A common question arises among Act 60 business owners: what are the tax implications of spending part of the year working remotely from abroad? This article examines a hypothetical case study to highlight the critical considerations for Act 60 entrepreneurs, emphasizing the need for strategic planning to avoid significant tax and legal complications.
Background:
Joe, a U.S. citizen and bona fide resident of Puerto Rico, owns a Puerto Rican LLC (“PRCo”) taxed as a corporation under both U.S. and Puerto Rican tax laws. PRCo qualifies for the 4% tax rate under Puerto Rico’s Act 60, and distributions to Joe are exempt from Puerto Rican income tax.
PRCo provides services to clients outside Puerto Rico, earning $25 million in annual revenue and $15 million in profits. Joe, as an employee and 90% contributor to the company’s revenue, receives $10 million annually in dividends. The company has three other employees, all bona fide residents of Puerto Rico.
Joe plans to spend summers in Italy while continuing to work remotely for PRCo. However, his U.S. tax advisor warns him that working abroad could create unintended tax liabilities, including the possibility of U.S. taxation on a portion of PRCo’s dividends.
Income Sourcing for PRCo’s Services
Under U.S. tax law, personal service income is sourced to the location where services are performed. Since Joe and his team previously worked exclusively in Puerto Rico, all of PRCo’s income has been considered Puerto Rican-source income.
Dividend Sourcing and Tax Implications
Two key Internal Revenue Code rules govern the sourcing of Joe’s dividend income:
-
The 861/862 Dividend Sourcing Rule
This rule determines whether PRCo is classified as a controlled foreign corporation (CFC). As all of PRCo’s income has been sourced from Puerto Rico, it avoids classification as a CFC, exempting it from Subpart F or GILTI rules. -
The 937 Dividend Sourcing Rule
This rule assesses whether Joe can exclude PRCo dividends from U.S. taxable income. PRCo must meet two tests during a three-year period:- The 80% Test, requiring at least 80% of gross income to come from Puerto Rican sources or be effectively connected to Puerto Rico.
- The 50% Test, requiring at least 50% of gross income to come from active business operations in Puerto Rico.
PRCo has passed these tests so far, allowing Joe to exclude dividends from U.S. taxable income. However, if Joe’s remote work in Italy shifts a significant portion of PRCo’s income outside Puerto Rico, the company could fail these tests, exposing Joe to additional U.S. tax liabilities.
Puerto Rico Tax Consequences
Under Act 60, the 4% tax rate applies only to eligible export activities. If Joe’s remote work does not qualify as an eligible activity, income generated from his services in Italy could be subject to Puerto Rico’s standard corporate tax rate, which can reach 37.5%.
For instance, if Joe spends 25% of his time working in Italy, 25% of PRCo’s income—approximately $3.75 million—could be taxed at this higher rate, resulting in a tax liability exceeding $1.2 million.
Compliance Risks and Legal Considerations
Joe’s decision to work remotely also raises compliance risks. If PRCo fails to meet the requirements for Act 60 benefits or if Joe misreports income on Puerto Rico tax returns, he could face severe penalties, including potential criminal liability for false reporting.
Planning Opportunities
Before finalizing his plans, Joe should consult with experienced tax advisors to explore potential solutions, such as:
- Amending the Act 60 Export Services Grant: Joe could request modifications to include specific remote workdays as incidental to PRCo’s primary business activities, potentially preserving the 4% tax rate.
- Revising Work Arrangements: By limiting the scope and duration of his remote work, Joe can minimize the risk of PRCo’s income being reclassified as non-Puerto Rican source income.
Conclusion
Joe’s case underscores the importance of careful tax planning for Act 60 business owners considering remote work abroad. Decisions about where and how to work can have profound tax and legal implications. Consulting with knowledgeable tax and legal professionals is essential to navigate these complexities and maintain compliance with U.S. and Puerto Rican tax laws.