On December 17, 2024 the IRS issued an important memorandum highlighting critical issues concerning the sourcing of gains for bona fide residents of Puerto Rico. Navigating the complexities of Act 60 compliance requires staying informed about IRS rulings that could impact your tax strategy. The recent IRS Advice Memorandum 2024-005 (AM 2024-005) highlights critical issues concerning the sourcing of gains for bona fide residents of Puerto Rico. Here are the key takeaways:
Challenging Aggressive Tax Positions
The IRS has specifically targeted strategies involving the transformation of built-in, unrealized gains into Puerto Rico-source income. Key findings include:
Scenario 1: Sale of S Corporation Stock
- Taxpayers who contribute appreciated securities to an S corporation before becoming bona fide residents of Puerto Rico cannot treat all gains from selling the S corporation stock as Puerto Rico-source.
- The IRS allows an election to apportion the gain between U.S.-source and Puerto Rico-source based on the taxpayer’s holding periods. For example, if appreciated securities were held for ten years in the U.S. and two years in Puerto Rico, only 2/10ths of the gain is Puerto Rico-source.
- In this memo, the IRS concludes that special rules for marketable securities did not apply to determine the Puerto Rico-source portion of the gain. In simpler terms, only the appreciation accrued after the taxpayer becomes a bona fide resident is eligible to be treated as Puerto Rico-source income. The basis behind this is that the shares of the S Corporation are not considered “marketable securities.” Through analysis of the memo, the IRS implies that there is no look-through for the application of the special rules for marketable securities, even if the shares contributed to the S corporation are considered marketable securities.
Scenario 2: Sale of Appreciated Securities by the S Corporation
- Gains from securities sold by an S corporation are treated as U.S.-source income because the S corporation is a U.S. entity.
- The IRS clarified that sourcing gains at the shareholder level does not apply to S corporations under Code §1366(b). As such, the IRS concluded that all gains from property dispositions earned by an S corporation must be sourced based on the residence of the S corporation. If the S Corporation is a US person, none of the gain from the disposition of the securities can be treated as Puerto Rico-sourced income.
Implications for Act 60 Participants
- Enhanced Scrutiny: The IRS is ramping up efforts to police transactions designed to improperly generate Puerto Rico-source income.
- Strategic Elections: Taxpayers may allocate gains to Puerto Rico under specific elections, but these require precise record-keeping and adherence to IRS guidelines.
What This Means for You
This memorandum is a clear signal that the IRS is intensifying enforcement. To ensure your tax strategy aligns with the latest rules and avoids penalties, consult with our team. We specialize in Act 60 compliance and can provide tailored advice to optimize your tax benefits while staying fully compliant.