With all due deference to the Bard, one perennial choice that bona fide residents of Puerto Rico1 face each tax filing season is whether to show items of Puerto Rico-source income not subject to federal income tax on their US tax returns, or—if they don’t otherwise have an obligation to file US returns—whether to file anyway and show the Puerto Rico-source income items. Certain recent developments support the conclusion that such individuals will likely derive a substantial benefit from showing such items on a US federal income tax return. Specifically, the reporting of such items should preclude an Internal Revenue Service (“IRS”) assertion that an extended or no statute of limitations applies to such items.
I. Short Technical Background
In general, bona fide residents of Puerto Rico are not subject to US federal income tax on items of Puerto Rico-source income.2 This exemption would not be of much interest if the income exempted from US federal income tax was subject to net Puerto Rico income tax. However, certain types of income—such as dividends, interest, capital gains and swap income—are exempt from Puerto Rico income taxes if the taxpayer has obtained a Puerto Rico Act 60 decree. In addition, an Act 60 decree allows a taxpayer to be subject to a 4% Puerto Rico tax (rather than the regular 31% Puerto Rico income tax), if they earn business income that constitutes export service income.
If substantially all of the income earned by a bona fide resident of Puerto Rico is Puerto Rico-source income, the individual may not have sufficient US taxable income to trigger the requirement to file a US federal income tax return.3 IRS Publication 570 specifically states, “If all of your income is from Puerto Rico sources, you are not required to file a U.S. tax return.” Publication 570 goes on to state that if a bona fide resident of Puerto Rico has other income, (s)he must file a “U.S. tax return reporting income from worldwide sources, but excluding Puerto Rico source income.” We note that the instructions for bona fide residents of the US Virgin Islands are substantially identical to those quoted for bona fide residents of Puerto Rico.
Both sets of instructions issued by the IRS unequivocally state that a bona fide resident of Puerto Rico need not report Puerto Rico-source income on a US federal income tax return. If the IRS is telling bona fide residents of Puerto Rico that they don’t have to file or report Puerto Rico-source income, what more is there to say?
II. The Audit Trail
In the 2000s and 2010s, the IRS initiated audits of US individuals who claimed to be bona fide residents of the Virgin Islands and sheltered their income by claiming that their income was Virgin Islands-source income and not subject to US federal income tax. (The tax rate in the Virgin Islands is only 10%.) As a result of these audits, there is now a robust body of law addressing when the statute of limitations begins for individuals who filed only US possessions tax returns. In response to these tax cases, the tax reporting rules and information exchange procedures between the IRS and the Virgin Islands Bureau of Internal Revenue (“VIBIR”) have been refined and improved.
While the enhanced formal information exchange procedures between the IRS and the Departmento de Hacienda (“Hacienda”) are not as refined as those between the VIBIR and the IRS, the IRS has initiated an intensive audit program of individuals claiming to be bona fide residents of Puerto Rico.4 If history at least rhymes (if it doesn’t repeat itself), as Hacienda turns over information to the IRS, the IRS will find itself seeking income taxes from taxpayers for tax years that would be barred by the three-year statute of limitations, if the statute applied. As we’ll see from the experience of taxpayers claiming to be bona fide residents of the Virgin Islands, if the taxpayer either omitted the items of Puerto Rico-source income—or did not file a US return at all—the IRS may not find these old claims to be time-barred.
III. Maybe the IRS Instructions Don’t Tell the Whole Story
In Commissioner v. Estate of Sanders,5 the IRS challenged the status of a US individual as a bona fide resident of the US Virgin Islands. The taxpayer in that case had not filed US federal income tax returns for the years at issue because he had claimed VI residency status, and that all of his income was Virgin Islands-source income. The IRS initiated its challenge to the taxpayer’s VI residency status more than three years after the time he had filed his Virgin Islands income tax return. The taxpayer asserted that the statute of limitations on a US tax assessment was barred by the statute of limitations by computing the limitation period from the time of filing of the VI tax return. The court of appeals held that the US statute of limitations on assessment only began on the filing of the VI return if the individual was a bona fide resident, which was the open issue. Accordingly, the filing of the VI tax return did not preclude the IRS from contesting his status as a bona fide resident more than three years after the filing of the VI return.
It is worth noting that in Estate of Sanders, the Virgin Islands shared the taxpayer’s VI tax return with the IRS. The taxpayer argued that this fact should be sufficient to start the statute of limitations. The court, however, held that this fact was immaterial to whether the statute started for the taxpayer because it is the taxpayer’s filing that starts the statute clock.
The facts in Coffey v. Commissioner6 are startlingly similar to those of Estate of Sanders. The taxpayers filed their 2003 and 2004 Virgin Islands tax returns as bona fide residents of the Virgin Islands. They did not file US tax returns. The VIBIR sent copies of the tax returns to the IRS. The IRS issued Notices of Deficiency to the taxpayers in 2009, more than three years after they filed the returns with the VIBIR (which would have been fine if they were bona fide residents of the Virgin Islands). The court of appeals held that the fact that VIBIR sent the returns to the IRS did not constitute the filing of a return by the taxpayers. The court further held that the filing of a return with the VIBIR did not constitute the filing of a US tax return. Accordingly, the IRS was allowed to assess tax against the taxpayers in the same manner as though they had not filed returns.
In May 2023, a substantially similar issue was considered by the Tax Court in Estate of Tanner.7 In Estate of Tanner, the taxpayer filed his 2003 and 2004 returns with the VIBIR in 2004 and 2005, respectively. 10 years later in 2015, the IRS mailed a Notice of Deficiency to the taxpayer for those years, asserting that the taxpayer was not a bona fide resident of the Virgin Islands. The Notice also charged that the taxpayer should have, but did not, file US federal income tax returns for such years. The taxpayer asserted that the statute of limitations barred the IRS from making these assessments.8 The Tax Court held that the relevant statute does not start the statute of limitations based on the taxpayer’s good-faith belief that they are a bona fide resident of the Virgin Islands. Only if the taxpayer actually is a bona fide resident of the Virgin Islands does the statute of limitations start on the date that the Virgin Islands income tax return is filed.9
In an IRS Internal Legal Advice Memorandum (an “ILM”) entitled Application of the Statute of Limitations for Assessment of Self-Employment Taxes to Territorial Returns,10 the IRS considered when the statute of limitations begins for bona fide residents of certain territories (but not Puerto Rico) who fail to file Form 1040-SS (for Social Security taxes) with the IRS. In this ILM, the IRS held that the statute of limitations does not toll if no US return is filed.11 The IRS held that if no return is filed with the IRS, then the tax may be assessed at any time.12
These issues are still winding their way through the courts. In Estate of Horne,13 which is still pending, the taxpayer filed returns with the VIBIR for 2002-2004 in 2003 through 2005. In 2010, five years after the most recent return was filed, the IRS issued a Notice of Deficiency to the taxpayer. The taxpayer is asserting that the Notice is time-barred in a petition dated December 20, 2022. The petition highlights the immense challenges posed to the IRS in auditing so many returns.
IV. You Convinced Me: I’ll File a US Return, But Do I Have to Show My Puerto Rico-Source Income?
Once a bona fide resident of Puerto Rico has decided to file a US federal income tax return, the next issue is whether the taxpayer should show items of Puerto Rico-source income on that return. In other words, is it sufficient to file a “zero” return, or one without the items of Puerto Rico-source income included on the return?
If a US tax return is filed, but the items of Puerto Rico-source income are not described or shown on the return, the taxpayer is likely facing a six-year (instead of a three-year) statute of limitations. Specifically, if the omitted items exceed either (i) 25% of the gross income shown on the return or (ii) constitute foreign-specified financial assets and the omission exceeds $5,000, a six-year statute of limitations applies.14 Thus, filing a return without the items of Puerto Rico-source income does start a statute-of-limitations defense, but the extended statute makes it unlikely that the statute of limitations would expire prior to an IRS examination. Nonetheless, it is better than a completely open-ended assessment period.
Mark Leeds (email@example.com; (212) 506-2499) is a tax partner with the New York office of Mayer Brown. Mark’s legal practice includes substantial amounts of work with U.S. individuals and businesses that have relocated from the United States to Puerto Rico and taken advantage of the local tax benefits provided by Puerto Rico Act 60.
4 See Leeds and Lopez, IRS Adds Puerto Rico Act 22 Beneficiaries to List of High-Priority Tax Audit Candidates, https://www.mayerbrown.com/en/perspectives-events/publications/2021/02/irs-adds-puerto-rico-act-22-beneficiaries-to-list-of-high-priority-tax-audit-candidates; Voreacos and Wyss, IRS Preparing Criminal Cases Against Tax Cheats in Puerto Rico (Bloomberg Law News) (July 2023); Borg and Camacho, Puerto Rico Resident Exemption to Be Focus of IRS Audit Campaign (Tax Notes April 25, 2022).
8 For tax years ending after April 9, 2008, special procedures apply to determine when the statute of limitations tolls for bona fide residents of the Virgin Islands. Since such procedures do not apply to Puerto Rico, the years at issue in the case provide more guidance than the specific later-promulgated rules.
11 In this ILM, the IRS reached a contrary conclusion under current law for bona fide residents of the Virgin Islands based on law changes after the date of the Estate of Tanner decision. Since these law changes do not bear on the rules for bona fide residents of Puerto Rico, they will not be considered in text.