Puerto Rico's Act 60, Income Sourcing And IRS Scrutiny In The Age Of Cryptocurrency

Highlights

• Puerto Rico's Tax Incentives Code (Act 60) provides major tax advantages, but only for taxpayers who meet strict residency and sourcing requirements.
• The IRS is actively enforcing these rules. This can be seen in the recent United States v. Suresh Gajwani case and Chief Counsel Memorandum 202538025.
• Taxpayers who maintain proper documentation and align their facts with Internal Revenue Code and U.S. Department of the Treasury guidance can benefit from Act 60, while those who cut corners risk audits and penalties.

Puerto Rico's Tax Incentives Code (Act 60) has quickly risen to the forefront of tax planning conversations, drawing intense interest from entrepreneurs, investors, cryptocurrency traders and taxpayers holding carried interests in hedge funds, venture capital or private equity. The promise is tantalizing: Move to Puerto Rico, become a bona fide resident and potentially pay little to no U.S. federal tax on Puerto Rico‑sourced income. Qualifying Puerto Rican corporations are subject to a corporate tax rate of just 4 percent, and individual Puerto Rican residents pay zero percent tax on capital gains accrued after establishing bona fide residency and a complete tax exemption on interest and dividends.

But ultimately, everything hinges on the income sourcing rules. The IRS has made very clear – most recently in the United States v. Suresh Gajwani case and IRS Office of Chief Counsel Memorandum (CCM) 202538025 supplemented by AM 2024‑005 – that it will scrutinize whether income is truly Puerto Rico‑sourced. For taxpayers hoping to leverage Act 60, understanding these rules is not optional – it's essential.

The Legal Framework

Several provisions of the Internal Revenue Code (IRC) and related U.S. Department of the Treasury regulations govern how income is sourced:

• IRC § 861, § 865. General rules for sourcing services income to the location where the services are being physically performed
• IRC § 861, § 862. General rules for sourcing dividends and interest to the location of the payer
• IRC § 865. General rules for sourcing personal property sales, including capital gains income, which are sourced to the taxpayer's residence at the time of the sale; note that cryptocurrency is treated as property under IRS Revenue Ruling 2019-24 and is sourced under these rules
• IRC § 937. General rules for sourcing of income to U.S. possessions, including Puerto Rico
• IRC § 937(b) and Treas. Reg. § 1.937‑2. Provides a special 10-year lookback rule that applies to the sale of property by individuals who moved to Puerto Rico. For such individuals, gain from the sale of certain property owned prior to the individual becoming a Puerto Rican resident is not considered Puerto Rican source income if the property is sold within 10 years of moving to Puerto Rico. Application of this rule to the sale of property an individual transfer to a partnership or other pass-through entity and subsequently sold is not entirely clear, although recent IRS informal guidance suggests the 10-year lookback should apply.

Together, these authorities form the foundation upon which IRS relies when disputing Puerto Rico income sourcing disputes.

Sourcing Services Income: Location, Location, Location

For service providers, the rule is deceptively simple: income is sourced to the place where the services are performed.

• Under the Act 60 Export Services Incentive (formerly Act 20), income from services performed by taxpayers in Puerto Rico for clients outside Puerto Rico is Puerto Rico‑sourced and taxed at just 4 percent.
• Examples include consulting, marketing, software development and financial services.
• The trap: If the taxpayer performs services outside Puerto Rico – say, while traveling in New York or Miami – that portion of income is U.S.‑sourced and subject to U.S. tax.

The IRS has emphasized that taxpayers must keep meticulous records of where services are performed. Travel logs, contracts and billing records are crucial in a sourcing dispute.

Sourcing Investment Income: Residency Is King

Under the Act 60 Resident Individual Investor Incentive (formerly Act 22), sourcing of investment income depends largely on residency:

• Capital Gains. Under IRC § 865(a)(2), the general rule is that gains are sourced to the taxpayer's tax home at the time of sale. Therefore, if a taxpayer sells property procured after becoming a Puerto Rico resident, the gain is Puerto Rico sourced and exempt under Act 60. If the property is sold before obtaining Puerto Rico residency, it remains U.S. sourced. However, Treas. Reg. § Section 1.937-2 provides bifurcation rules for property acquired prior to establishing a tax home in Puerto Rico and disposed of after acquiring such tax home in Puerto Rico. Note that cryptocurrency is treated as property under IRS Revenue Ruling 2019-24 and is sourced under these rules
• Dividends and Interest. Generally sourced to the payer's location, Puerto Rico‑source dividends and interest are exempt for residents, but U.S.‑source dividends (e.g., from U.S. corporations) may still be taxed by the IRS.
• Cryptocurrency. Revenue Ruling 2019‑24 treats crypto as property. Thus, gains are sourced like stock to the residence of the seller at the time of disposition.

The Gajwani case illustrates this point. The IRS will scrutinize whether cryptocurrency gains claimed as Puerto Rico‑sourced were in fact U.S.‑sourced. The taxpayer's guilty plea underscored that residency timing and documentation are critical. A taxpayer cannot expect to move to Puerto Rico and immediately sell crypto without scrutiny – the IRS may treat the appreciation as U.S.‑sourced if it accrued before residency was established.

IRS Scrutiny: Lessons from Gajwani and Beyond

The IRS has signaled that it will aggressively police Act 60 claims. In Gajwani, the court focused on:

• residency tests under IRC § 937 (183‑day presence, tax home and closer connection)
• timing of gains (pre‑ vs. post‑residency)
• documentation of where services or trading activity occurred

CCM 202538025 as supplemented by AM 2024‑005 reinforced this stance, cautioning that taxpayers cannot simply "re‑characterize" U.S.‑sourced gains as Puerto Rico‑sourced through Sub-S corporations and partnerships. The IRS is particularly wary of crypto traders who move to Puerto Rico to attempt to shelter large gains.

Practical Takeaways

1. Residency Must Be Real: Bona fide residency requires more than just paperwork. Physical presence, a Puerto Rico tax home and a closer connection to Puerto Rico are essential.
2. Document Everything. Travel logs, brokerage statements and service contracts should clearly show where income was earned.
3. Timing Matters: Gains realized before residency remain U.S.‑sourced. Plan dispositions carefully.
4. Entities Complicate Things: Pass‑through rules mean U.S. resident owners may still face U.S. tax, even if the entity operates in Puerto Rico.
5. Crypto Is Property: Treat cryptocurrency gains like stock sales. The IRS will not allow shortcuts.
6. Beware of Judicial Doctrines: In its informal guidance, the IRS is telegraphing that the literal language of the statutes may not control, and it will use judicial doctrines such as the step-transaction and aggregate versus entity rules to enforce the sourcing rules.

Conclusion: Act 60 Is No Loophole

Puerto Rico's Act 60 offers extraordinary tax benefits, but it is not a loophole. It is a statutory regime built on precise sourcing rules. The IRS has shown – through Gajwani, Revenue Ruling 2019‑24 and CCM – that it will enforce those rules rigorously, especially in the volatile world of cryptocurrency.

For taxpayers, the message is clear: Act 60 rewards compliance, not creativity. Those who align their facts with the sourcing rules in IRC §§ 865, 937 and 933, as well as Treas. Reg. § 1.937 2 and related guidance, can reap the benefits. Those who cut corners risk audits, penalties and disappointment.

In the end, Puerto Rico's tax incentives are powerful, but only for those who play by the rules.