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IRS Whistleblower Claims Agency Lags in Investigating Puerto Rico Tax Break Abuse

S.J. Steinhardt
Published Date:
May 29, 2024

iStock-481506953 Bermuda Offshore Beach Island

An IRS insider has blown the metaphorical whistle on the tax agency’s failure to investigate individuals who may be taking illegal advantage of a law that offers tax-related benefits for investing in Puerto Rico, The New York Times reported.

The 2012 law, known as Act 22, sought to attract investment by refraining from assessing taxes for all Puerto Rico-sourced income, dividends and interests, and capital gains for those wealthy investors who earn residency status on the island commonwealth. In July 2023, the IRS publicly stated that it is investigating 100 Act 22 beneficiaries and might pursue criminal charges against them. The investigations, and the audits that preceded them in 2021, focused on U.S. taxpayers who may have inaccurately claimed Act 22 benefits without meeting its residency requirements.

Despite those efforts to uncover possible abuse, the agency has audited barely two dozen people and has collected back taxes from none, according to a letter that the whistleblower wrote this year to lawmakers. The letter was reviewed by the Times, which also interviewed IRS officials.

IRS Commissioner Danny Werfel said in an interview with the Times that the agency’s enforcement campaign in Puerto Rico, while still in its “early chapters,” was accelerating because of the $80 billion in new funding that the 2022 Inflation Reduction Act provided to the agency.

“We’re still coming out of our period of underinvestment, and we are still building muscle that atrophied,” he said. “If you look at a given campaign, you can come up with the conclusion that this feels slow out of the gate, and you wouldn’t be wrong.”

To become eligible for the tax break, residents have to apply to the Puerto Rican economic development agency, which publicly discloses their identities. Once they are registered, they can receive a tax break only if they report eligible income. The number of registrants has nearly quadrupled over the past five years, to more than 5,000, though fewer than 3,000 of those people actually received any tax benefits in the most recent year for which records are available, the Times reported.

If a person becomes a resident in Puerto Rico and later sells a business, that person is eligible for the tax exemption only on the portion of investment profits that were generated in Puerto Rico while the person lived there. And that is where there is potential for abuse, the Times said. For example, if an investor buys a stake in a business in 2013, moves to Puerto Rico in 2020 and then sells the stake in 2023 for a big profit, the first seven years of profits should be taxed by the U.S. government at the capital gains rate of up to 23.8 percent. The remaining three years of profits can get attributed to Puerto Rico, where they are exempt from federal taxes. But some investors are allegedly claiming that all of those profits are exempt—even the portion generated while they were living on the U.S. mainland.

“You’ve got high-income business owners self-identifying to the IRS, so that’s a nice ready-made population” for the agency to audit, said Jay Nanavati, a former federal prosecutor who is now a criminal defense lawyer at Kostelanetz, a tax-focused law firm, in an interview with the Times. “I would think this would be low-hanging fruit.”

The whistleblower wrote that fewer than 20 people—or fewer than 1 percent of the beneficiaries of the tax break—had been contacted as part of the IRS review. “My understanding is that no assessments have been made by any office nationwide for a campaign that has been open for three years,” the letter said.

In enforcement campaigns such as this one, the IRS can use what is known as a “soft letter” that  alerts taxpayers that they may have a problem and encourages them to rectify it voluntarily. The whistleblower wrote that the agency had not sent any soft letters to beneficiaries of the Puerto Rican tax break.

Werfel confirmed that the IRS had not sent any soft letters but said that the agency had audited dozens of taxpayers. Another IRS official said the figure was about 20, according to the Times.

Werfel also said the agency had assessed “millions of dollars” in back taxes related to the Puerto Rican break, though he would not say how many individuals had received such bills. In any case, no taxes have actually been collected yet, a person familiar with the agency’s efforts told the Times.

In addition to the whistleblower’s letter, the Senate Finance Committee had separately received information that set off concerns about the potential improper use of the Puerto Rican tax break, a committee aide told the Times.

Last month, the committee’s investigators contacted the IRS asking how many audits it is conducting as part of the enforcement campaign, how much money has been recovered and how many people are under criminal investigation. Sen. Ron Wyden (D-Ore.), the committee chair, told the Times that he was worried that individuals were potentially evading billions of dollars in taxes.

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