Claiming Residency in Puerto Rico May Spur More State-Based Tax Audits

State Residency Background

While the IRS campaign has been well publicized, less attention has been paid to how states will respond to the Puerto Rico tax incentives. Because a taxpayer’s residency status directly impacts whether a state can tax a taxpayer and on what income streams the state’s tax may be imposed, states may expand their residency audits of high-income taxpayers moving to other states (often low or no-tax jurisdictions like Florida and Nevada) to include taxpayers newly claiming residency status in Puerto Rico. While taxpayers who have moved to or are considering moving to Puerto Rico may already be expecting an IRS audit or inquiry, they should also be prepared for state residency audits as well. This is especially true for taxpayers leaving states with high income-tax rates, such as New York, New Jersey, and California; in fact, approximately 30% of the Act 22 beneficiaries who moved to Puerto Rico were from one of those three high-tax states (Report to Congress Pursuant to Pub. L. 116-93, p. 5).

To satisfy the residency requirements for the Puerto Rico tax exemption, taxpayers must establish that: 1) they were present in Puerto Rico for at least 183 days during the tax year (“presence test”), 2) they do not have a tax home outside of Puerto Rico (“tax home test”), and 3) they do not have a closer connection to the U.S. or some other country than to Puerto Rico (“closer connection test”). To satisfy the sourcing requirements, taxpayers must show, amongst other things, that their income derives from sources within Puerto Rico and is not effectively connected with the conduct of a trade or business within the U.S.

Once a taxpayer has established bona fide residency in Puerto Rico, they may exclude their Puerto Rico-sourced income from their U.S. gross income for federal tax purposes under IRC section 933. The IRS has argued that some taxpayers do not meet the residency and income-sourcing tests and have improperly claimed the Puerto Rico tax benefits. These efforts have received substantial attention.

State residency audit programs are already robust and are becoming increasingly common. Public reporting indicates that New York State conducted 15,000 residency audits between 2013 and 2017, resulting in over $1 billion in collections, and that California collected $85 million from residency audits between January and November 2023 (Laura Nahmias and Eliyahu Kamisher, “New York’s Rich Get Creative to Flee State Taxes. Auditors are On to Them,” Bloomberg, April 19, 2024, https://tinyurl.com/5n8m7mat).

The remainder of this article discusses the residency rules for those two states and the implications of state residency rules for taxpayers utilizing the Puerto Rico Act 60 tax incentives.

New York State Residency Rules

New York State taxes residents on their worldwide income, even income that is not New York–sourced. Nonresidents, however, are only taxed on the New York–sourced portion of their income. A taxpayer is a New York resident for tax purposes if they are domiciled in New York or if they qualify as a statutory resident.

Under New York law, a taxpayer’s domicile is “the place which an individual intends to be such individual’s permanent home” and “the place to which such individual intends to return whenever such individual may be absent” [N.Y. Tax Law section 605(b)]. During residency audits, New York considers the following factors when determining domicile:

• ▪ The size, value, and nature of use of the taxpayer’s N.Y. residence to the size, value, and nature of use of the newly acquired residence;
• ▪ The taxpayer’s employment or business connections in both locations;
• ▪ The amount of time the taxpayer spends in both locations;
• ▪ The physical location of items that have significant sentimental value to the taxpayer in both locations; and
• ▪ The taxpayer’s close family ties in both locations. (N.Y. State Department of Taxation and Finance Publication 88, General Tax Information for New York State Nonresidents and Part-Year Residents).

Even if a taxpayer is not domiciled in New York, they may be a statutory resident of the state. A taxpayer is a statutory resident of New York if they “maintain a permanent place of abode for substantially all of the taxable year” in New York and if they spend “in the aggregate more than 183 days of the taxable year in New York State” [NY Tax Law section 605(b)]. For these purposes, any part of the day counts as a full day towards the 183-day threshold.

California Residency Rules

California residents are taxed on their total income, while nonresidents are only taxed on their California-sourced income.

For California tax purposes, the term resident “includes (1) every individual who is in the State for other than a temporary or transitory purpose and (2) every individual who is domiciled in the State who is outside the State for a temporary or transitory purpose. All other individuals are nonresidents.” [Cal. Code Regs. Title 18, section 17014].

The “underlying theory of residency” for California tax purposes is that a taxpayer is “a resident of the place where [they] have the closest connections” (CA FTB 2023 Publication 1031, Guidelines for Determining Residency Status, p. 6). California considers the following factors, although no one factor is determinative:

• ▪ Amount of time the taxpayer spends in California versus amount of time they spend outside California.
• ▪ Location of the taxpayer’s spouse/registered domestic partner (RDP) and children;
• ▪ Location of the taxpayer’s principal residence;
• ▪ State that issued the taxpayer’s driver’s license;
• ▪ State where the taxpayer’s vehicles are registered;
• ▪ State where the taxpayer maintains their professional licenses;
• ▪ State where the taxpayer is registered to vote;
• ▪ Location of banks where the taxpayer maintains accounts;
• ▪ Origination point of the taxpayer’s financial transactions;
• ▪ Location of the taxpayer’s medical professionals and other healthcare providers, accountants, and attorneys.

Notably, California does not consider individuals who are present in the state for “temporary or transitory purposes” to be residents. For example, a businessperson from out of state who takes three, two-week long business trips to California during a tax year would not be considered a state resident and would only be subject to tax on their California-sourced income (CA FTB 2023 Publication 1031, Guidelines for Determining Residency Status, p. 6). California presumes that an individual who spends more than 9 months in the state during the tax year is a resident (CA FTB 2023 Publication 1031, Guidelines for Determining Residency Status, p. 6).

Tensions Between State and Federal Definitions of Residency

Taxpayers should be sensitive to potential differences between federal and state definitions of residency and income sourcing.

Federal law provides an exception to the tax home and closer connection tests in the year in which a taxpayer moves to Puerto Rico. The taxpayer will satisfy the tests in the year of their move if:

• ▪ The taxpayer has not been a bona fide resident of Puerto Rico for any of the three previous tax years;
• ▪ For each of the final 183 days of the tax year, the taxpayer does not have a tax home outside Puerto Rico or a closer connection to the U.S. or foreign country than they do to Puerto Rico; and
• ▪ The taxpayer is a bona fide resident of Puerto Rico for each of the three tax years immediately following their move [Treasury Regulations section 1.937-1(f)].

This exception may not apply at the state level, however. For example, consider a taxpayer who begins the year as a California resident but generates Puerto Rico–sourced income throughout the entire year. The taxpayer moves to Puerto Rico on May 2 and meets the federal “year of the move” exception to satisfy the tax home and closer connection tests. The taxpayer would be able to exclude all their Puerto Rico–sourced income from their U.S. gross income for federal tax purposes. But because there is no “year of the move” exception at the state level, California would theoretically treat the taxpayer as a partial-year resident and may tax the Puerto Rico-sourced income earned from January 1 to May 1 while the taxpayer was a California resident. Nonetheless, this scenario should not result in any California tax being imposed on the taxpayer because, even absent a year of the move exception, if the taxpayer properly qualifies for Act 60 benefits for federal tax purposes, they would not have any federal income (other than income deemed U.S. source for Puerto Rico residents), which is the starting point for California’s income tax determinations. Absent any federal income, the taxpayer in this scenario would not be subject to California state tax regardless of technical residency status.

Similarly, partial days present in the U.S. (with the remainder in Puerto Rico) and days present in the U.S. as a qualifying student do not count as U.S.–presence days for federal purposes but would count as New York days for New York residency purposes. Under such a scenario, if the taxpayer ultimately qualifies for Puerto Rico tax benefits at the federal level, the taxpayer would not have any federal income (other than income deemed U.S. source for Puerto Rico residents), and thus no income to report to New York, regardless of residency status.

In both examples, while the taxpayer may not have any taxable income as a resident of either California or New York, such a taxpayer would still be required to file a resident return in the respective state.

Factors to Consider

While the IRS campaigns targeting the Puerto Rico tax incentives have been well-publicized, taxpayers who are considering a move to Puerto Rico should also be aware of the potential for state residency audits, which differ from federal residency audits. Finally, taxpayers who are audited by the IRS and are determined to be ineligible for Puerto Rico residency status should expect that such a determination may be shared with their state taxing authority, which will then likely seek to initiate a residency audit. Taxpayers wishing to take advantage of the Puerto Rico tax benefits should seek competent professional counsel to ensure that they truly qualify for the benefits and that they can establish such to the satisfaction of state and federal tax authorities.