How does the IRS classify the source of income and how is this treated under the Puerto Rico Tax Code and IRC Section 933?
In the United States, citizens and residents are taxed on their worldwide income, no matter where the taxpayer is located or the location where the money comes from. Taxpayers who receive all of their income from within the United States don’t need to worry about their “source of income“. On the other hand, those taxpayers with incomes from sources from Puerto Rico may want to pay attention, because their income may be exempt from U.S. tax under Section 933 of the Internal Revenue Code. These credits will be calculated based on their Puerto Rico income.
Salaries & Earned Compensation
The place in which a taxpayer originates its income is what is used to determine the source of income. Locations that refer to the source of income are the following:
- United States
- Puerto Rico
Take the following example: Joe is a U.S. citizen and a bona fide resident of Puerto Rico, where he works for Company X. During the months of May to July he was sent to California for a temporary assignment. His employer continued to pay wages by depositing his money in his Puerto Rico bank account. For purposes of the IRS, Joe has a U.S. source income for his temporary assignment in California and the other income is Puerto Rico based income.
Interest Income & Pensions
The residence the person paying the interest determines the source. Interest may come from:
- Notes, or
- Other interest bearing obligations of residents, corporation, etc.
For example, if there was a Puerto Rico bona fide resident receiving interest from a U. S. Bank account, this Puerto Rico resident would have a U.S. source income.
Other different treatment include:
- In the case of pensions, the source of pension distributions derives from the place that the taxpayer performed the services that earned him/her the pension.
- With pension distributions on investment earnings, the location of the pension trust is used to determine the source of investment earning.
- The source of income for dividend is determined considering the location of the payer of the dividend. So, if the Corporation is located in Delaware it is U.S. source income. If the Corporation is located in Puerto Rico, it is Puerto Rico source income.
Sale of Personal Property & Real Property
- For this type of income, the source will be determined based on the residence of the seller (Seller’s tax home).
- On the other hand, source of income for a real property sale is based on the location of the property being sold.
Rents and Natural Resource Royalty Incomes
When we consider Rent Income, the source of this income derives from the location of the property that is being rented and generating the income. Same rule applies for the natural resource royalties (Examples of natural resources are: Oil Well, Coal Mines and Natural Gas source)
For Other Royalties (Patents, copyrights, etc.)
For other types of royalties, the source of income depends in the place in which the Intellectual Property (IP) is being used.
These rules are of special importance when discussing Act 20 and Act 22 tax incentives in Puerto Rico.
If you are an individual considering to relocate to Puerto Rico to take advantage of the tax incentives available, there are other several rules and regulations from the Internal Revenue Service that you must abide to fully comply with the law. Furthermore, there are filings to submit the IRS in case of a change in bona fide residency.
General Rules for Determining U.S. Source of Income – as per 26 U.S. Code § 861
- Salaries and Services
- Interest Income
- Dividend Income
- Rental Income
- Royalty Income
- Sale of Real Property
- Sale of Personal Property
Investment Earnings: Where pension trust is located
Patents, Copyrights, etc.: Where property is used
U.S. income rule. This rule states that income is not possession source income if, under the rules of Internal Revenue Code sections 861–865, it is treated as income:
- From sources within the United States, or
- Effectively connected with the conduct of a trade or business within the United States
If you have a question, or comment related to the compliance of relocating to Puerto Rico, feel free to send me an email to the contact information below. Maybe I can help.