[Smart Money] Consider all Factors to Take Advantage of Acts 20/22’s Amazing Incentives
As one of the first recipients to move to Puerto Rico in 2013 and the founder of The 20/22 Act Society, I have witnessed firsthand the growth of the amazing incentives under Acts 20 & 22 of 2012. We are constantly telling potential recipients that they need to consider multiple factors in making their move, such as lifestyle, culture, cost of living, and not only the incentives under the program. As part of this role, we always try to emphasize that properly complying with the sourcing rules lands much stronger on the Internal Revenue Service (IRS) side than on the Treasury Department (Hacienda) side, although I think it is a valid point to say you now serve two masters rather than having escaped one. Most people focus on the 183-day rule, which is only one small part of the picture. The tax home rule, and possibly more importantly the closer connection rule, is really an area where people can make some critical mistakes with disastrous consequences. Further, there are other IRS rules specifically related to company income-sourcing rules that relate to ECI (effectively connected income) and dividend distributions based on what percentage of income is locally sourced, among others, of which many people do not have a strong grasp.
As a result, to prepare our members, we hosted a Cocktails & Compliance event last year with the objective of ensuring our members would remain compliant with the program. One of our speakers, who is a member of The 20/22 Act Society, was David Nissman. David was formerly the attorney general for the U.S. Virgin Islands (USVI) and worked directly with the criminal division of the IRS in the USVI prosecuting individuals for tax evasion daily. He is now part of the local law firm Friedman & Feiger, and is one of our best resources to understand the audit process and how to avoid some common pitfalls by simply being prepared for what will be asked for in an IDR (Informational Document Request). The IDR is quite onerous and most people would not be able to present the items required within the typical 20 days allotted.
I interviewed him to summarize the concerns, based on his experience, that recipients need to focus on to properly comply with and survive an audit. We have learned, on very good authority, that U.S.-side IRS audits started last month, and the results of these audits will likely determine how much wider the net will be cast. Because of the importance of having recipients understand the totality of their tax obligations, we recently re-created our Cocktails & Compliance event, as part of our service to the community. The main reason the USVI economic program was not very successful is due to mass audits by the IRS, which effectively shut the program down even though the laws were similar. Few logical people wanted to join a program that would guarantee them a tax audit.
Robb Rill, founder of The 20/22 Act Society: David, you moved your private practice from the USVI to P.R. in 2014, I assume primarily because of the establishment of the 20/22 program. I know you also came to establish an eco-resort here as well. How would you compare this program to the Economic Development Commission [EDC] program in the USVI?
David Nissman: I moved here in 2014 for two reasons. One was to get closer to a better health system and the second was to develop a treehouse eco-resort, which we are doing in Ciales.
The P.R. laws are better than those in the USVI because P.R. has a better congressional lobby and was able to convince both the Treasury Department and Congress to allow P.R. to create Act 22. There is nothing like Act 22 in any other territory.
RR: From your experience as the former U.S. Attorney in the USVI, how has the level of compliance changed from the early 2000s to now by companies in both economic programs? For example, the American Jobs Creation Act of 2004 established the residency rules in [Internal Revenue Code] IRC Section 933, such as the 183-day physical presence test, the tax home test and the closer connection test. Were these the main changes?
DN: The IRS is incredibly aggressive and, shamefully, this agency does not follow its own rules when it has an agenda. Parts of the U.S. government have declared war against successful entrepreneurs (the 1% you always hear about from politicians). As a consequence, the IRS feels as if there are no limitations against any enforcement activity when examining the 1%. Successful entrepreneurs are the lifeblood of the [U.S.] economy. They typically create small businesses; in fact, lots of them, and each business needs employees.
Between 2004 and 2008, new statutes and rules on sourcing and residency were developed. For a time, the IRS was very comfortable with the notion that it did not have to conduct mass audits once the rules were in place. Starting in 2013, that began to change. We have seen many new audits in the USVI and the IRS has been disingenuous in those audits and has taken incorrect positions on the law and the facts. It is important to understand the law, to understand the IRS, and to create compliance programs that protect those businesses participating in compliance programs, so those businesses will not be the low-hanging fruit when they get audited.
RR: What are some of the common mistakes and pitfalls companies fall into from a compliance perspective that they otherwise could have avoided with a little proactivity?
DN: It is a long list. Here is a short version to stimulate thoughtfulness: 1) Insufficient documentation of residency facts; 2) Lack of understanding about the closer connection test; 3) Lack of understanding about the requirement that they separately source and allocate U.S. income; 4)Failure to maintain all necessary records that will be needed in an audit, so the audits start with the taxpayer being on the defensive (it should be the other way around); 5) Failure to create good consulting facts, follow-up and performance, and absence of contracts; 6) Absence of transfer pricing studies; and 7) Failure to follow transfer pricing studies.
RR: Why did you decide to leave the U.S. Attorney’s office and go into private practice instead? Obviously, money was probably a motivator, but what else motivated you to defend people you previously were tasked to go after?
DN: The U.S. Attorney job was a great honor and most lawyers think of it as the greatest legal job in the world. Your job is to assess community-wide civil and criminal problems, to effectively use resources to combat the worst of those problems, to marshal the federal law enforcement agencies to follow your lead and to put their resources alongside yours. You learn great team-building skills and you have to develop a thick skin.
Conversely, you are dealing with the slowness of the federal bureaucracy. I did a lot of public corruption work, and one day I realized I could spend the next 10 years prosecuting corrupt officials. And by then, there would be a new crop of corrupt officials in their place. In addition, while I had a great working relationship with IRS CID [Criminal Investigation Division], I had ethical concerns about how the civil side—principally the examination division—of the IRS operated. One day I woke up and felt I would better serve the country by defending people who were inappropriately attacked by the civil side of the IRS. The IRS has an important function, and they are to be respected. But one should never roll over when an agency breaks its own rules, refuses to follow the law and regularly ignores the constitutional limitations of the federal government. Fighting for these principles is a higher calling. One of the great problems facing our country today is the growth of the federal bureaucracy and the proliferation of agency rules that upset our concept of ordered liberty. It concerns me when I watch citizens steamrolled by the unelected part of our government. I became a prosecutor because I believed somebody had to stand up for crime victims. Now, I believe it is the average citizen who is victimized by an executive branch that is way out of control. It is a higher calling.
RR: What types of companies do you think are best poised to utilize the Act 20 grant? Obviously, it is suitable for all service companies. Yet, from your perspective, are there some companies more suitable than others?
DN: Technology companies, service companies where the services can be provided from Puerto Rico, banking, manufacturing, contract manufacturing and investment companies, to name a few.
Retail sales do not work when the sales offices are elsewhere and the economic activity also occurs elsewhere. The key is to be able to provide the services from Puerto Rico. That is what an export service statute is designed to promote.
RR: How have you adapted to Puerto Rico, and how would you compare the two islands [P.R. & USVI] from a livability point of view?
DN: I love Puerto Rico and have always wanted to live in a Latin community. They call me a “Boringo.” My sons are Cuban-Americans and my daughter is Colombian. They all loved growing up in St. Croix [USVI] but they are really enjoying (and contributing to) Puerto Rico. Because of the bond crisis, everyone has a diminished view of Puerto Rico, but I believe the Puerto Rican people have created one of the great societies in [the U.S.] Where else, besides Southern California, can you go and enjoy all the benefits of a great and dynamic metropolitan area and walk to beautiful beaches in 10 minutes’ time? Act 20/22’ers need to peel back the onion and discover Puerto Rico’s cultural and natural richness.
RR: When you speak to a client in determining whether this move makes sense for him or her, what would you consider the most important considerations?
DN: Puerto Rico is a fantastic place in which to live, but I am not sure if it is for everybody (it should be), so our first piece of advice is to come down and experience Puerto Rico and decide if you and your partner / spouse (and children) will enjoy living here. If people are not really going to move here and commit to Puerto Rico, I send them to other service providers. Then, Teresa Jiménez and I essentially perform a feasibility analysis to determine what parts of a business we can move here, what the value of that operation would be here, whether we believe we can help grow a company’s top-line revenues, as well as provide more efficient tax treatment to grow the bottom line.
RR: In preparing for an audit, what would be the most important considerations for a client to consider in preparation?
DN: We have a team here. I am just a small part of it. Attorney Teresa Jiménez does the local legal work. I work as a consultant in support of her efforts. We have a company called Export Service Strategies LLC that puts the needed resources together to help clients through potential moves to Puerto Rico. At the outset, we tell clients to expect an audit, because to be prepared lowers the level of anxiety and stress.
An audit is a retrospective process designed to make you PROVE the bona fides of your position. Therefore, the best advice I can give a client is to first establish that your positions are correct and well-documented. With new clients, it is a good exercise to say: ‘OK, assume you are audited by an agency that does not play fair. It is not what you know, it is what you can prove. Show me how you prove you are a resident. Show me how you would prove that your eligible income is P.R.-source income.’
Many times, clients want me to take the role of the IRS and give them a hard time so they know if they are audited, they are in a position to prove the bona fides of their position. We drill down on the details of residency and income sourcing. We help clients build a truthful narrative. IRS agents are human (their off-island managers are not). The IRS managers hide behind the green door and direct the agents to take unreasonable positions. But, ultimately, you are sitting in a room with your client and the agent. The agent is not in a position to understand every kind of business or how it functions. These are frequently people with an accounting background but not much of a business background. You have to understand what makes the agent tick. You have to understand what that agent’s life is like in the bureaucracy. What pressures is he or she under? How can you help the agent get his or her job done? The IRS may be the enemy, but the agent is not necessarily your adversary. If we can help the agent: a) Get the needed information; b) Understand the business; c) Understand the client’s narrative; and d) Understand that your client is not low-hanging fruit, many cases can be resolved favorably on behalf of the taxpayer.
RR: When you spoke at our 20/22 Act Society members’ Compliance Seminar last year, you unveiled a really interesting tracking software that some of our members are now beta testing. Can you elaborate on how that works and why you came up with it?
DN: After successfully defending several clients’ IRS audits, a couple things became abundantly clear:
The audit process is both archaic and incredibly tedious for both the auditor and taxpayer.
Many entrepreneurs moving to Puerto Rico and the USVI in search of tax breaks are usually ill-prepared for the document-laden process and, in some cases, not completely familiar with the IRS regulations that define what it means to be a resident (IRC Section 933).
With this in mind, we began to develop a small audit-preparation service for our clients that will advise them on what it takes to become a resident, give them the tools to monitor their progress and prepare them IN ADVANCE for their eventual audit. Furthermore, I developed a mobile app that uses the GPS in their phones to create scientific evidence on their behalf and help move the audit process into the 21st century.
The app has been a hit so far and we are now making the service available to all Act 20/22 recipients if they are interested. The service is called Footprints and, as you know, much of the Society’s members are using it to track their days and movement.
RR: In closing, what advice would you have for both existing and new companies that have made the move to ensure they are compliant with the program from both the Hacienda and IRS side?
DN: Put together a good team of advisers and have them analyze the local and federal requirements. Then put in a robust compliance program because it takes an ongoing effort to make sure you stay compliant. But, at the outset: Do not join one of these programs unless you really love living in Puerto Rico. If you love Puerto Rico, it is not difficult to do the physical presence test (and we recommend at least 200 days a year here as a minimum). If you are uncomfortable here, you will look to minimize your stay. Remember that both the U.S. and commonwealth are giving you these benefits so you will contribute to the local economy. There are great investment opportunities here, and one of the things that will be examined in an audit is whether you have made investments and contributed to your new home’s economy.
RR: David, we certainly appreciate your perspective and are looking forward to your next presentation along with the other tax professionals, so our members and recipients can be prepared for these audits and lower their anxiety to survive what is arguably one of the most difficult and challenging experiences any taxpayer can go through.