This article discusses opportunities for traders in securities and commodities to dramatically decrease the U.S. federal income tax they owe on trading gains by relocating to Puerto Rico. As with all tax-reduction strategies, it assumes that traders will continue to generate gains from their activities. The article is written from the perspective of a U.S. citizen, but certain steps and conclusions also apply to U.S. resident aliens.
Capital Gains From Trading
The gains or losses from trading in securities and commodities are considered capital unless the trader makes a mark-to-market election under Sec. 475, which treats the gains and losses as ordinary income. Certain futures contracts under Sec. 1256 can receive special treatment. Generally, except for Sec. 1256 contracts, traders gain tax advantages by making the Sec. 475 election. However, traders who relocate to Puerto Rico should not make the mark-to-market election, thus treating all gains from their trading activity as capital.
Note that this discussion applies only to traders, not to dealers or investors. Traders are treated as carrying on a trade or business, but, unlike dealers, they do not have inventory or customers. Therefore, their gains and losses on the sales of securities are treated as capital gains and losses (except as noted above) and are reported on Schedule D, the same as an investor. Dealers, on the other hand, regularly purchase securities and sell them to customers in the ordinary course of their business, and the securities owned by a dealer for use in his or her business activity represent inventory held primarily for resale. At the other end of the scale, investors are not in the business of buying and selling securities but buy and sell on their own behalf.
Puerto Rico Tax Advantages
In January 2012, Puerto Rico passed Act No. 22 of 2012, (1) which offers incentives for individuals to relocate to Puerto Rico. The law provides a 100% tax exemption from Puerto Rico income taxes to new Puerto Rico bona Me residents on certain capital gains.
The new bona fide resident must not have been a resident of Puerto Rico at any time during the 15-year period preceding the effective date of Act 22 (i.e., between Jan. 16, 1997, and Jan. 16, 2012).
Act 22 provides that the grant of a tax exemption is a contract with the Puerto Rican government. The individual files an application for a Puerto Rico tax decree before relocation, the approval of which also serves as a contract guaranteeing the incentives through 2035 from any subsequent changes in local legislation. The reason for this is to afford certainty that the tax benefits under Act 22 will not be revoked by subsequent legislation. Since the Puerto Rico Constitution prohibits legislation impairing contractual obligations, it is expected that making the tax grant a contract will protect the tax benefits.
Other laws aimed at stimulating investment enacted in 2012 are:
* The Export Services Act (Act 20), (2) which provides for a 4% maximum tax rate on income related to services for export provided by new export services businesses in Puerto Rico. Qualifying business may also be subject to requirements relating to employment of Puerto Rico residents, income, investment, and other factors or conditions.
* The International Financial Center Regulatory Act (Act 273), (3) which aims to make Puerto Rico an international banking and financial center by providing tax incentives (mainly, a 4% income tax rate) for new banking and financial activity in Puerto Rico conducted for clients outside Puerto Rico.
Income Exclusion for Bona Fide Residents of Puerto Rico
In general, a U.S. citizen or resident remains subject to full federal income tax regardless of domicile. The Internal Revenue Code, however, provides special rules for an "individual who is a bona fide resident" of Puerto Rico. (4) Income derived from sources within Puerto Rico (except amounts received for services performed as an employee of the United States or any agency thereof) is not included in U.S. federal gross income and is exempt from U.S. federal taxation for individuals who are bona fide residents of Puerto Rico during the entire tax year.
According to Sec. 937(a) and Regs. Sec. 1.937-1, the term "bona fide
resident" means a person who satisfies all three tests below.
Presence test: The taxpayer must be present for at least 183 days during the tax year in Puerto Rico, but the test can also be satisfied by any of the following:
* Was present in Puerto Rico for at least 549 days during the three-year period consisting of the tax year and the two immediately preceding tax years, provided that the taxpayer was also present in Puerto Rico for at least 60 days during each of these years;
* Was present in the United States for no more than 90 days during the tax year;
* Did not have more than $3,000 of earned income in the United States and was present in Puerto Rico for more days than...