Puerto Rico, a U.S. territory, has a unique relationship with the United States when it comes to taxes. While residents of Puerto Rico are subject to federal income tax, the tax system in the territory operates differently than that of the mainland United States. Understanding the intricacies of taxation in Puerto Rico can provide insight into the financial responsibilities of its residents, as well as the potential benefits and challenges they face in comparison to their counterparts in the rest of the country.
Bona fide residents of Puerto Rico generally do not need to file a U.S. federal income tax return if their only income is from sources within Puerto Rico. However, if their income also comes from sources outside of the territory, including from the United States, federal income taxes may apply if the income exceeds the U.S. filing threshold. On the other hand, Puerto Rican residents are subject to local income taxes, which can have more favorable conditions for those who qualify for tax incentive decrees like Act 60 (formerly Acts 20 and 22) source. These unique features of the Puerto Rican tax system make it an interesting area to explore in terms of tax obligations and advantages.
U.S. Citizens and Bona Fide Residents
Determining Bona Fide Resident Status
Determining whether a U.S. citizen or lawful permanent resident is considered a bona fide resident of Puerto Rico involves meeting certain criteria. According to the IRS, a person should meet the Puerto Bona-Fide Resident Rule, which differs from the Substantial Presence Test. A bona fide resident of Puerto Rico is:
- Present in Puerto Rico for at least 183 days during the tax year,
- Not having a tax home outside Puerto Rico during the tax year, and
- Not having a closer connection to the United States or a foreign country than to Puerto Rico.
Taxing Worldwide Income
Once an individual is classified as a bona fide resident of Puerto Rico, their tax situation may change. The income derived from Puerto Rico might be exempt from U.S. taxes. However, it is worth noting that Puerto Ricans still pay federal taxes, but most residents do not pay federal income taxes. It’s important for bona fide residents of Puerto Rico to understand their tax obligations:
- U.S. citizens and lawful permanent residents with bona fide resident status in Puerto Rico are only taxed on their non-Puerto Rican income by the U.S. federal government.
- Income derived from sources within Puerto Rico is generally exempt from U.S. federal income tax. However, bona fide residents must still report their worldwide income on their U.S. federal tax return when required to file a return.
- Bona fide residents may be liable for the Net Investment Income Tax (NIIT) if the taxpayer’s modified adjusted gross income from non-territory sources exceeds a specified threshold amount, as explained by the IRS Publication 570.
- Act 60, previously known as Acts 20 and 22, offers tax incentives for Americans who move a qualifying business to Puerto Rico. Becoming a bona fide resident and establishing an office in the territory allows those individuals to pay only 4% corporation tax, and no taxes on dividends, interest, capital gains, or royalties.
In summary, it is crucial for U.S. citizens and lawful permanent residents to determine their bona fide resident status in Puerto Rico and understand their tax obligations, especially when it comes to worldwide income and federal income tax.
Tax Credits and Deductions
Child Tax Credit
As a Puerto Rican resident, you may be eligible to claim the Child Tax Credit for each qualifying child. For the 2021 tax year, the credit is up to $3,600 for each qualifying child, and for the 2022 tax year, it is up to $1,500 per qualifying child. To claim this credit, residents of Puerto Rico must file a federal tax return with the IRS, even if they don’t have a filing requirement and have little or no income from a job, business, or other source.
An Informative Return is a document that provides information about your financial activities during the year, including your gross income and taxable income. It is important to accurately report your financial information on your tax return to ensure that you claim the correct amount of tax credits and deductions. This may include credits such as the Child Tax Credit and deductions related to business expenses or other allowable expenses. Properly completing and filing your Informative Return can help you maximize your tax savings while also avoiding any issues with the IRS.
Foreign Tax Credit
If you have taxable Puerto Rican source income on your U.S. income tax return, you can claim a credit for foreign taxes paid to Puerto Rico. This credit is known as the Foreign Tax Credit (FTC). To claim this credit, a Puerto Rico resident must file Form 1116, Foreign Tax Credit (Individual, Estate, or Trust) with the IRS, subject to the rules and instructions applicable to Foreign Tax Credits. However, it is important to note that you are not allowed to claim a credit for foreign taxes paid with respect to Puerto Rican source income that is excluded from a U.S. tax return.
By understanding and utilizing the available tax credits and deductions for Puerto Rican residents, you may be able to reduce your overall tax liability, optimize your financial situation, and ensure compliance with all relevant tax regulations.
Filing Tax Returns
Forms 1040-SS and 1040-PR
Residents of Puerto Rico with income from various sources need to file specific tax forms with the IRS. For instance, individuals with self-employment income use Form 1040-SS or Form 1040-PR to report their self-employment tax. Form 1040-PR is similar to Form 1040-SS, but it is in Spanish.
Besides self-employment income, Puerto Rico residents must file a federal tax return to claim certain credits like the Child Tax Credit, even if they have little or no income from a job, business, or any other source. The credit can be claimed on Form 1040-PR or Form 1040-SS. However, bona fide residents of Puerto Rico generally do not file a U.S. income tax return (Form 1040) unless they have income from sources outside of Puerto Rico or if they are employees of the U.S. government.
There are specific filing thresholds for residents of Puerto Rico. Generally, an individual whose gross income from Puerto Rico sources, net of exemptions, exceeds zero must file a tax return, unless the tax is fully paid at the source. Furthermore, every individual whose net income is subject to alternate basic tax of $25,000 or more during the taxable year must file a tax return1. However, some Puerto Rico residents are not required to file federal income tax returns if their income falls below the poverty threshold2.
The tax year in Puerto Rico follows the calendar year. In most cases, taxpayers must file their individual income tax return by April 15 of the following year3. The due dates for filing Forms 1040-SS and 1040-PR are also typically April 15, coinciding with the filing deadline for U.S. federal income tax returns. Publication 570 provides detailed information regarding tax matters for U.S. citizens and resident aliens living in Puerto Rico.
Keep in mind these filing guidelines and due dates when preparing and submitting your tax forms as a resident of Puerto Rico.
Federal Insurance Contributions Act (FICA) and Unemployment Taxes
Social Security and Medicare Taxes
Employers and employees in Puerto Rico, like in other parts of the United States, are required to pay taxes under the Federal Insurance Contributions Act (FICA). This consists of two components: the Social Security tax and the Medicare tax. In order to fund these federal programs, employers need to withhold a portion of their employees’ wages, currently set at 6.2% for Social Security and 1.45% for Medicare. Employers also contribute an equal amount for each employee, making the total Social Security tax rate 12.4% and the total Medicare tax rate 2.9% source.
These taxes are necessary for the funding of social security and Medicare benefits. Here’s a breakdown of the current tax rates as a quick reference:
|Tax Type||Employee Rate||Employer Rate||Total Rate|
|Social Security||6.2 %||6.2 %||12.4 %|
|Medicare||1.45 %||1.45 %||2.9 %|
The tax rates listed above apply to employers and employees in Puerto Rico source.
Federal Unemployment Tax Act (FUTA)
In addition to FICA taxes, employers in Puerto Rico are subject to the Federal Unemployment Tax Act (FUTA). This tax funds unemployment benefits for eligible workers, including those who lose their jobs through no fault of their own, and it’s the employer’s responsibility to pay this tax. FUTA taxes are not withheld from employees’ wages source.
Compliance with FICA and FUTA requirements helps to ensure that important federal programs, such as Social Security, Medicare, and unemployment benefits, remain funded and available for those who need them. As an employer in Puerto Rico, it is essential to understand and follow the guidelines for withholding, depositing, paying, and reporting these taxes source.
Business Taxation in Puerto Rico
Corporate Income Tax Rates
In Puerto Rico, a domestic corporation is subject to taxation on its worldwide income. On the other hand, a foreign corporation engaged in trade or business within Puerto Rico is taxed at regular corporate tax rates on income generated from Puerto Rican sources that is effectively connected income1. Both federal and local taxes must be paid, with federal taxes being filed with the Internal Revenue Service (IRS) and local taxes filed through the Puerto Rico Department of Treasury2.
Tax Incentives: Acts 20 and 22
Puerto Rico offers various tax incentives to encourage business growth and investment by both local and foreign entities. The most notable incentives are provided under Acts 20 and 22. These incentives aim to stimulate economic development and promote Puerto Rico as a destination for businesses3.
Act 20: Export Services Act
The Export Services Act, commonly known as Act 20, was introduced to provide tax benefits to Puerto Rico-based corporations that export services. Key advantages of Act 20 include:
- A fixed 4% corporate income tax rate on export services4
- 100% tax exemption on dividends or profit distributions from export services entities
- Decree for tax benefits with a 15-year term, renewable for an additional 15 years
Eligible services include, but are not limited to, research and development, advertising and public relations, financial services, and professional services5.
Act 22: Individual Investors Act
Act 22, also known as the Individual Investors Act, was designed to attract high-net-worth investors to relocate to Puerto Rico. The benefits of Act 22 include:
- 100% tax exemption on both long-term and short-term capital gains for new Puerto Rico residents6
- 100% tax exemption on interest and dividend income
To qualify for Act 22, an individual must establish residency in Puerto Rico and not have been a Puerto Rico resident within the previous 15 years7. This tax incentive can help attract investors who, in turn, generate revenue and contribute to the local economy.
Taxation of Non-Residents
Tax Obligations for Non-Residents
In Puerto Rico, non-residents are only taxed on their income that is derived from Puerto Rican sources. This means that income earned by non-residents for services performed in Puerto Rico will be subject to Puerto Rican taxes. The income is typically prorated to Puerto Rico based on workdays.
It is important for non-residents to understand their tax obligations while working or living in Puerto Rico. Although they may not be required to pay federal income taxes, they are still responsible for paying:
- Customs taxes
- Federal commodity taxes
- Federal payroll taxes (Social Security, Medicare, and Unemployment taxes)
Tax Withholding on Puerto Rican Sources
Employers in Puerto Rico are responsible for withholding income tax from their employees’ wages. For Puerto Rican residents, the employer computes the income tax withholding based on the information provided by the employee on a specific form and with tables or percentage methods provided by the PR Treasury Department.
However, for non-resident employees in Puerto Rico, they are subject to a flat 29% withholding tax on their income sourced from Puerto Rico. This ensures that appropriate income taxes are collected from individuals who are earning income within the territory.
To summarize, non-residents working or living in Puerto Rico are taxed on their income from Puerto Rican sources only. Employers withhold taxes on this income, with a flat 29% rate applied to non-residents. Understanding these tax obligations can help non-residents in Puerto Rico avoid potential tax issues and ensure compliance with the territory’s tax laws.
Customs Taxes and U.S. State Taxation
Residents of Puerto Rico pay customs taxes when importing goods into the territory. The Impuesto sobre Ventas y Uso (IVU) or “Sales and Use Tax” is a two-pronged tax system covering both sales tax and use tax. As part of the United States, Puerto Rico adopts the federal customs framework for imported products.
The state general sales tax rate in Puerto Rico is 10.5%. The combined rates in Puerto Rico, which vary by municipality, are the result of the state rate (10.5%) and a county rate that ranges from 0% to 1%. Puerto Rico does not have a separate city sales tax, hence the local tax rates are based on the county regulations.
In terms of federal income tax, some Puerto Rico residents also pay U.S. federal income taxes. This is in addition to the payroll taxes known as FICA taxes, which include:
- Social Security
- Unemployment taxes
Despite the similarities in customs taxes and U.S. state taxation, Puerto Rico offers incentives to lure American mainlanders, such as having an income tax rate of only 4%, in comparison to the 37% federal rate and the 13.3% state rate in California.
In summary, Puerto Rico’s tax system includes both customs taxes and state taxation, with different tax rates for various types of taxes. These tax rates and regulations create a complex yet unique tax environment for the island’s residents and businesses.
Tax Benefits for U.S. Government Employees
U.S. government employees residing in Puerto Rico, including members of the armed forces, may benefit from certain tax advantages. They are still subject to federal income tax on their worldwide income, but certain deductions and credits may apply. For example, self-employed individuals can claim deductions for their business expenses, and charitable contributions may qualify for tax credits.
Insurance premiums paid by an employer in Puerto Rico on behalf of a resident alien employee are generally exempt from Puerto Rico income tax. Furthermore, U.S. government employee civilian spouses may also qualify for certain tax benefits under federal law.
Regarding investment income, U.S. residents who hold stocks in Puerto Rican corporations are typically taxed on their net taxable income. However, resident aliens and U.S. government employees may be eligible for credits or deductions on their taxes related to these investments.
Democracy and Representation in the Tax Code
Puerto Rico’s tax system operates autonomously, with notable differences from the mainland U.S. tax code. Although Puerto Rico pays federal taxes, such as business income taxes, individual income taxes, FICA tax, and other taxes, taxation issues remain a significant part of the ongoing debates on Puerto Rico’s status as a U.S. territory.
The island’s median income is significantly lower than that of the mainland U.S., which impacts the tax obligations of residents. One critical issue often raised is the lack of representation in the adoption or amendment of federal laws affecting Puerto Rican taxpayers.
For example, Puerto Rico’s tax system provides fewer benefits and supports, such as Medicaid, in comparison to the mainland U.S. Any changes to the federal tax code or social support programs may directly affect Puerto Rican residents yet be decided without direct representation in Congress.
This issue of democracy and representation emphasizes the need for continued dialogue and consideration when addressing Puerto Rico’s relationship with the mainland U.S. tax system. Ultimately, effective tax policy in both the United States and Puerto Rico should strive to balance equitable distribution of benefits and burdens while respecting the unique context of each jurisdiction.