Overview
Most Americans are aware of the hurricane devastation in Puerto Rico. Puerto Rico’s equivalent event to September 11, 2003 occurred on September 20, 2017. First, the island suffered through Hurricane Irma on September 6, 2016 followed by the “knockout” punch of Hurricane Maria on September 20, 2017. Other cities such as New Orleans, Florida and Houston have suffered devastating hurricanes and have come back “bigger and better”. Nevertheless, the story in the PR is a different story. The PR seems to be on continued life support with lingering doubt about a full recovery. Perhaps, it might be like the Stage 3 or Stage 4 cancer patient who suffered a devastating stroke.
It was originally thought that only 64 Puerto Ricans died as a result of the hurricanes. Harvard University recently said that the correct number may be as high as 4,640. Since the hurricanes, over 200,000 Puerto Ricans have left the PR. Over 500,000 have left the PR in the last decade. The exodus is likely to continue due to the continued slow response to extended power outages, communication lapses and infrastructure failures and colossal financial crisis. The NY Federal Reserve reported that the power outage was the largest in U.S. history. As recently as a few weeks ago, over ninety percent of the PR lost power again. The immediate job loss was higher than any of the other significant hurricanes in recent memory. In the months preceding the hurricanes, PR filed for bankruptcy protection unable to meet its commitments on more than $70 billion in bonds and nearly $50 billion in employee pensions, declared bankruptcy. As far as municipal bond defaults go, it is the largest in U.S. history.
Time will tell what will happen in the PR. In the meantime, the tourist industry is open for business. The sun still shines in and on Puerto Rico! While Puerto Ricans sprint to the Mainland to take economic cover, wealthy “gringos” on the Mainland have been left wondering about the tax benefits under Act 22 and Act 20 that the PR government had been aggressively promoting in the last several years. Following the hurricanes as expected there was a drop off in interest in Act 22 and Act 20. Investors from the Mainland adopted a “wait and see” posture to determine the direction and delay in recovery efforts. The pace of renewal and reconstruction has picked up pace and interest has renewed in Act 20 and Act 22.
The contrarian should achieve success in the current environment betting that the federal government will not allow Puerto Rico to fall into the sea and drown under the colossal weight of its debt and bankruptcy obligations. It is hard to imagine the federal government allowing this to happen. As a result, the infrastructure will be rebuilt, and economic incentive programs will re-energize economic activity on the Island.
One of the significant changes in the Puerto Rican tax incentive legislation is the addition of trade companies to the list of qualified companies. Puerto Rico Act 43 (2017) expanded the definition of a trade company for Act 20 purposes. Previously, a Trading Company had to derive 80% of their gross income solely from trading activities to be considered as such. The amendment allows the inclusion of other export eligible services’ gross income to meet the 80% threshold. The legislation also does not have a minimum employee requirement. The Puerto Rican government has dropped minimum employee requirements for Act 20.
This report is designed to highlight the tax benefits of the Puerto Rican Trade Company in the sale of goods as well as the sale of services to operating companies on the Mainland. The article will discuss the unique advantage of structuring ownership within a Roth IRA or Roth 401(k) and will compare it to IC-DISCs which have structured ownership with Roth IRAs. Iowa! Business owners on the Mainland may create a new Puerto Rican Trade Company that has a decree under Act 20 and structure ownership within a self-directed Roth IRA. The Puerto Rican Trade Company will be taxed at four percent in Puerto Rico without any taxation in the United States. The Puerto Rican Trade Company will be able to pay dividends to the Roth IRA without taxation. In Puerto Rico or the United States.
The ability to own IC-DISCs with in Roth IRAs has been successfully litigated on behalf of the taxpayer in the Sixth and First Circuit Federal Court of Appeals. From a tax standpoint, the Puerto Rican Trade Company travels on a parallel path as the IC-DISC. However, the Puerto Rican Trade Company has greater utility than the IC-DISCs and provides the same opportunity to supercharge the Act 20 benefits within a Roth IRA. All of this without leaving the comfort of the taxpayer’s home in Dubuque,
The potential benefits of the Puerto Rican Trade Company owned within a Roth IRA have taken new meaning since tax reform and the introduction of IRC 199A business deduction and its limitation to specific services businesses. The strategy outlined in the article will allow service companies that otherwise would not benefit from the IRC Sec 199A business deduction to lease services or purchase goods from a Puerto Rican Trade Company.
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.
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.
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.
Legislation in July 2017 added a requirement for each decree holder to make an annual donation of $5,000 to a recognized Puerto Rican not-for-profit organization.
(2) The Export Services Act
A business that relocates to Puerto Rico can significantly reduce its tax liability provided that the Puerto Rican entity is not engaged in a U.S. trade or business. The top U.S. corporate tax rate in 2018 is 21 percent at the federal level. Assume another 5-8 percent at the state level. Many pass-through businesses will qualify for the new 20 percent business deduction under IRC Sec 199A. However, most professional service companies will not qualify for this deduction. These businesses might be well served to evaluate Act 20 status.
Under Puerto Rico’s Export Services Act, the corporate tax rate is flat four percent. Additionally, shareholders who relocate to Puerto Rico will have a 100 percent exemption on corporate distributions received from the Puerto Rican company.
Under the Export Services Act, services that are directed to foreign markets may generate income that will qualify for the special tax rate. Services for foreign markets include services performed for nonresident individuals and businesses. To qualify as “promoter services” under the Export Services Act, the net income must be earned, and service performed within the 12-month period ending on the day preceding the day the business commenced operations within Puerto Rico. The term “eligible services” includes a wide range of service-oriented businesses from research and development to investment management.
Significant changes were made to Act 20 on July 11, 2017. These changes eliminated the five-employee requirement and no minimum employee requirements for most businesses. In most cases, this will be the business owner. The new legislation added two new eligible services – (1) Hospital services and laboratories including medical tourism and telemedicine services; (2) Trading companies with no less than 80% of business in PR exporting business. At least thirty percent of the of the doctors at medical tourism and telemedicine facilities should be Puerto Rican residents. International banks licensed in Puerto Rico under Act 273 also qualify for the special rate of four percent. Investment advisors, funds and family offices operating as international financial entities also qualify. Payday lenders with a hybrid licenses qualify as do fund managers with an offshore master/feeder structure.
Overview of IC-DISCs
An IC-DISC is a C-corporation that elects IC-DISC treatment under U.S. tax law. An IC-DISC does not have to own any tangible assets or have a business location. An IC-DISC must have a minimal equity capitalization of $2,500 and must meet strict asset and income tests, which require that 95 percent of its income and assets be related to qualified export property. An IC-DISC’s primary income results from commissions paid by the exporting company on export sales.
The tax benefits of an IC-DISC result from converting sales income that would otherwise be taxed as ordinary income rates to qualified dividend income which is generally taxed at 20 percent. This occurs by the exporting company paying the IC-DISC a commission equal to the greater of 4 percent of qualified export gross receipts or 50 percent of net income from qualified exports.
This commission payment reduces the exporting company’s taxable ordinary income and the IC-DISC is exempt from tax on such income. This commission income is generally not taxed until the IC-DISC distributes the income to its shareholders. At such time, it is taxed at qualified dividend rates which are roughly 15-20 percent lower than ordinary income rates, resulting in substantial tax savings. An IC-DISC can generally retain commission income (subject to certain limitations), which allows for tax deferral. In exchange for this deferral, the shareholders must pay an annual deferral charge, which presently is below 1 percent.
Overview of Roth IRAs
The Roth IRA provides for tax-deferral and tax-free distributions without the requirement for minimum distributions during lifetime, but distributions over the lifetime of the beneficiary at death. The Roth IRA allows for annual contributions of $5,500 ($6,500 if age 50 or older). A taxpayer that files jointly is able to contribute to a Roth IRA if the taxpayer’s modified adjusted gross income (AGI) does not exceed $189,000. The contribution phases out between $189,000-199,000.For a single taxpayer, contributions phase out between $120,000-$135,000.
The Roth IRA does not have required minimum distributions. Distributions before age 59 ½ are subject to the 10 percent early withdrawal penalty as well as normal tax treatment on the distribution (as if it were a traditional IRA). Exceptions to these rules exist for a distribution for a first-time home buyer; distribution to a disabled taxpayer, or a distribution to a beneficiary on account of the taxpayer’s death.
The American Taxpayer Relief Act 2012 included a provision that allows private company defined contribution plans (i.e., 401(k) and profit sharing plans) to allow plan participants to convert any vested pre-tax amounts held within those plans into Roth amounts. The only requirement is that the plan include (or is amended to) provide for Roth contributions other than rollovers. Converted amounts are subject to federal and state income taxes in the year converted but the 10% early withdrawal tax is waived. Converted amounts are not subject to withholding and financial planners After the five-year Roth holding period, earnings on Roth accounts is income tax free.
Roth IRAs and IC-DISCS
Taxpayers have combined the benefits of Roth IRAs and IC-DISCS by causing the shares of the IC-DISC to be owned within the Roth IRA. The accumulation benefits are extremely powerful. In Summa Holdings, Inc., No. 16-1712 (6th Cir. 2/16/17) the Sixth Circuit held that the substance-over-form doctrine did not apply to Summa's transactions, finding that the doctrine did not "authorize the Commissioner to undo a transaction just because taxpayers undertook it to reduce their tax bills." The court concluded that because Summa used the DISC and the Roth IRAs for the congressionally sanctioned purpose of tax avoidance and the transactions had economic substance, the IRS had no basis for recharacterizing the transactions.
The First Circuit in Benenson, No. No. 16-2066 (1st Cir, 4/6/18) in a majority opinion, concluded that the application of the substance over form doctrine to reclassify IC-DISC dividends as excess Roth IRA contributions was inappropriate. The First Circuit, following the Sixth, noted that the DISC and Roth IRA rules were both designed by Congress to serve as tax reduction tools, and the taxpayers in this case complied in full with the statutes governing both. In reaching their conclusion, the court stated that the taxpayers, “used DISCs, a unique, congressionally designed corporate form their family's business was authorized to employ, and Roth IRAs, a congressionally designed retirement account all agree they were qualified to establish, to engage in long-term saving with eventual tax-free distribution. Such use violates neither the letter nor the spirit of the relevant statutory provisions.”
The First Circuit's final comment stated that, “The substance-over-form doctrine is not a smell test. It is, in this circuit, a tool of statutory interpretation. When, as here, we find that the transaction does not violate the plain intent of the relevant statutes, we can push the doctrine no further.”
Puerto Rican Trade Companies and the IC-DISC
The Puerto Rican Trade Company under Act 20 is far more expansive in the type of industries that can benefit than the IC-DISC. Act 20 can also include service businesses that otherwise cannot benefit from business deduction in IRC Sec 199A. Furthermore, the Puerto Rican Trade Company is not encumbered with the complexity and limitations of the IC-DISC. Ultimately, there is no cap in the amount of money that may be received by an Act 20. Additionally, the ownership Puerto Rican Trade Company can be structured for ownership within a Roth IRA or Roth 401k.
The Puerto Rican Trade Company will be taxed for Puerto Rican tax purposes at a four percent rate. The dividends paid by the Puerto Rican Trade Company will not be taxable for Puerto Rican tax purposes and will not be subject to U.S. taxation within the Roth IRA. Future distributions to the taxpayer from the Roth IRA will not subject to taxation. The Roth IRA is not subject to a statutory limit in the amount of money that can be accumulated within the Roth IRA.
Summary
Currently, most taxpayers on the Mainland have no interest in moving to Puerto Rico following the hurricanes and state of affairs and lack of infrastructure. The strategy outlined in this article provides powerful tax benefits to all forms of businesses on the Mainland – service businesses or manufacturers or sellers of good services. Operating companies buying good or services from a Puerto Rican Trade Company will create significant tax arbitrage. Ownership of the Puerto Rican Trade Company will provide for tax-free repatriation and tax-free distribution of income within the Puerto Rican Trade Company. The recent decisions in the Sixth and First Circuits dealing with Roth IRAs and IC-DISCs provide ample tax and legal authority for the proposition of owning the Puerto Rican Trade Company within the Roth IRA.
The potential tax and wealth accumulation benefits of the proposed strategy are exceedingly beneficial to business owners. The cost considerations in the formation of the Puerto Rican Trade Company with an Act 20 decree are relatively modest and quick to implement. The cost and time involved in forming a Roth IRA are very modest. The combination of the two strategies are breath-taking!
