Puerto Rico for the whole year.
How Can Someone Become a Bona Fide Puerto Rican Tax Resident?
Because of the special arrangement between Puerto Rico and the United States, it’s quite common for Americans to move to Puerto Rico.
Some Americans wish to work and live in the territory. Others, however, just want to reap the island’s tax benefits. Regardless of your particular situation, it is not easy to file for Puerto Rican tax residency.
If you want to become a Puerto Rican tax resident, you will need to fulfill a few requirements that have been defined by the IRS. These three requirements are presence, tax home, and closer connections. Read on to learn more.
Requirement #1: Presence
As mentioned above, this is definitely one of the most important factors in your application for tax residency. Random vacationers can’t suddenly claim Puerto Rican residency. To qualify, you have to live there.
But, how are those terms defined? Is it enough to rent an apartment in Puerto Rico? Does having a Puerto Rican job help you establish your presence?
The truth of the matter is that presence is all about mathematics. The IRS is less interested in your rental house than they are in the number of days that you’ve spent in Puerto Rico.
You must spend 183 days per tax year in Puerto Rico in order to prove presence. Alternatively, you can spend only 60 days there per tax year, if you have also spent 549 days there in the last 3 tax years.
At first glance, this might not seem like an extraordinary amount of time. 183 days is equal to six months. Thus, it would be easy to think that a person could spend half the year in Puerto Rico and half the year on the mainland.
Not so fast.
There is a major twist to these rules. In order to qualify as a Puerto Rican tax resident. you cannot spend more than 90 days per fiscal year on the US mainland. This means you can’t spend more than 3 months in your home state.
Because of these strict rules, becoming a Puerto Rican tax resident requires a lot of commitment. If you want to pay taxes in Puerto Rico, you have to be willing to live there full-time.
Requirement #2: Tax Home
We have outlined the main points of this requirement above. Maintaining a “Puerto Rican tax home” is just a fancy way of saying that your income comes from Puerto Rico.
This is very easy to prove if you are physically working in Puerto Rico. An employment contract should be more than enough to prove that Puerto Rico is your tax home.
For business owners and entrepreneurs, this process is a bit more complicated. Opening a small business in Puerto Rico should be enough to establish that the island is your “tax home.”
However, this only works if you do not source part of your income from the US mainland. Anyone who earns more than $3,000 from an American company in any given year is automatically disqualified from Puerto Rican tax residency.
Therefore, you have to establish yourself as financially dependent on the Puerto Rican economy in order to become a tax resident of the island.
Requirement #3: Closer Connections
Of all three points, this is the most subjective one. As a result, it is also the most difficult point to prove.
Closer connections are defined by factors like your social network. And, no, this isn’t a reference to your online friends. On the contrary, closer connections are about roots.
Where did you open your current bank account? Where do you vote? What state or territory is on your divers’ license? While these factors might seem like bureaucratic details, they actually say a lot about you.
If you truly consider Puerto Rico your home, you will bank, vote, and drive in Puerto Rico. However, as you have probably guessed, closer connections go well beyond these three activities.
Closer connections also entail your friendships and family connections. Do you have friends in Puerto Rico? Do you engage in any religious community there? What about other kinds of clubs, groups, organizations?
In terms of family, these questions become even more intimate. Where does your spouse live and work? What about your children? Are they enrolled in Puerto Rican schools?
All of these factors can help determine how closely tied you are to Puerto Rico. If you truly live, work, and socialize on the island, it shouldn’t be too hard to obtain residency.
However, if you are looking for a quick way to cut costs, obtaining a Puerto Rican tax residency may not be viable.
Why Do Business Owners Call The Island: “The Puerto Rican Tax Haven”?
Depending on how much money you make, Puerto Rican taxes can either help you or hurt you. However, depending on how you earn your money, Puerto Rican taxes might be wonderful.
The reason? Puerto Rico is actively trying to attract entrepreneurs and foreign investors. Because of this, businesses based in Puerto Rico pay very low tax rates.
At just 4%, the corporate tax rate in Puerto Rico is one of the lowest in the world. In fact, it’s more than 5 times lower than the US corporate tax rate of 21%. This makes Puerto Rico a very attractive location for businesses.
While the 4% corporate tax rate is already quite attractive, Puerto Rico offers other benefits to businesses.
Businesses based in Puerto Rico do not pay tax on capital gains, interest, dividends, or royalties. They have a 50% exemption from municipal taxes. They also get a 75% exemption from property taxes.
Finally, businesses based in Puerto Rico do not pay taxes on distributions from earnings or profit.
Which Businesses Qualify for Massive Puerto Rican Tax Breaks?
Before you get too excited about Puerto Rico’s corporate tax policy, remember that not every business qualifies for all of these exemptions.
The Puerto Rican government didn’t introduce these tax breaks as a favor to business owners. Rather, they created these tax policies in hopes of lifting up the local community.
As a result, the Puerto Rican government expects businesses to make certain changes in order to cash out on these benefits.
For one thing, they require business owners to give back to the community. This can be achieved in the form of a charitable contribution to a local organization.
This contribution must be a minimum of $10,000. And it has to be paid on an annual basis.
In addition to the charity requirement, the Puerto Rican government wants business owners to invest in property. For a business to take advantage of that 4% tax rate, the business owner must purchase property in Puerto Rico.
However, said property cannot be just any plot of land. To cash out on these benefits, a business owner must invest in a Puerto Rican residence. This residence must become the business owner’s primary residence to qualify.
Do I Have to Be a Puerto Rican Resident to Qualify for Corporate Tax Cuts?
The answer to this question is: yes. If you are not a Puerto Rican tax resident, your business cannot benefit from the 4% corporate tax rate.
It doesn’t matter if you make your charitable donation or buy a house. Only Puerto Rican residents can benefit from these business taxes.
And if you exaggerate your company’s ties to the island, you could go to jail. In late 2020, the CPO of DBO Puerto Rico was arrested for fraud. He tried to take advantage of Puerto Rico’s tax code, despite the company’s strong US ties.
According to court documents, the CPO in question tried to “abuse” Puerto Rican tax codes.
As the prosecution explained in a statement, the purpose of these tax codes is to stimulate the local economy and “provide relief” to Puerto Rican residents. The code was not created so that Americans could avoid paying taxes.
This case illustrates the reality that the IRS doesn’t want people to abuse Puerto Rican tax laws for their own benefit. At the end of the day, Puerto Rico offers tax breaks to people who are serious about living there.
However, the IRS does not appreciate it when people and businesses try to cut corners to evade taxes. Therefore, you should not take advantage of these incentives unless you actually work and live in Puerto Rico.
So, Should I Use Puerto Rico as a Tax Haven?
The answer to this question is actually fairly simple. If you intend to live and work in Puerto Rico full-time, you should pay taxes in Puerto Rico. Otherwise, you shouldn’t even consider Puerto Rico a viable option.
The truth is that only two types of mainland Americans should pay taxes in Puerto Rico. People who got a job in Puerto Rico should pay taxes there. People who are opening Puerto Rican businesses should pay taxes there.
If you do not fall into one of these two categories, it is a bad idea for you to try to become a Puerto Rican tax resident.
As mentioned above, the IRS is one of the most strict tax bodies in the entire globe. If the US government suspects that you moved to Puerto Rico as part of a tax evasion scheme, you won’t just be in big trouble. You may also go to jail.
Learn About Other, More Realistic Ways to Save Money on Your Taxes
In recent months, the idea of the Puerto Rican tax haven has become somewhat of a legend. With a low 4% corporate tax rate, the island has grown increasingly attractive for most business owners.
However, it’s important for people to keep in mind that these special tax incentives are meant to boost the local Puerto Rican economy. They were not created to help non-Puerto Rican businesses cut costs.
As a result, anyone who falsely claims Puerto Rican tax residency could get into serious trouble with the law. Tax evasion is illegal in the United States and the Commonwealth of Puerto Rico. It could lead to arrest and imprisonment.
So, how can you save money on taxes without filing for Puerto Rican tax residency?
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