Going in Circles: The IRS Limits Puerto Rico Source Rules in Responding to Aggressive Tax Positions
The tax advantages for US individuals who become bona fide residents of US possessions can be substantial.1 These tax advantages have lured more than a few taxpayers to take unreasonably aggressive positions that they are entitled to those benefits.2 Although the Internal Revenue Service (IRS) announced an audit campaign to ensure that taxpayers claiming these benefits in Puerto Rico were properly doing so, Congress has been concerned that IRS enforcement was too lax.3 Notwithstanding general silence from the IRS since the campaign announcement, just-released Advice Memorandum 2024-0054 shows that the IRS has been diligently searching for abusive transactions. In AM 2024-005, the IRS has challenged a tenuous position that has been adopted by certain taxpayers. But the IRS appears to have taken the long way to reach its goal, proving Professor Peter Senge’s observation that “The world is made of circles and we think in straight lines.”5
The facts of AM 2024-005 address transactions undertaken by or with respect to an S corporation. The IRS states, however, that “the conclusion would be identical” if the transactions were undertaken by a partnership. The analysis below follows the S corporation transaction and sets out the IRS’s position if the same transactions were undertaken by a partnership.
The Strategy Being Challenged by the IRS
The US tax rules severely limit the ability of a US taxpayer to transform built-in and unrealized gains accrued prior to the taxpayer’s initiation of Puerto Rico residency into tax-free Puerto Rico-source income.6 At its heart, the transactions described in AM 2024-005 represent taxpayer’s attempt to mitigate the impact of those rules. In AM 2024-005, the taxpayer held a portfolio of appreciated securities prior to becoming a bona fide resident of Puerto Rico. The taxpayer contributed that stock to an S corporation in a tax-free transaction. Shortly after the contribution, the taxpayer became a bona fide resident of Puerto Rico. For the next two years, the taxpayer held the stock of the S corporation, and the S corporation held the appreciated securities. For illustrative purposes, we’ll assume that the taxpayer had held the appreciated securities for five years prior to the contribution to the S corporation (although AM 2024-005 is silent on this point). The IRS then considers two different transactions.
A. Sale of the S Corporation Stock
In the first transaction, the taxpayer sold the S corporation stock. Under the general rule applicable to split-holding-period assets—that is, property that has both a US holding period and a Puerto Rico holding period—all of the gain would have been treated as US-source.7 A taxpayer may elect, however, to split their holding period between the US and Puerto Rico.8 If the taxpayer made this election, the IRS concludes that the gain from the disposition of the S corporation stock would be treated as Puerto Rico-source based on the number of days the taxpayer held the appreciated securities in the US versus the number of days they held the S corporation stock as a bona fide resident of Puerto Rico. Using our assumptions (and years instead of days), 5/7ths of the gain would be treated as US-source, and 2/7ths of the gain would be treated as Puerto Rico-source. We understand that certain taxpayers determined their share of the income that was Puerto Rico-source income without reference to their US holding period of the appreciated securities. AM 2024-005 directly challenges this position.
The IRS’s conclusion in the first scenario is interesting because it appears that the IRS consciously concludes that the special rules for marketable securities did not apply to determine the Puerto Rico-source portion of the gain.9 Under the special rules, a taxpayer may elect to determine the Puerto Rico-source portion of the gain from split-holding-period marketable securities to the extent that the gain exceeds the gain that the taxpayer would have earned if they sold the stock at the time that they became a bona fide resident of Puerto Rico. In other words, under the special rule, it is only appreciation accruing after the taxpayer becomes a bona fide resident that is eligible to be treated as Puerto Rico-source income. The IRS focuses solely on the fact that the shares of the S corporation were not “marketable securities.” Implicitly, it appears the IRS concludes that there is no look-through for purposes of applying the special rules for marketable securities even if the shares contributed to the S corporation were themselves marketable securities (a fact that is not specified in AM 2024-005).
B. Sale of Appreciated Securities by the S Corporation
In the second transaction, the S corporation sold the appreciated securities. Certain taxpayers have taken the position that, in this case, the S corporation’s holding period need not be bifurcated between Puerto Rico and US holding periods. Instead, these taxpayers have taken the position that the gain is Puerto Rico-source based on the shareholder’s holding period of the S corporation stock (which may be 100% of the holding period). In AM 2024-005, the IRS—in its zeal to prevent taxpayers from taking this spurious position—narrowly interprets Code § 1366(b) and concludes that none of the gain from the sale of the securities should be treated as Puerto Rico-source income. And worse yet, IRS regulations would have provided the IRS with the result that it sought without having to contort the source rules.
Notwithstanding that Code § 1366(b) states the “character of any item included in a shareholder’s [income]. . . shall be determined as if such item were realized directly from the source from which realized by the [S] corporation,” many tax practitioners do not view the Code section as an independent rule that requires taxpayers to determine the source of income at the shareholder level.10 Instead, they view the Code section as a character rule (e.g., capital versus ordinary) that determines character at the S corporation level and then passes through that character to the S corporation shareholder.
After concluding that Code § 1366(b) does determine the source of gains from the disposition of property at the S corporation level, AM 2024-005 considers whether Code § 1373(a)—which contains special rules for foreign tax credits (FTCs)—permits sourcing of gains from property dispositions at the shareholder level. This Code section states that for purposes of certain sections of the Code, most notably the FTC rules (but not the rules for determining source), an S corporation is treated as a partnership. The IRS concludes that since the Code § 1373(a) rule treating an S corporation as a partnership for FTC purposes does not apply with respect to Code § 865 (which provides source rules for sales of personal property), all gains from property dispositions earned by an S corporation must be sourced based on the residence of the S corporation.11 Since the S corporation is a US person, and Code § 865(a) generally sources gain from sales of personal property based on the residence of the seller, AM 2024-005 concludes that none of the gain from the disposition of the securities can be treated as Puerto Rico-source income.
In the author’s view, the IRS’s conclusion that Code § 1366(b) does not allow for a determination of the source of gains from property dispositions at the shareholder level is not without doubt and could be successfully challenged. That said, an extremely interesting aspect of AM 2024-005 is that the Code did not have to go in circles on this issue. It had a straight line to the conclusion that it sought. As the IRS correctly notes with respect to partnerships, Treasury Regulation § 1.937-2(f)(1)(v) provides that if (1) an individual who has not been a bona fide resident of Puerto Rico for more than 10 years owns, directly or indirectly, at least 10% (by value) of an entity, (2) split holding period property was transferred to the entity in a transaction in which gain or loss was not required to be recognized (in whole or part), and (3) any portion of the gain from the sale of the individual's interest in the entity would not be considered Puerto Rico-source, then any gain from the sale of that property by that entity will not be considered Puerto Rico-source. The IRS could have relied on this same rule to hold that any gain from the disposition of the appreciated securities by the S corporation acquired as non-taxable contributions to capital should not be treated as Puerto Rico-source income. Notably, this regulation refers to property that has been contributed to an “entity,” which would include an S corporation. It’s really unclear why the IRS chooses the circuitous analysis for the S corporation when it could rely on the same unambiguous route it uses for its partnership conclusion.
C. Service Income
The conclusions in AM 2024-005 are limited to gain from the disposition of stock in the S corporation and gain from the disposition of securities held by the S corporation acquired by way of non-taxable contribution. There is no indication as to the IRS’s thoughts on service income earned by an S corporation. For example, an S corporation shareholder that is a bona fide resident of Puerto Rico may earn pass-through service income from the S corporation. Since service income earned by an S corporation from services performed by the corporation in Puerto Rico would be treated as Puerto Rico-source income at the S corporation level, the IRS’s conclusion in AM 2024-005 should confirm that the income should pass through to the shareholders as Puerto Rico-source income.12
D. Summary
The conclusion in AM 2024-005 takes aim at US individuals who sought to use pass-through entities to create Puerto Rico-source gains with respect to property that would not generate such income in their own hands. It is clear that the IRS has been developing deliberate strategies to police the US tax rules for individuals who are taking advantage of the rules for bona fide residents of Puerto Rico. Accordingly, while audit activity by the IRS has been slow in developing, more active enforcement is clearly on the horizon.
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Mark Leeds (mleeds@mayerbrown.com; (212) 506-2499) is a tax partner with the New York office of Mayer Brown. Mark regularly works with individuals and businesses migrating to Puerto Rico to take advantage of the combination of the favorable US tax rules for bona fide residents of Puerto Rico and the local tax incentives provided by Puerto Rico Act 60-2019. Mark expresses his gratitude to Lucas Giardelli (lgiardelli@mayerbrown.com) and Jason Bazar (jbazar@mayerbrown.com) for their helpful suggestions on this Legal Update. Mistakes and omissions remain the sole responsibility of the author.
1 See a video of the author providing an overview of the US tax benefits provided to bona fide residents of Puerto Rico.
2 See IRS Notice 2004-45, 2004-28 IRB 1 (IRS putting taxpayers on notice to be aware of abusive tax reduction scheme involving claiming residence in the Virgin Islands); see also our prior coverage of IRS audit initiative to audit individuals claiming to be bona fide residents of Puerto Rico.
3 See Letter from Congresspersons Torres, McGovern, et. al. to IRS Commissioner Daniel Wefel re: encouragement of more aggressive enforcement of US tax laws relating to Puerto Rico (Nov. 17, 2023).
5 Peter Senge Quotes (change, hard work)
6 Treas. Reg. § 1.937-2(f) (rules for splitting holding period for property held by a bona fide resident of Puerto Rico prior to becoming a bona fide resident).
7 Treas. Reg. § 1.937-1(f)(1)(i).
8 Treas. Reg. § 1.937-1(f)(1)(vi).
9 See Treas. Reg. § 1.937-1(f)(6)(A).
10 Compare Code § 865(i)(5) (applying the source rules for personal property sales by partnerships at the partner level).
