Do Puerto Rico Residents Pay Federal Taxes?

The question of whether residents of Puerto Rico pay U.S. federal taxes stems from the island’s unique status as a U.S. territory. The answer depends on an individual’s specific circumstances, as the tax relationship between the U.S. and Puerto Rico creates distinct rules. These rules differ from those for residents of the 50 states and depend on a person’s residency and income source.

Determining Bona Fide Residency in Puerto Rico

A primary element in determining federal tax obligations for individuals in Puerto Rico is their status as a “bona fide resident.” To qualify as a bona fide resident for a given tax year, an individual must satisfy three tests outlined in IRS Publication 570.

The first is the presence test, which requires an individual to be physically present in Puerto Rico for at least 183 days during the tax year. Alternatively, this test can be met by being present in Puerto Rico for at least 549 days during the three-year period that includes the current tax year and the two preceding years, with a minimum of 60 days of presence in Puerto Rico during each of those years. This multi-year lookback prevents individuals from claiming residency based on a brief or temporary stay.

Next, an individual must satisfy the tax home test. This test requires that a person’s tax home—the main place of their work or business—be in Puerto Rico for the entire tax year. If an individual does not have a regular place of business, their tax home is considered their regular place of abode.

Finally, the closer connection test must be met. This test examines whether an individual has maintained more significant ties to Puerto Rico than to the United States or any other foreign country. The IRS considers various factors, such as the location of one’s permanent home, family, personal belongings, social and political affiliations, and where one conducts personal banking.

Federal Income Tax Obligations for Bona Fide Residents

Individuals who qualify as a bona fide resident of Puerto Rico can exclude income derived from sources within Puerto Rico from their U.S. federal income tax return. This means that wages, salaries, and business profits earned from work performed on the island are not subject to U.S. income tax.

This exclusion has limitations and does not cover all types of income. An exception applies to income earned from sources outside of Puerto Rico. For instance, if a bona fide resident of Puerto Rico receives a salary from a company on the U.S. mainland or earns investment income from U.S.-based stocks and bonds, that income is fully subject to U.S. federal income tax.

A specific rule applies to employees of the U.S. federal government and members of the U.S. Armed Forces. The wages of federal government employees in Puerto Rico are considered U.S. source income, making them subject to U.S. federal income tax. For a bona fide resident of Puerto Rico serving in the U.S. Armed Forces, their active-duty pay is considered Puerto Rico source income and can be excluded, but these service members are still required to file a U.S. tax return.

Bona fide residents must carefully track where their income originates to comply with their federal tax obligations. While their local earnings are exempt, they remain part of the U.S. tax system for any income generated outside the territory.

Social Security, Medicare, and Self-Employment Taxes

The exemption for Puerto Rico-sourced income applies to federal income tax and does not extend to other federal payroll taxes. Wages paid for services performed in Puerto Rico are subject to Social Security and Medicare taxes, known as FICA taxes, just as they are in the United States. Employers in Puerto Rico are required to withhold these taxes from employee paychecks.

Even though a bona fide resident’s wages may be excluded from U.S. income tax, they still contribute to federal social insurance programs. The FICA tax consists of a 6.2% tax for Social Security on earnings up to the annual wage base limit and a 1.45% tax for Medicare with no wage limit. The employer matches these amounts, bringing the total contribution to 15.3% of the employee’s wages.

Individuals who are self-employed in Puerto Rico are subject to the Self-Employment Contributions Act (SECA) tax. This tax is analogous to FICA taxes. The SECA tax rate is 15.3% on the first $176,100 of net earnings from self-employment and 2.9% on earnings above that amount. This ensures that self-employed individuals also contribute to Social Security and Medicare.

These rules underscore that residents of Puerto Rico are integrated into the U.S. federal system for social insurance funding. In fiscal year 2021, residents and businesses in Puerto Rico contributed over $4 billion in federal taxes, a portion of which comprised these payroll and self-employment taxes.

Federal Tax Rules for Non-Bona Fide Residents

The tax situation changes for a U.S. citizen living in Puerto Rico who does not meet the three-part test for bona fide residency. These individuals, referred to as non-bona fide residents, are taxed in the same manner as U.S. citizens residing in one of the 50 states. Their tax obligations are not determined by the source of their income but by their status as a U.S. citizen.

Non-bona fide residents are subject to U.S. federal income tax on their worldwide income, regardless of whether it is earned in Puerto Rico, the United States, or another country. They cannot exclude income earned from Puerto Rican sources from their U.S. tax return.

To prevent double taxation on income earned and taxed in Puerto Rico, these individuals may be eligible to claim a foreign tax credit. Since the U.S. treats Puerto Rico as a foreign country for tax purposes in this context, taxes paid to the Puerto Rico Treasury can be credited against their U.S. federal income tax liability.

Filing Requirements with the IRS

The actions a person living in Puerto Rico must take with the IRS depend on their residency status and income source. For a bona fide resident of Puerto Rico who has income derived exclusively from sources within the territory, they do not have to file a U.S. federal income tax return (Form 1040).

The situation changes for a bona fide resident who has income from sources outside of Puerto Rico. These individuals are required to file a Form 1040 with the IRS to report that non-Puerto Rican source income. For example, if a bona fide resident receives dividends from a U.S. company, that income must be reported.

U.S. citizens who are not bona fide residents of Puerto Rico must file a Form 1040 and report all income from all sources worldwide, including any income earned within Puerto Rico. To avoid being taxed twice on the same income, they can claim a credit for the income taxes they paid to the government of Puerto Rico by filing Form 1116 along with their U.S. return.