How to Pay Zero Federal Income Tax

The One Place on the Planet Where You Can “Escape” the IRS.

There’s only one place on the planet where a U.S. taxpayer can avoid paying U.S. federal income tax—and it’s part of the United States.

As you’re probably aware, the U.S. is the only developed country that taxes its residents on their global income. It doesn’t matter where you’ve earned your money… Uncle Sam wants a chunk of it.

Unless you live in Puerto Rico.

Understanding why involves a bit of history.

Puerto Rico is a U.S. colony. The U.S. took it from Spain in 1899 at the end of the Spanish-American War. It’s an “unincorporated territory” of the U.S., so Congress has ultimate authority over the island and can override local laws.

People born in Puerto Rico are natural-born U.S. citizens. But because Puerto Rico is not a state, they don’t have full citizenship rights. Puerto Rico sends a delegate to the House of Representatives, but that delegate does not have voting rights. Puerto Ricans don’t vote for president. That makes Puerto Ricans “second class” citizens (unless they establish residence in a U.S. state, in which case they can vote for Congress and Senate like everyone else).

Because of this second-class citizenship, bona fide residents of Puerto Rico are exempt from paying federal income tax on all income earned in Puerto Rico. It’s a clear case of “no taxation without representation.”

Because it is part of the United States, any U.S. citizen or green card holder can move to Puerto Rico to live, work, or run a business. Once you become a resident of the island, you won’t have to pay income tax or even file a return.

To be a bona fide resident, you must meet one of the following conditions:

• Be physically present on the island for at least six months each year or spend at least 549 days in Puerto Rico during the current and previous two tax years.
• Spend no more than 90 days a year on the mainland, with the rest of your time split between Puerto Rico and other countries.
• Earn no more than $3,000 on the mainland and spend more time in Puerto Rico than on the mainland throughout the year.
• Have no significant connections to the mainland throughout the year.
• Maintain a tax home in Puerto Rico. That could mean an office or your personal residence.

The basic requirement is that Puerto Rico becomes your genuine home. Here are some examples of the benefits:

• You work remotely for a U.S. company as an employee or a contractor. You move to Puerto Rico and establish bona fide residence there. Because you perform your work in Puerto Rico, you are exempt from federal income tax.

• You become a bona fide resident of Puerto Rico and establish a business there. Even if you provide services to individuals or businesses on the mainland, you pay no federal income tax because your business is domiciled in Puerto Rico.

Excellent! But what about Puerto Rican income tax? Although they are lower than on the mainland, rates can be as high as 33%.

In 2012, Puerto Rico adopted Act 22, which gave newmigrants from the mainland 100% income tax exemption on passive income (dividends and interest), as well as on all capital gains after becoming a resident, no matter what their source, for 15 years. Capital gains accrued but unrealized before becoming a Puerto Rican resident are taxed at concessionary rates. Gains from cryptocurrency trading are also exempt.

That means that if you subsist primarily on passive income, even if it comes from sources on the mainland, you are exempt from both federal and Puerto Rican income tax.

Also in 2012, the Puerto Rican government adopted Act 20. This provides for a 4% tax rate for service businesses established by new Puerto Rican residents from the mainland. To qualify, the business must serve markets outside of Puerto Rico itself. For example, if you run an online consultancy targeting mainland clients, becoming a bona fide resident of Puerto Rico means your business won’t pay any federal tax, and only 4% to Puerto Rico for 15 years (extendable for another 15).

In 2019, the Puerto Rican government made some changes to these rules in response to criticism from Puerto Rican natives and from Congress. To qualify under Act 22, you must now buy a residential property and live in it within two years of becoming a Puerto Rican resident.  You must also make an annual charitable donation of $10,000 to government-approved charities.

The $10,000 donation is a form of backdoor tax. But it’s still possible to save substantially on income taxes by taking advantage of the Puerto Rican exception.

Tax savings aren’t the only potential benefit of becoming a Puerto Rican resident. Bona fide residents of Puerto Rico are regarded as citizens of a Latin American country by the Spanish government. As such, they are eligible to apply for naturalization as a Spanish citizen after only two years residence in the country.

On top of that, it’s a spectacularly beautiful island. What have you got to lose… except of course, your tax chains?