One of the things that generates political fireworks each year is the number and names of famous Americans renouncing their U.S. citizenship. The number is 2012 was about 1800. Regardless of whether you are politically a liberal or conservative, the topic generates a lot of conversation. For some it is a reaction to the belief that the country is headed in the wrong direction. For others, it is a negative reaction to what the U.S. stands for in the world.
Regardless of your political perspective, I believe many more people would consider expatriation for tax purposes if your grandparents had not gone through such difficulty emigrating from the Old Country, or Grandpa had not served in World War II or the Korean War. I also think that is also very difficult to give up your citizenship for tax purposes when you have served in the U.S. Armed Forces. The voices in your mind will not let up.
What if I were to tell you that you can gain many of the tax benefits of expatriation without giving up your U.S. citizenship? How so? Playing on the line from the song in the Broadway musical West Side Story "I want to live in America", the goal of this planning strategy is leave America without leaving it for citizenship purposes.
Puerto Rico passed a series of stunning tax legislation in 2012 making the U.S. Commonwealth highly desirable as a jurisdiction from a tax standpoint. This article will focus on an alternative to a taxpayer giving up their U.S. citizenship for tax purpose and instead becoming a Puerto Rican resident for tax purposes.
Taxation of Americans Who Expatriate
What are the tax reasons for giving up your U.S. citizenship? First, American citizens and permanent residents are taxed on their worldwide income and assets. Who said that freedom does not come without a cost? A non resident alien is generally taxed on income that is effectively connected to a U.S. trade or business, income that is fixed or determinable and periodic income. Most interest income may be exempt under the portfolio interest exemption.
I personally have known two U.S. citizens who gave up their U.S. citizenship. One of the two could have easily have fared as well under the new Puerto Rican tax planning opportunities as a former investment professional living off of investment income and mostly short term capital gain income from investments in hedge funds. The other one was three or four steps ahead of the G-men.
The exit price has become increasingly confiscatory over the years. One of the more publicized stories was the of Ken Dart who gave up his citizenship to become a citizen of Belize with his personal residence in the U.S. becoming the consulate for Belize. That may have been the straw that broke the camel's back.
Denise Rich whose ex-husband Marc Rich was officially pardoned by President Clinton joined her ex-husband in giving up U.S. citizenship to become a Swiss Citizen. Then there was Tina Turner who had been living in Europe for many years, giving up her citizenship. After all, what's love got to do with it?
The expatriation rules apply to U.S. citizens or long term residents that have a "tarjeta verde" or Green Card in eight of the last fifteen years preceding the application for expatriation. A "covered expatriate" is a taxpayer that meets the Net Worth Test of IRC Sec 877A(g)(1) of $2 million or more. Under the Tax Liability Test, the expatriation rules apply if the taxpayer's tax liability for the five years preceding the year of expatriation exceeds $155,000 in 2013. Alternatively, the expatriation rules apply if the taxpayer fails to certify that the taxpayer is complaint with all of his federal tax obligations on Form 8854.
A taxpayer that give up his U.S. citizenship is treated as a U.S. taxpayer in any year that the former citizen spends more than 30 days in the U.S. The Heroes Earning Assistance and Tax Relief Act of 2008 repealed the former ten year look back period and instead introduced a deemed disposition on worldwide assets. These gains are taxed at capital gains rates without any of the exclusions available for a principal residence. The tax only applies if the amount of gain exceeds $668,000. The gain may be delayed on a property-by-property basis until the property is actually sold.
Why Puerto Rico?
The expatriation rules doo not apply to Puerto Rico. Puerto Rico is a U.S. Commonwealth. Puerto Ricans are U.S.. citizens. Nevertheless, as a commonwealth, Puerto Rico has its own tax code. Did I mention that it is a tropical island with sunny beaches and over fifty flights per day to a number of major cities? Puerto Rico is noticeably exempt from all for the draconian compliance requirements for Americans with foreign bank and financial accounts.
Puerto Rico (“the PR”)is an unincorporated territory of the U.S. and is subject to most federal laws unless “locally inapplicable”. The currency of the PR is the U.S. currency. No passport is required for travel to the PR for U.S. citizens. The banks in the PR are regulated by the U.S. Federal Deposit Insurance Corporation.
The definition of a U.S. person under IRC Sec 7701(a)(3) does not include Puerto Rican entities. As a result, Puerto Rican entities are not subject to U.S. income taxation unless the business is engaged in a trade or business within the U.S.- effectively connected income (ECI); or investment income that would be subject to a withholding tax with an exemption for portfolio interest.
Under IRC Sec 933, bona fide residents of the PR that have PR-sourced income are exempt from U.S. taxation. IRC Sec 937 defines a bona fide resident for tax purposes. A person is a PR resident for tax purposes if present in the PR for at least 183 days during the taxable years and does not have a tax home outside of the PR and does not have a closer connection to the U.S. or a foreign country than the PR.
The Individual Investors Act
Under IRC Sec 933, interest and dividends that qualify as PR-sourced income are excluded from the income of a “resident individual investor (an individual who has not been a resident of the PR for the past fifteen years before his first year of residence in the PR). Long term capital gains derived by the “resident individual investor” that were deemed to have accrued before the individual became a PR resident and are recognized within the first ten years after the date the individual becomes a PR resident, will be taxed at a 10 percent rate.
If the gains are recognized after the ten year period but before, January 1, 2036, the gains will be taxed at a 5 percent rate. Gains considered to have accrued after the investor becomes a U.S. resident will receive a 100 percent exemption. Dividend and portfolio interest income are exempt from PR taxation under the new law.
The U.S. taxpayer that gains Puerto Rican tax residency will be exempt on his short term and long term capital gain income for U.S. federal and PR tax purposes. Investment interest that qualifies as portfolio interest exemption will not be subject to U.S. or Puerto Rican tax purposes. However, dividend income will be subject to a thirty percent withholding tax for U.S. federal purposes but not subject to PR taxation.
For taxpayer that have significant dividend income, it may be possible to form an investment a Puerto Rican corporation to covert some of the investment income into Puerto Rican-sourced income. However, the dividend income payable to the corporation are likely to be subject to withholding taxes.
Estate Taxation in Puerto Rico
IRC Sec 2209 provides that Puerto Rican residents are not subject to U.S. estate taxation at death providing the Puerto Rican resident acquired his U.S. citizenship by virtue of his birth in the PR or his naturalization as a U.S. citizen in the PR. Puerto Rico administers its own estate and gift tax system which largely parallels the U.S. system. The U.S. taxpayer who becomes a PR resident for tax purposes will remain subject to the U.S. estate tax.
The decision to give up your citizenship is not an easy one for any reason - tax or personal. The decision has many tradeoffs in my view including limited access to the U.S. on an ongoing forward basis. For anyone that has children or grandchildren or any friends for that matter, expatriation may be a non-starter for most taxpayers.
Puerto Rican residency is an excellent alternative for those living primarily on investment income and with strong personal ties in the U.S. The PR's proximity to the U.S. and easy accessibility may present as a new type of Florida without generally federal taxation on most investment income and no taxation within Puerto Rico. The federal estate tax is still applicable but if one day the Republicans prevail, it too may be repealed. Over thirty years ago, Professor George Cooper referred to the federal estate tax as a "voluntary" tax because of the variety of planning techniques to reduce or eliminate it.
When it is all said and done, you need to be able to look at yourself in the mirror. PR tax residency gives you the ability to do that while enjoying substantial tax benefits.