Act 60 Tax Compliance: IRS Scrutiny, Reporting and Remediation for Fund, Crypto Investors

Puerto Rico's Tax Incentives Code (Act 60) continues to attract entrepreneurs, hedge fund managers, cryptocurrency traders and high-net-worth investors seeking to reduce their overall tax burden by establishing bona fide residency on the island. The incentives can be powerful when properly implemented. At the same time, the IRS, U.S. Department of Justice, Puerto Rico Department of the Treasury (Hacienda), U.S. Government Accountability Office (GAO) and members of the U.S. Senate Committee on Finance have all intensified their focus on taxpayers who claim Act 60 benefits.

This Holland & Knight alert provides a practical overview of Act 60 incentives, summarizes the key U.S. and Puerto Rico tax and reporting obligations, walks through a representative case study involving a hedge fund and crypto investor, and outlines remediation options for taxpayers who may have compliance gaps.

Act 60 Incentive Overview

Act 60 consolidated several prior Puerto Rico tax incentive programs, most notably the former Act 20 (Export Services) and Act 22 (Individual Resident Investor) programs. The principal incentives include:

Export Services (Former Act 20)

• Qualifying Puerto Rico businesses that export eligible services to clients outside Puerto Rico may be subject to a 4 percent Puerto Rico corporate income tax rate on eligible export services income.
• Qualifying services include consulting, technology, financial services, management and other professional services performed in Puerto Rico for external markets.

Individual Resident Investor (Former Act 22)

• Qualifying bona fide Puerto Rico residents may receive complete or partial exemptions from Puerto Rico income tax on certain capital gains, dividends and interest that accrue after the individual establishes bona fide residency.
• Post-move capital gains on property acquired after establishing residency can be Puerto Rico-source under applicable sourcing rules and potentially exempt from both U.S. federal and Puerto Rico income tax.
• Key Risk Area: Appreciation that accrued before the taxpayer established bona fide Puerto Rico residency is generally not Puerto Rico-source income. This "pre-move appreciation" issue is at the center of most IRS enforcement actions.

Upcoming Changes: Act 38-2026

• Taxpayers filing new individual resident investor decree applications on or after January 1, 2027, may be subject to a 4 percent Puerto Rico income tax rate on capital gains and investment income, rather than the current full exemption. Existing decree holders should confirm the terms of their decrees.

U.S. Tax Framework: Residency and Sourcing

The U.S. tax benefits associated with Act 60 flow primarily from Internal Revenue Code (IRC) Section 933, which allows bona fide residents of Puerto Rico to exclude Puerto Rico-source income from U.S. gross income. Eligibility depends on satisfying the bona fide residency requirements of IRC Section 937 and Treasury Regulation Section 1.937-1.

Bona Fide Residency: 3 Tests

A taxpayer must satisfy three tests to qualify as a bona fide Puerto Rico resident:

1. Presence Test. The taxpayer must be physically present in Puerto Rico for at least 183 days during the taxable year or satisfy one of several alternative presence tests provided under U.S. Department of the Treasury regulations.
2. Tax Home Test. The taxpayer's tax home (generally the principal place of business or principal place of abode if no principal place of business) must be in Puerto Rico throughout the taxable year.
3. Closer Connection Test. The taxpayer must not have a closer connection to the U.S. or any foreign country. Relevant factors include location of home, family, personal belongings, social and civic ties, banking relationships, business activities, driver's license, voter registration, and official forms or documents.

Sourcing of Services Income

Compensation for personal services is generally sourced to the location where the services are physically performed. Taxpayers who are claiming that management fees, consulting income or other services income is Puerto Rico-source must demonstrate that the services generating the income were actually performed in Puerto Rico. Travel logs, contracts, billing records and work-location records are essential documentation.

Sourcing of Investment Income and Capital Gains

• General Rule: Gain from the sale of personal property is generally sourced based on the taxpayer's residence or tax home at the time of disposition.
• Pre-Move Appreciation/Lookback Rule: Treasury Regulation Section 1.937-2 includes special rules for property held before Puerto Rico residency began. For marketable securities, a split-sourcing approach may allocate gain between pre- and post-residency periods based on a snapshot value at the start of the Puerto Rico holding period. For nonmarketable property, a day-count method may apply. The 10-year lookback rule can taint certain gains as non-Puerto Rico-source.
• Cryptocurrency: Bitcoin and other digital assets are treated as property under Revenue Ruling 2019-24. Pre-move crypto appreciation is a major audit target; the IRS will not accept that moving to Puerto Rico and immediately selling long-held crypto converts decades of U.S.-source appreciation into Puerto Rico-source income.
• Partnership/S Corporation Structures: IRS memo AM 2024-005 and Chief Counsel Advice 202538025 address IRS positions on the use of S corporations and partnerships to convert pre-move appreciation into Puerto Rico-source income. Taxpayers should not assume that partnership or pass-through structures provide a settled safe harbor from the split-sourcing or lookback rules.

U.S. and Puerto Rico Reporting Obligations

U.S. Federal Reporting

• Form 8898: Required for individuals who begin or end bona fide residence in a U.S. possession. Failure to file can keep the statute of limitations open indefinitely on related tax items.
• Income Tax Returns: U.S. returns may still be required for U.S.-source income, income that is not Puerto Rico-source and other non-excludable income.
• International Information Returns: Depending on the applicable structure and facts, Forms 926, 5471, 3520, 3520-A, 8938, FinCEN 114 (Report of Foreign Bank and Financial Accounts (FBAR)) and other international information reporting obligations may apply. Notably, Puerto Rican financial accounts are not considered "foreign" for FBAR purposes. For Form 8938, shares of Puerto Rican corporations are generally treated as specified foreign financial assets. However, Puerto Rican financial assets generally are not treated as "foreign" with respect to a bona fide resident of Puerto Rico. Failure to satisfy these reporting obligations may result in significant penalties, independent of any underlying tax liability.
• Transfer Pricing: Related-party transactions between U.S. and Puerto Rico entities should be supported by contemporaneous transfer-pricing documentation demonstrating arm's-length pricing.
• Statute-of-Limitations Management: Report total gross income and exclude Puerto Rico-source income where appropriate. Omission of gross income in excess of 25 percent of reported gross income can extend the assessment period to six years.

Puerto Rico Reporting

Act 60 decree holders and Puerto Rico entities must generally comply with Puerto Rico income tax filing, decree compliance and annual reporting obligations, and employment and office substance requirements, as well as municipal, property and payroll obligations administered by Hacienda and the Department of Economic Development and Commerce (DDEC). Requirements vary by decree type and taxpayer status, and taxpayers should obtain fact-specific guidance from qualified Puerto Rico tax professionals.

Documentation Best Practices

Taxpayers should maintain contemporaneous evidence of:

• physical presence in Puerto Rico (e.g., travel records, flight manifests, utility bills, credit card activity, cell phone records)
• community involvement and personal ties to Puerto Rico
• work location for each day services are performed
• asset acquisition and disposition dates and valuations
• source-of-income positions for each material income item
• decree compliance filings and annual reports

Case Study: Hedge Fund Manager/Crypto Investor

The following hypothetical is illustrative only and does not constitute legal advice.

Consider a hypothetical taxpayer who is a hedge fund portfolio manager and an early cryptocurrency investor who relocates to Puerto Rico and obtains an Act 60 decree. The taxpayer's structure includes:

• a Puerto Rico management company (Act 60 export services decree) that provides investment management services to an offshore fund
• a personal Act 60 individual resident investor decree
• pre-move holdings, including cryptocurrency acquired several years before the move, carried interest in a U.S.-domiciled hedge fund and publicly traded securities
• related U.S. entities, including the fund's U.S. feeder vehicle and a prior U.S. management company

Key Compliance Questions

Bona Fide Residency: Can the taxpayer demonstrate 183-plus days of physical presence in Puerto Rico? Is the taxpayer's principal place of business (and tax home) genuinely in Puerto Rico? Where does the taxpayer's family reside? Does the totality of the closer-connection factors support Puerto Rico residency?

Services Income Sourcing: Where are investment management services physically performed? If the portfolio manager travels frequently to New York or other financial centers, what portion of management and incentive fees is properly allocated to Puerto Rico versus the U.S.?

Pre-Move Appreciation: For cryptocurrency acquired before the move, what is the split-sourcing allocation between U.S.-source pre-move gain and Puerto Rico-source post-move gain? For carried interest in a U.S. fund, has the IRS' position on partnership lookback/tainted property been considered?

Related-Party Transactions: Are management fees between the Puerto Rico management company and fund arm's-length? Is there sufficient economic substance and personnel in Puerto Rico to justify the services income allocation?

U.S. Information Returns: Has the taxpayer satisfied all applicable U.S. federal reporting obligations, including:

• Residency and Status Filings. Form 8898 (commencement of Puerto Rico residency)
• Foreign Entity and Transaction Reporting. Forms 5471 (foreign corporations), 8865 (if applicable), 926 (transfers to foreign corporations), 8858 (disregarded entities) and 3520/3520-A (foreign trusts, if applicable)
• Financial Account and Asset Reporting. Form 8938 and FBAR, as applicable
• Income Reporting. Proper reporting of U.S.-source income (e.g., management fees, carried interest, trading income) on Form 1040, including appropriate sourcing and allocation between U.S. and Puerto Rico
• Transfer Pricing and Intercompany Documentation. Section 482 compliance, including contemporaneous documentation supporting arm's-length pricing between the Puerto Rico management company and related entities

Puerto Rico Compliance

Has the taxpayer met all Puerto Rico tax and decree-related requirements, including:

• Individual Income Tax Filings. Annual Puerto Rico income tax return (Form 482) reporting worldwide income (with appropriate exclusions for Puerto Rico-source income under Act 60)
• Act 60 Individual Decree Compliance. Annual reports, filing fees, and satisfaction of residency and charitable contribution requirements
• Act 60 Export Services Decree Compliance (Management Company). Annual report filings with Puerto Rico DDEC, maintenance of required employees, payroll and operational substance in Puerto Rico, as well as compliance with local tax rate and exemption conditions
• Puerto Rico Business Filings. Corporate income tax returns, volume of business declarations, municipal license taxes, and any applicable sales and use tax (IVU) obligations
• Withholding and Payroll Compliance. Puerto Rico payroll taxes, employee withholding and employer reporting requirements
• Related-Party Disclosures. Compliance with Puerto Rico transfer pricing or intercompany disclosure rules, as applicable

Cautionary Examples

Recent enforcement actions illustrate the risks:

• United States v. Gajwani. A cryptocurrency investor pleaded guilty to tax evasion after misrepresenting the timing and sourcing of gains.
• Karakashian v. Commissioner. The IRS rejected a taxpayer's claim of bona fide Puerto Rico residency and asserted civil fraud penalties, asserting a 75 percent fraud penalty on a nearly $5 million deficiency.
• United States v. Skelly. Allegations of circular fund flows, deductions to Puerto Rico entities, trust arrangements and lack of economic substance. (Note: these are allegations and have not yet been adjudicated.)

These cases share common themes: inadequate documentation, residency that does not withstand scrutiny, aggressive recharacterization of pre-move income and reliance on structures that lack genuine economic substance.

Current Enforcement Landscape

• IRS Campaign: Launched in January 2021, the IRS Large Business and International Division's dedicated campaign targets Act 60 claimants, with a particular focus on high-income individuals such as crypto traders and fund managers who may have misreported U.S.-source income as Puerto Rico-source.
• Criminal Investigations: By July 2023, the IRS identified approximately 100 high-wealth individuals for investigation, with many cases expected to proceed to criminal referral.
• Data Sharing: The IRS uses Form 8898 filings and Puerto Rico decree holder lists to identify audit targets. The GAO has recommended that IRS establish procedures to obtain current data from Hacienda on all Act 60 decree recipients, and the IRS concurred.
• Hacienda Coordination: Puerto Rico's Hacienda has reportedly audited approximately 1,800 Act 20/Act 22 decree holders, introduced additional reporting requirements and strengthened background checks for new applicants.
• Congressional Pressure: The Senate Finance Committee and other lawmakers continue pressing the IRS on enforcement, including requesting legal opinions on the treatment of appreciated property and pre-move gains.
• Professional Scrutiny: Public reporting indicates subpoenas and investigations involving law firms and opinion letters associated with aggressive Act 60 planning strategies.

Potential Remediation Options

Taxpayers who identify compliance gaps should evaluate remediation options promptly. Once the IRS initiates an audit or investigation, available options narrow significantly.

Corrective Steps Before IRS Contact

• Amended Returns/Qualified Amended Returns: Where the statute of limitations remains open and the taxpayer has not yet been contacted, filing amended returns may correct errors and limit penalty exposure.
• Delinquent International Information Return Procedures: Taxpayers who have not been contacted by the IRS may be able to file late international information returns (e.g., Forms 5471, 3520 and 8938, FBAR if applicable) with reasonable-cause statements.
• Streamlined Filing Compliance Procedures: Eligible taxpayers with non-willful conduct may qualify for reduced penalties through the IRS Streamlined Procedures, including the Streamlined Foreign Offshore and Streamlined Domestic Offshore Procedures. Notably, Puerto Rico is not considered "foreign" for purposes of satisfying the non-residency requirement for the Streamlined Foreign Offshore Procedures.
• IRS Criminal Investigation Voluntary Disclosure Practice (VDP): For taxpayers with potential criminal exposure, the VDP may provide a path to resolve tax liabilities while mitigating criminal prosecution risk. Importantly, proposed reforms announced in March 2026 would replace the current 75 percent civil fraud penalty and 50 percent willful FBAR penalty with a 20 percent accuracy-related penalty for each disclosure year. Final guidance has not yet been issued, and taxpayers should monitor developments closely. The VDP requires full cooperation and is not available once the IRS has initiated an investigation.

After IRS Contact

• IRS Examination/Appeals: Taxpayers under audit may resolve issues through the IRS examination process or by requesting consideration from the IRS Office of Appeals (Independent Office of Appeals).
• Tax Court Litigation: After receiving a Notice of Deficiency, taxpayers may petition the U.S. Tax Court to challenge proposed assessments, penalties and fraud determinations.
• Federal District Court/U.S. Court of Federal Claims: In certain circumstances, taxpayers may pay the assessed tax and seek a refund through these forums.

Critical Takeaway: Remediation options are most favorable before IRS contact. Taxpayers should not wait for an audit letter to evaluate their compliance posture.

Holland & Knight Can Help

Act 60 rewards compliance and meticulous documentation – not aggressive recharacterization of income. Holland & Knight's Puerto Rico Act 60 Tax Team brings deep experience across the full spectrum of Act 60 compliance and controversy matters, including:

• tax compliance planning and review of existing structures
• bona fide residency and income sourcing analysis
• U.S. and Puerto Rico reporting coordination
• audit defense and IRS examination representation
• criminal tax investigations and voluntary disclosure
• U.S. Tax Court and federal court tax litigation
• bilingual English/Spanish capabilities
• coordination with Puerto Rico tax professionals, certified public accountants and wealth managers
• remedial action planning and penalty mitigation

If you or your clients have claimed Act 60 benefits and have questions about compliance, documentation or potential exposure, or if the IRS has already initiated contact, we encourage you to reach out to the authors of this alert promptly. Early engagement of experienced tax controversy counsel can preserve remediation options and reduce penalty risk.

For more information on this matter, please contact the authors.

Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.