Desde Panama Hasta Puerto Rico – Transitional Tax Planning Considerations Before You Move to Puerto Rico
My family lived in the Panama Canal Zone from 1960-2004. Even though it does not exist in its former status, I still consider it home. For most of the kids in my generation, it is their primary identification, i.e. their status as Zonians. It even rubbed off on military kids that lived in the Canal Zone particularly if they graduated from high school there. When I graduated from West Point, the Panama Canal Treaty had been signed and the Army decided that I could not put Panama Canal Zone on my diploma. I resisted this command strongly.
The Army suggested my birthplace as my home of record for my diploma and I responded that I lived in Washington, DC for less than a year. The next suggestion was Florida. My response at that time was that my only connection to Florida was having spent a few hours in the Miami Airport. Ultimately, the Army caved in and for all I know, I may be one of the last Zonians who went to service academy that has Panama Canal Zone on it.
No place that I have visited on the Planet reminds me of the Panama Canal Zone as much as Puerto Rico. The comparison is strong – Spanish speaking, tropical, beautiful beaches, baseball, boxing, American infrastructure, Salsa and a strong presence of the federal government. So if you are considering a move to Puerto Rico, it is not the same as moving to Honduras. I have been to Honduras. It is a nice place with great weather and nice people, but it is not Puerto Rico and vice versa.
I have written a series of articles espousing the benefits of Puerto Rican Acts 22 and 20 for tax planning purposes. The combination of these benefits for an American living on the Mainland is extremely powerful. In effect, Puerto Rican residency is the antidote to expatriation fever.
Unlike expatriation, an American taxpayer does not run the risk of becoming the Black Sheep of the family for expatriating. Grandpa who fought in WWII does not need to rollover in his grave. Mama does not need to cry “Where did I go wrong”! The beauty of Acts 22 and 20 is that it allows the American taxpayer to retain his U.S. citizenship while severing the shackles of worldwide taxation of U.S. taxpayers. If you want to see what patriotism looks like, take a look at all of the Puerto Ricans that have served in the Armed Forces and fought in our wars. Nine Boricuas have won the Medal of Honor!
What about Florida. I have live there too! However, Florida may not have a state income tax, but it does not provide the opportunity to legally avoid federal income tax on service income or investment income. Additionally, I think that the PR is much prettier than Florida.
Inevitably, I receive a lot of questions from U.S. taxpayers contemplating the sale of a business and capital asset asking whether the PR tax incentives can provide a benefit in their situation. On its face, the answer is “No”, but if you combine it with the powerful transitional planning in this article, the answer changes to the affirmative.
This article is designed to demonstrate how the combination of an installment sale under IRC Sec 453(c) combined with a monetization loan will allow the Seller to defer capital gain on the sale for up to 30 years while accessing 93.5 percent of the sales price on a tax-free basis through a monetization loan of the installment loan. The Seller can reinvest the proceeds of the monetization loan on a tax-free basis and reinvest the proceeds while receiving tax-free income for both U.S. and PR purposes under a decree under Act 22.
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.
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.
What does it take to become a Puerto Rican resident in order to take advantage of Act 22? How about S50 for the application fee which is less than the cost of dinner in a good restaurant, and meeting three tax tests? For federal income tax purposes the taxpayer will be considered a bona fide resident of Puerto Rico if you meet the following: (i) Substantial Presence Test -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) Closer Connection Test – 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.
(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. The law capture built in gain preceding Puerto Rican residency and taxes the pre-residency appreciation at ten percent during the first ten years following residency and five percent for the next ten years.
(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 is 35 percent to 40 percent for most corporations, assuming a federal rate of 35 percent and a state rate of five percent. 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. The term range of eligible services ranges from consulting, and professional services (law, engineering, architecture) to investment management.
In many cases, a business may have multiple owners and is often the case, the business owner cannot convince the spouses of his fellow shareholders to move to Puerto Rico. Surprise! It is possible to structure a new Puerto Rican corporation with the business owner that becomes a Puerto Rican resident. The new corporation can be structured so that the new Puerto Rican corporation is not treated as a controlled foreign corporation for tax purposes allowing the Puerto Rican corporation to be taxed at four percent instead of 39.6 percent or 35 percent.
IRC Sec 453(c) defines an installment sale as method under which the income recognized in any taxable year from a disposition is the proportion of the payments received in a year which the gross profit (realized or to be realized when a payment is completed) bears to the total contract price. Essentially, the taxpayer is required to pay the tax proportionately as the principal payments are received.
Under IRC Sec 453(d), the taxpayer is entitled to installment reporting unless the taxpayer affirmatively elects not to have the transaction Under IRC Sec 453(c), the resale of the asset by the Buyer has no effect on the installment sale, if the installment buyer is unrelated to the installment seller. Under IRC Sec 453(f)(3), the term “payment” does not include the receipt of evidence of indebtedness of the person acquiring the property whether or not the payment of such indebtedness is guaranteed by another person.
The S Crow Collateral Corp. is a specialty dealer that facilitates and structures collateralized installment sales. As a dealer in capital assets, the company can purchase assets from a Seller. The assets can be virtually any capital asset, whether it’s a business, investment or personal asset, on an installment basis. The installment note calls for payments of interest only from the Dealer to the Seller for a specified number of years, followed by payment of the entire purchase price at the end of the term.
Most often, the Seller has already found an ultimate buyer for the asset before the Dealer becomes involved. Frequently, the ultimate buyer is prepared to pay cash, or a considerable portion of the price in cash, while the Seller prefers to defer the tax on the cash proceeds.
With these circumstances in mind, the Seller brings the Dealer into the transaction as an intermediate purchaser from the seller. At the same time as the purchase, the Dealer resells the asset to the ultimate Buyer to whom the Seller had planned to sell directly. The Dealer receives and retains the sale proceeds which the final buyer pays. Both the installment sale to the Dealer and its resale to the final Buyer are closed simultaneously, pursuant to mutually agreed closing instructions provided to the closing agent.
Concurrent with the closing of the transaction, a third-party lender which is unrelated to the Dealer may be willing to lend to the Dealer’s Seller, an amount of cash that is equal to a specified high percentage (90=93.5% of the sales price) of the cash paid by the final Buyer. The Dealer’s monthly payments on the installment contract will equal or exceed the Seller’s loan-interest payments on the monetization loan. The final due dates on the installment contract and the monetization loan will typically be the same, while the principal amount paid on the installment contract at the end will equal or exceed the amount that the seller then owes on the loan.
The Seller may then use those loan proceed which are non-taxable for tax purposes for any business or personal; investment purpose which the Seller prefers, including to pay debt on the asset being sold or to pay other business debt. The lender does not receive a lien on the installment contract, or the asset that was sold including the installment payments made by the Dealer. The Dealer is not a party to the loan; it is a transaction solely between the Seller and the lender.
From an estate tax standpoint, installment contracts are typically valued at a value considerably discounted value from an estate tax perspective while the installment debt related to the monetized loan reduces the taxable estate by the full amount owed. The combination of a collateralized installment sale and the loan from the separate lender can materially reduce the seller’s future estate tax liability. At the same time, it provides the Seller with tax-free use of 90-93.5 percent of the sales price while deferring recognition of the gain related to the installment sale for up to thirty years. Not bad!!!
Sam Silverstein is the sole shareholder of a closely held business which is organized as a regular corporation. The company is contemplating an offer to sell the assets of the corporation for $5 million. The assets have no basis. The corporation is in a combined federal and state marginal tax bracket of 42 percent. Assuming the distribution of the sales proceeds as a qualified dividend, the combined tax cost could be as high as 72.8 percent. Sam has been contemplating a move to Puerto Rico in order to take advantage of Act 22 but his advisors have told him that there is no practical way to avoid the tax impact of the sale.
Instead of an outright sale, the sale of the assets are structured as installment sale with no money down and a non-amortizing installment contract with due in thirty years with interest payments due on a monthly basis. At the same time, a third party lender arranges a monetization loan equal to $4,675,000. The proceeds are made available to Sam individually outside of the corporation on a tax-free basis.
Sam applies for Act 22 and is approved. After receiving his decree, Sam moves to the PR and meets all of the tax requirements for PR residency. He invests the proceeds in a manner which produces interest that qualifies for tax-free treatment under the portfolio exemption and capital gains income. This income is not subject to U.S. or Puerto Rican taxation.
Sam has been able to defer the gain from the installment sale for the next thirty years while accessing 93.5 percent of the sales proceeds on a tax-free basis through the monetization loan. The Act 22 decree allows Sam to reinvest the proceeds in a manner that qualifies the income as tax-free income for both federal and PR tax purposes. The value of his estate is reduced by the value of the monetization loan along with the discounted value of the note.
I get a lot of calls regarding the viability of PR residency in the event of a capital realization event. The collateralized installment sale is a very attractive weigh to defer capital gain on a sale of a capital asset while accessing a substantial portion of the sale on a tax-free basis during the deferral period. The addition of PR residency is the proverbial icing on the cake. Of course, the devil is always in the details, but it is a path worth considering.