Many professional living and working in Silicon Valley over the last twenty years have become very wealthy as a result of their participation in company stock options plans – qualified and non-qualified. While these high tech professionals have made a lot of money, they have also paid more than their fair shares of taxes at the federal and state level in California. My hope is that these professionals and their advisors will begin to consider the PR option in earnest. It is not such as wild idea as many of these professionals work remotely.
The focus on this article is the tax treatment of Incentive Stock Options which are considered qualified stock options. Non-qualified stock options including restricted stock unit plans are also abundant. I will cover the tax treatment of these options from the perspective of becoming a Puerto Rican resident in a separate article.
It is a nice thing to own a bunch of ISOs as a result of your employment in a high tech start up in Silicon Valley but it becomes sobering when you consider the level of taxation imposed at the federal and state level in California. The combined long term capital gains tax rate can roughly equal the top federal marginal tax bracket of 39.6 percent. How can that be?
The federal long term capital gains tax rate is 20 percent. The new Medicare tax of 3.8 percent income is likely to apply to most employees when company shares are ultimately sold. Long term capital gains in California are taxed at ordinary rates and can add another 10.3-12.3 percent to the federal tax. The net result is that the taxpayer can see long term capital gains at a rate of 36.1 percent.
I have stated for the record several times that Silicon Valley is a very expensive place to live and the weather is not really all that exceptional. You may not get the San Francisco Giants and Forty Niners but you will get many of the PR major league baseball players playing winter ball in the PR. Puerto Rico offers a lower cost of living and good weather and world class beaches. More importantly, the PR offers the best tax and business incentives on the globe for American taxpayers.
I admit my bias for all things Latin as a result of growing up in the Panama Canal Zone and being a Spanish and Portuguese major as an undergraduate plus another ten years in the Republic of Miami. I consider missing the opportunity to see the Fania All Stars in Madison Square Garden in 1978 as one of my major regrets in life. I did live to see Celia Cruz, Johnny Pacheco and his black flute along with Tito Puente in the Bronx. Where else!!!!
This article is another segment to make the business and tax case that you should be considering the PR option for its strong business and tax incentives. In my last article, I suggested moving Silicon Valley to the PR but if the Boss won’t move because he’s a Gringo, then maybe the Boss will allow the engineers and other tech employees that work remotely to move.
Overview of Puerto Rican Tax Considerations and Residency
A. Puerto Rican Tax Basics
Two important pieces of legislation were passed by the Puerto Rican legislature in 2012. Both the Export Services Act (Act 20) and the Individual Investors Act (Act 22) were signed into law by the Governor of Puerto Rico on January 17, 2012.
Puerto Rico is an unincorporated territory of the United States, commonly referred to as a U.S. commonwealth. It is subject to most federal laws unless “locally inapplicable. “The currency is the U.S. dollar, and the banks in Puerto Rico are regulated by the U.S. Federal Deposit Insurance Corporation. No U.S. passport is required for U.S. citizens to travel to Puerto Rico.
The definition of a U.S. person under §7701(a) (30), however, does not include Puerto Rican entities. As a result, a Puerto Rican entity is not subject to U.S. income taxation unless the entity is engaged in a trade or business within the United States and its income is considered effectively connected income, or investment income that would be subject to a withholding tax under §871 (unless an exemption for portfolio interest under §881(a) applies).
Under §933, bona fide residents of Puerto Rico who have Puerto Rico-sourced income are exempt from U.S. taxation. Section 937 defines a bona fide resident for tax purposes. A person is a Puerto Rican resident for tax purposes if the person is present in Puerto Rico for at least 183 days during the taxable year and he or she does not have a tax home outside Puerto Rico and does not have a closer connection to the U.S. or a foreign country than to Puerto Rico.
Section 2209 provides that Puerto Rican residents are not subject to U.S. estate taxation at death provided that the Puerto Rican resident acquired his or her U.S. citizenship by virtue of birth in Puerto Rico or naturalization as a U.S. citizen in Puerto Rico. Puerto Rico administers its own estate and gift tax system that largely parallels the U.S. system. Note that a U.S. person who does not expatriate, but merely takes up Puerto Rican residency, will not avoid U.S. federal transfer taxes on worldwide assets, unless born in Puerto Rico. The Puerto Rico estate tax for non-Puerto Rican property is 10 percent.
For federal income tax purposes you will be considered a bona fide resident of Puerto Rico if you meet the following: (i) the physical presence test (generally spending 183 days in PR, or less than 90 days in the US); (ii) the tax home test; and (iii) the closer connection test for the entire taxable year which means that you can’t have stronger personal connections to another jurisdiction that is not Puerto Rico, as prescribed in the regulations promulgated under Section 937 of the Internal Revenue Code.
(1) The Individual Investor's Act
Under the Individual Investors Act, neither capital gains (long-term or short-term), interest, nor dividends are subject to Puerto Rican taxation. Dividend income is subject to U.S. federal income taxation for U.S.-sourced dividend income, as is interest income unless the interest income is exempt under the portfolio interest exemption. Long-term capital gains derived by the resident individual investor that (1) were deemed to have accrued before the individual became a Puerto Rican resident and (2) are recognized within the first 10 years after the date the individual becomes a resident, will be taxed at a 10 percent rate.
If the gains are recognized after the 10-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 Puerto Rican resident will receive a 100 percent exemption. Dividend and portfolio interest income are exempt from Puerto Rican taxation under the new law.
Tax Treatment of ISOs
The U.S. tax code recognizes two general types of employee options, “qualified” and nonqualified. Qualified (or “statutory”) options include “incentive stock options,” which are limited to $100,000 a year for any one employee. Qualified options are not taxed to the employee when granted or exercised under IRC Sec 421 (under the regular tax); tax is imposed only when the stock is sold.
If the stock is held one year from purchase and two years from the granting of the option, the gain is taxed as long-term capital gain under IRC Sec 422(a). The employer is not allowed a deduction for these options. However, if the stock is not held the required time, the employee is taxed at ordinary income tax rates and the employer is allowed a deduction.
The value of incentive stock options is included in minimum taxable income for the alternative minimum tax in the year of exercise; consequently, some taxpayers are liable for taxes on “phantom” gains from the exercise of incentive stock options. . Provisions were added to the Internal Revenue Code in 2008 that provided abatement of any taxes still owed on “phantom” gains.
Incentive stock options (IRC Section 422) must be granted in accordance with a written plan approved by the shareholders. The plan designates the number of shares to be subject to the options and specifies the classes of employees eligible to participate in the plan. The option price must be no less than the market value of the stock at the time of the grant, and it must require exercise within 10 years from the time it was granted. An employee must be an employee within three months of the date of exercise.
The market value of the stock for any incentive stock options exercisable in any year is limited to $100,000 for any individual under IRC Sec 422(d)(1). This is the limit on the amount that receives favorable tax treatment, not on the amount that may be granted; options for stock exceeding $100,000 in market value are treated as non-qualifying options.
The taxpayer recognizes no income (for regular tax purposes) when the options are granted or when they are exercised. Taxes (under the regular tax) are not imposed until the stock purchased by the employee is sold. If the stock is sold after it has been held for at least two years from the date the option was granted and one year from the date it was exercised, the difference between the market price of the stock when the option was exercised and the price for which it was sold is taxed at long-term capital gains rates. If the option price was less than 100% of the fair market value of the stock when it was granted, the difference between the exercise price and the market price (the discount) is taxed as ordinary income (when the stock is sold).
Companies generally receive no deduction for qualified stock options, so the tax advantage accrues to the employee, not the employer. If the stock is not held for the required two years from the granting of the option and one year from its exercise, special rules apply.
The employee is taxed at ordinary income tax rates instead of capital gains rates on the difference between the price paid for the stock and its market value either when the option was exercised or when the stock was sold, whichever is less. The company is then allowed a deduction just as if the employee’s taxable gain were ordinary compensation paid in the year the stock is sold.
The alternative minimum tax (AMT) on qualified stock options reduces their tax advantage for taxpayers paying the AMT. Although the minimum tax exemptions limit the minimum tax to relatively high-income taxpayers, it does impose some burden on the otherwise tax-favored option plans. Puerto Rican residency would also eliminate the federal AMT exposure. Qualified stock options are excluded from FICA and FUTA taxes.
C. Tax Planning for ISOs Considering the Individual Investors Act
The application for Tax Incentives under Act 22 generally takes 30-60 days for the approval of the Puerto Rican government. Upon approval, PR residency is backdated to the date of application. Under PR tax law, Section 1046 provides for the tax treatment of "qualified stock options." Section 1046, with certain exceptions, provides the same tax treatment and requirements as IRC Sections 421 and 422. The income from the exercise of qualified stock options may be excluded to the extent the stock options meet the qualification requirements contained in IRC Section 422. As a practical matter, most PR employees working for American companies participate in the U.S. stock option program.
To the extent the plan is considered qualified for Puerto Rico purposes, the exercise of the stock options will not trigger income taxation. Such income will be recognized only upon the sale of the shares, at which time it will be reported as a capital gain. This will be the case even if the individual makes a simultaneous exercise of options and sale of shares. Under the Individual Investor’s both short term and long term capital gains receive tax-free treatment for PR tax purposes.
The U.S. taxes capital gains based upon the residency of the taxpayer. In the event that the taxpayer exercises ISOs after becoming a PR resident, the subsequent sale of the company shares will tax-free for federal tax purposes as well as PR purposes after a one year holding period.
Assume a Silicon Valley programmer was granted 10,000 ISOs at $2.50 per share in April 2011. The company had its IPO in 2013 and is currently trading at $56 per share currently.
Based upon the ISO grant in April 2011 and presumed PR residency in April-May 2014, the taxpayer would meet the federal ISO holding period by April-May 2015 and receive capital gains treatment for federal purposes. As a PR resident under Act 22, the taxpayer would not be subject to income taxation for federal and PR purposes.
The tax savings would be substantial. A taxpayer that is a California resident, the ultimate gains might be otherwise taxed at a combined rate of 36.1 percent (23.8 percent federal and 12.3 California) producing a tax liability of approximately of $311,038. As previously mentioned, the tax rate as a PR resident would be zero. It bears repeating that approval of your residency does not carry with it a minimum residency requirement.
Stock option programs are a major component of the compensation programs of high tech startups and companies in general in Silicon Valley. These options become very valuable making employees independently wealthy as these companies become public companies and the stock performs well. Under the money-making doctrine that is what you get to keep (after taxes) that is important, Puerto Rican residency has to be looking attractive to Silicon Valley professionals looking to keep more of what they make. The combination of U.S. law, tropical weather and beaches along with the best tax incentives on the Planet, make the PR a compelling option for those of you with options including the option of where to live.