Tax Guide for US Expats Living and Working in Puerto Rico
Who Is Liable For Income Taxes in Puerto Rico
Act 1 of 31 January 2011 contained a tax reform that introduced a new tax code known as the Internal Revenue Code for a New Puerto Rico (IRCPR). The IRCPR is effective for tax years beginning after 31 December 2010. Act 1 of 31 January 2011 is part of a complete overhaul of Puerto Rico’s system of taxation, which is intended to reduce the tax burden of individual taxpayers and businesses.
Residents of Puerto Rico are subject to Puerto Rican tax on their worldwide income. Nonresidents are taxed only on their income from Puerto Rican sources and on income treated as effectively connected with the conduct of a trade or business in Puerto Rico. In general, nonresident U.S. citizens are taxed on their Puerto Rican-source income only. Most residents of Puerto Rico are U.S. citizens but are not subject to U.S. federal income tax under Internal Revenue Code (IRC) Section 933, except on income derived from sources outside Puerto Rico.
For purposes of U.S. taxation, under the American Jobs Creation Act of 2004 (AJCA), which was enacted on 22 October 2004, an individual is considered to be a resident of Puerto Rico if he or she satisfies all of the following conditions:
- He or she is present for at least 183 days during the year in Puerto Rico. This determination is made under the substantial presence test.
- He or she does not have a tax home outside Puerto Rico during the tax year.
- He or she does not have a closer connection to the United States or a foreign country than to Puerto Rico.
The 183-day presence test applies for tax years beginning after 22 October 2004.
Under the AJCA, rules similar to the rules for determining whether income is from sources in the United States or is effectively connected with the conduct of a trade or business in the United States apply for purposes of determining whether income is from sources in Puerto Rico. However, any income treated as income from sources in the United States or as effectively connected with the conduct of a trade or business in the United States may not be treated as income from sources in Puerto Rico or as effectively connected with the conduct of a trade or business in Puerto Rico. These sourcing rules apply to income earned after 22 October 2004.
For local purposes, whether an individual is considered resident or nonresident generally is a question of intent, which is determined based on the facts and circumstances of each case. Individuals are presumed to be residents if they are domiciled in Puerto Rico for not less than 183 days in a calendar year.
Income subject to tax. Taxable income (or net income) is computed by subtracting allowable deductions and exemptions from gross income. Gross income broadly includes virtually all realized economic gains. However, certain items are specifically excluded by statute from the definition of gross income, including interest on U.S. and Puerto Rican government bonds (state and municipal bonds), life insurance proceeds, gifts and inheritances.
Education allowances provided by employers to their local or expatriate employees’ children are taxable for income tax and social security purposes.
Employment income. Salary deferred under a 401(k)-type plan may be excluded, subject to limitations, provided the plan is qualified by the Puerto Rican tax authorities.
In general, a nonresident individual who performs personal services as an employee in Puerto Rico at any time during the tax year is considered to be engaged in a Puerto Rican trade or business. An exception to this general rule applies to a nonresident individual performing services in Puerto Rico if all of the following conditions apply:
- The services are performed for a foreign employer.
- The employee is present in Puerto Rico for no more than 90 days during the tax year.
- Compensation for the services performed in Puerto Rico does not exceed US$3,000.
If these conditions are not met, all income, including the first US$3,000, is subject to tax.
Self-employment and business income. Self-employed individuals conducting a business for profit in Puerto Rico are subject to income tax at the rates.
A nonresident individual engaged in a trade or business in Puerto Rico during the tax year is subject to tax on net income effectively connected with the conduct of the trade or business. The tax rates are the same as those for residents. All income, gains and losses from sources within Puerto Rico, including Puerto Rican-source passive income, are treated as income, gains or losses effectively connected with the trade or business in Puerto Rico.
Investment income. In general, dividend and interest income is taxed at the regular income tax. However, dividend income from corporations deriving 80% or more of their gross income from sources within Puerto Rico is taxed at a maximum rate of 10%, but the effective tax rate could be higher as a result of recent amendments to the alternate basic tax system. The first US$2,000 of annual interest income paid on a deposit with a financial institution doing business in Puerto Rico is tax-free for single taxpayers, head of household taxpayers or married taxpayers filing jointly (for married taxpayers filing separately, the exclusion is US$2,000 each). Interest in excess of the US$2,000 amount is taxed at a maximum rate of 10% if a taxpayer complies with certain conditions concerning withholding tax, but the effective tax rate could be higher as a result of recent amendments to the alternate basic tax system.
Rental operations and certain other activities that generate income are considered passive activities. Income from passive activities is included with other taxable income and taxed at the rates.
A nonresident individual not engaged in a trade or business in Puerto Rico is taxed, in general, at a rate of 29% on Puerto Rican-source fixed or determinable, annual or periodical gains, profits and income. This consists of investment income, including interest, dividends, rental income and capital gains. Generally, the tax on fixed or determinable income must be withheld at source by the payer. A nonresident alien with income derived from real property located in Puerto Rico, or with gains derived from the sale of real property, may elect to treat rental income from that property as effectively connected with the conduct of a trade or business in Puerto Rico, thereby permitting the deduction of related expenses and depreciation.
If received by a nonresident alien not engaged in a trade or business in Puerto Rico, interest on Puerto Rican bank deposits is treated as non-Puerto Rican-source income and is not subject to tax. Nonresident aliens are entitled to the special maximum 10% tax rate on dividends discussed above.
Directors’ fees. In general, directors’ fees are considered earnings from self-employment.
Services payments. A withholding tax of 7% applies to payments made to persons for services rendered in Puerto Rico by other persons carrying on a trade or business in Puerto Rico. The withholding applies to payments for services that are not covered by other withholding provisions, including payments of wages subject to income tax withholding.
Taxation of employer-provided stock options. In general, employer-provided stock options are taxed the same in Puerto Rico as they are in the United States, with the following exceptions:
- The exercise of a qualified stock option does not constitute a taxable event in Puerto Rico.
- No alternative minimum tax (AMT) adjustment applies in Puerto Rico.
- No holding period is required for qualified stock options.
- Stock option plans established on or after 1 January 2001 must obtain a ruling from the Puerto Rico Treasury Department to obtain qualified status and beneficial income tax treatment.
Capital gains. Net long-term capital gains (the excess of net gains derived from the sale of capital assets held for longer than six months over losses from the sale of most capital assets held for six months or less) are generally subject to tax at a maximum rate of 10%, but the effective tax rate could be higher as a result of recent amendments to the alternate basic tax system.
Deductions. Nonresident U.S. citizens are allowed the same deductions applicable to residents but, in general, are not allowed any deduction that is allocable or apportionable to income not subject to Puerto Rican income tax.
Deductible expenses and standard deductions. To calculate taxable income, individuals may reduce gross income by using specific deductions, itemized deductions or the standard deduction, plus certain additional deductions.
In general, deductions allowed in the computation of adjusted gross income are costs and expenses directly incurred in, or attributable to, generating or earning income. The following deductions are included in this category:
- Deductions attributable to rents and royalties (losses may not offset other types of income)
- Losses from the sale or exchange of property
- A portion (not exceeding US$1,000) of the excess of capital losses over capital gains
- Alimony payments
- Distributive shares in special partnership losses
Allowable deductions reduce adjusted gross income. These include mortgage interest on both a principal residence and a second home located in Puerto Rico, charitable contributions (subject to limitations), certain disaster losses, and medical expenses over specified amounts. Nonresident aliens may deduct certain charitable contributions made to various Puerto Rican charitable organizations.
Deductions for part-year residents and nonresident individuals must be apportioned on the basis of income sources.
The standard deduction was eliminated for 2011 and subsequent years.
In addition, deductions are allowed for contributions to individual retirement accounts (IRAs; subject to limitations) and for contributions by government employees to certain retirement plans. A deduction of up to US$500 is available for cash contributions to an Educational Contributions Account for the exclusive benefit of a child or relative up to the third degree of blood relationship or second degree by affinity.
The IRCPR reduced the number of categories of filing status to the following three categories:
- Married filing jointly
- Married filing separately
- Individual taxpayer (which includes single, head of household and married not living with spouse)
Personal exemptions. In addition to the deductible expenses discussed above, the following exemptions may be subtracted from adjusted gross income to arrive at taxable income.
Personal exemptions and credits for dependents are not available for nonresident aliens.
Business deductions. Self-employed individuals are entitled to the same deductions as employees and may also deduct business expenses. Self-employed persons generally may deduct directly related ordinary and necessary business expenses. Deductible expenses for business meals and entertainment are limited to 50% of the amount incurred, and this amount may not exceed 25% of gross income. Depreciation on automobiles is deductible, up to the first US$30,000 of the cost of the automobile.
A nonresident alien is entitled to the business deductions allowed to a resident, only to the extent that the deductions are related to income effectively connected with the conduct of a trade or business in Puerto Rico.
Optional tax computation for married individuals who both work and file a joint return.
If a married couple lives together and if both spouses work and file a joint return, an option exists to pay tax in an amount equal to the sum of the tax determined individually for the spouses. The rules applicable to this optional tax computation are summarized below.
Gross income. The gross income of each spouse consists of salaries, wages, professional fees, commissions, income from annuities and pensions, gains attributable to trade or business and distributive shares in the income of special partnerships and corporations of individuals, and other income derived from services rendered by each spouse in his or her individual capacity. All other income is equally divided between husband and wife, regardless of who derived the income.
Exemptions and deductions. The personal exemption of a married couple filing jointly and the dependent exemption are divided equally between the spouses. Deductions for contributions to IRAs, Educational Contributions Account or Health Savings Accounts are allowed to the spouse to whom they individually correspond, subject to the limitations that apply to each particular deduction. All other deductions are divided equally between the spouses.
Tax calculation. The regular tax is determined separately for each spouse in accordance with the tax rate schedule applicable to individual taxpayers and then aggregated.
Rates. The 2011 income tax rates applicable to resident individuals, nonresident U.S. citizens and nonresident aliens engaged in business in Puerto Rico are set forth in the table below. These rates apply to married individuals who file jointly, single individuals and married individuals not living with their spouse, and heads of households.
Credits. Individuals resident in Puerto Rico who generate earned income of less than US$22,500 and are not claimed as a dependent by another taxpayer for the tax year may claim a tax credit of 3.5% of their earned income, up to $350.
Relief for losses. Net principal trade or business losses may be used to offset income from other activities. If each spouse has a principal trade or business, a married couple is considered a single trade or business. Unused operating losses may be carried forward for seven years.
Losses from other trade or business activities may offset income only from the same trade or business.
Capital losses are fully deductible against capital gains. In addition, net capital losses of up to US$1,000 a year are deductible against other income. Unused capital losses may be carried forward for five years.
A nonresident alien may deduct certain losses from sources within Puerto Rico.
B. Estate and gift taxes
Puerto Rico estate and gift taxes are imposed at a fixed rate of 10% on the net taxable value of property transferred at death or by gift.
For estate and gift tax purposes, a resident of Puerto Rico generally may transfer property located in Puerto Rico tax-free because a deduction is allowed for property located in Puerto Rico in determining the value of the gross estate.
Gift tax. For a resident, gift tax is imposed on the value of transfers of property located outside of Puerto Rico. For a nonresident, gift tax is imposed on the value of property located in Puerto Rico only.
A tax is imposed on the value of all taxable gifts made during the tax year and in all prior years. The gift tax is computed by applying a fixed 10% rate to taxable gifts made during the calendar year. Donors are entitled to an annual exclusion of US$10,000 to each donee from taxable gifts.
Various deductions are also allowed. A credit against gift tax may be claimed for gift taxes paid to the United States or to foreign governments.
If the gift tax is not paid by the donor, it may be assessed against the donee to the extent of the value of the gift received by the donee.
Estate tax. Estate tax is computed by applying a fixed 10% rate to the taxable estate. For a resident, the taxable estate is defined as the gross estate (generally the fair market value of the transferred property, wherever located, on the date of transfer or gift), less allowable deductions. Various specified deductions are allowed, as well as a fixed exemption of US$1 million, reduced by any deduction claimed for property located in Puerto Rico.
Credits are permitted for certain amounts that were included in the estate of a previous decedent, as well as for estate taxes paid to the United States or foreign countries.
Nonresidents are subject to Puerto Rico estate tax on estate property located in Puerto Rico only. Certain deductions and exclusions are allowed. A nonresident U.S. citizen decedent is allowed a minimum exemption of US$30,000, and a nonresident alien decedent is allowed a US$10,000 exemption.
The Puerto Rico estate tax is limited to the maximum credit allowed under the rules of the government of the decedent. This rule applies, for example, to Puerto Rico residents who are subject to U.S. estate taxes. Residents of Puerto Rico who were born or naturalized in Puerto Rico are subject to U.S. estate and gift taxes on assets located in the U.S. only.
C. Social security
Three principal social security taxes are levied under U.S. federal law: the Federal Insurance Contributions Act (FICA), the Self-Employment Tax (SE Tax) and the Federal Unemployment Tax Act (FUTA).
In addition, Puerto Rico levies its own unemployment tax, as well as a disability tax and a workers’ compensation insurance contribution.
FICA. For 2011, FICA tax is imposed on wages at a total rate of 13.3%, which includes a 2.9% Medicare Tax. The combined tax rate for employee’s wages is 5.65%, which is composed of a 4.2% component for Old-Age, Survivors and Disability Insurance Tax (OASDI) and a 1.45% component for hospital insurance (Medicare). For 2011, OASDI tax is imposed on wages up to an OASDI wage base of US$106,800. No limit applies to the amount of wages subject to the Medicare portion of the tax.
SE Tax. SE Tax is imposed on a U.S. citizen’s or resident alien’s self-employment income after deductions for business expenses.
The 2011 rate is 10.4% on the first US$106,800 of self-employment income. No limit applies to the amount of income subject to the 2.9% Medicare portion of the tax. Self-employed individuals must pay the entire tax but may deduct 50% as an adjustment to gross income on their federal income tax returns. Individuals who are subject to both FICA and SE Tax first deduct employment income from the 2011 net available base before determining SE Tax. Therefore, a self-employed individual who also has FICA wages of US$106,800 is subject to the additional Medicare tax only.
FUTA. FUTA tax is imposed on an employer’s wage payments to employees for services performed within the United States, which is defined to include Puerto Rico. This tax is levied without regard to the citizenship or residence of an employer or an employee.
Until 30 June 2011, the tax rate is 6.2% on the first US$7,000 of wages for each employee. After that date, the rate is reduced to 6%. Self-employed individuals are not subject to FUTA. A credit for the amount of state unemployment insurance paid to the government of Puerto Rico is available.
Puerto Rican employment taxes. The maximum 2011 Puerto Rican unemployment tax rate is 5.4% on the first US$7,000 of an employee’s wages. The rate may be lower, depending on the employer’s rating, which is based on the employer’s history of layoffs. This tax may be credited against the FUTA tax.
A disability tax is imposed on the first US$9,000 of an employee’s wages. The rate is 0.6%, with 0.3% paid by the employer and 0.3% paid by the employee.
Premiums for workers’ compensation insurance are borne solely by the employer and are based on total wages paid. The rate varies, depending on the occupation of the workers.
Double tax relief and tax treaties
Residents of Puerto Rico are taxed by the Puerto Rican government on their worldwide income. Puerto Rico is a part of the United States, and most U.S. laws apply in Puerto Rico. However, under special legislation, Puerto Rican-source income derived by individuals residing in Puerto Rico is generally exempt from U.S. individual income taxation. Income from sources outside Puerto Rico derived by individuals residing in Puerto Rico is subject to U.S. taxation.
A foreign tax credit is available to prevent double taxation of Puerto Rican residents subject to U.S. or foreign tax on non-Puerto Rican-source income. Generally, the foreign tax credit permits a taxpayer to reduce Puerto Rican tax by the amount of income tax paid to the United States or to foreign governments. The credit is limited to the lesser of the following:
- The actual U.S. or foreign taxes paid or accrued
- The Puerto Rican tax applicable to the non-Puerto Rican-source taxable income
Separate limitations may apply for situations in which non-Puerto Rican-source income is derived from more than one foreign jurisdiction. Puerto Rico has not entered into any double tax treaties. A protocol provision of the treaty between the United States and Spain states that the U.S. and Spanish governments should meet to extend the treaty’s coverage to Puerto Rico, but this has not yet occurred.
To learn more about the history, culture, economy and other information about Puerto Rico
We have been preparing US income tax returns for US Citizens and permanent residents living in Puerto Rico for over 15 years. As a US Citizen or permanent resident (green card holder) you are required to file a US return each year regardless of the fact that you file and pay taxes in your residence country. The expatriate earned income exemption ($100,800 for 2015) can only be claimed if you file a timely tax return. It is not automatic if you fail to file.
We have scores of clients located in Puerto Rico and know how to integrate your US taxes into the local income taxes you pay. Any income tax you pay there can be claimed as a dollar for dollar credit against the tax on your US return on the same income.
As an expat living abroad you get an automatic extension to file until June 15th following the calendar year end. (You cannot file using the tax fiscal year for US tax purposes). You must pay any tax that may be due by April 15th in order to avoid penalties and interest. You can get an extension to file (if you request it) until October 15th.
There are other forms which must be filed if you have foreign bank or financial accounts; foreign investment company; or own 10% or more of a foreign corporation or foreign partnership. If you do not file these forms or file them late, the IRS can impose penalties of $10,000 or more per form. These penalties are due regardless of whether you owe income taxes or not.
There are certain times you may wish to make elections with respect to your Corporation or Investment Company which will give you US tax benefits. There are other situations where forming a US corporation to receive your business income may be more advantageous than using a corporation in your resident country. We can help you with these decisions.
If you are self-employed, you will have to pay US self-employment taxes (social security). If you are a bona-fide employee you do not have to worry about paying US social security on your wages earned in Puerto Rico.
We have helped hundreds of expats around the world catch up because they have failed to file US returns for many years. Unfortunately, unlike India, Canada, UK, etc. you must also file so long as you are a US citizen or resident. You can if you follow proper IRS and State Department procedures surrender your US Citizenship and therefore cut off your obligation to pay US taxes in the future. You must surrender that Citizenship for non-tax avoidance reasons and then can usually not return to the US for more than 30 days per year for the subsequent ten years.
Let us help you with your US tax returns, US tax planning and other US tax and legal concerns. Download our expat tax questionnaire or request a request a consultation by phone, skype or email