Over the past decade, thousands of wealthy Americans have flocked to Puerto Rico to take advantage of a tax break that allows them to pay zero taxes. For almost as long, the argument has been that the benefit allows billionaires to avoid paying debts while making huge investment gains.
Now, IRS insiders are accusing the agency of lax oversight of the tax cuts. Despite a highly publicized campaign more than three years ago to uncover possible fraud, the agency has audited only about two dozen people and never collected back taxes from anyone, according to a letter they wrote to lawmakers this year and interviews with IRS officials reviewed by The New York Times.
Senate officials have opened an investigation into whistleblower claims about Puerto Rico's tax breaks.
“It's been three years since the IRS announced any enforcement action on this issue,” said Sen. Ron Wyden, Democrat from Oregon and chairman of the Senate Finance Committee. “The IRS needs to speed up.”
Hampered by decades of budget cuts, the IRS has always struggled to crack down on tax evasion by America's wealthiest people and biggest corporations. Audits of billionaires have fallen more than 80 percent in the past decade to a record low. The agency rarely investigates big private equity firms, and the annual “tax gap” — the difference between taxes owed and those actually paid — is estimated at $600 billion.
In an interview, IRS Commissioner Danny Wuerfel said the agency's enforcement efforts in Puerto Rico are still in the “early stages” but are accelerating thanks to $80 billion in new funding provided to the agency by the Inflation Control Act of 2022.
“We're still coming out of a period of underinvestment and we're still building up our weakened muscles,” he said. “You look at certain campaigns and you'll come to the conclusion that they're off to a slow start, and you'd be right.”
In addition to auditing about 20 people who took advantage of Puerto Rico's tax breaks, the IRS said its criminal division has identified about 100 people suspected of tax evasion, focusing on what it calls potential criminal facilitators.
The creation of this tax break was part of a decades-long effort by Puerto Rico and the U.S. federal government to remake the island into an offshore tax haven. (For example, since the 1950s, U.S. citizens who moved to Puerto Rico have been exempt from federal taxes on income and capital gains earned in the territory.) The goal was to attract wealthy Americans and big corporations to the island and spur its economic growth.
In 2012, Puerto Rico enacted a series of tax breaks that allow new residents to avoid local taxes on investment income while they reside on the island.
To qualify for the tax credit, residents must apply to the Puerto Rico Economic Development Authority, which makes their identities public. After registering, they can only receive the credit if they declare qualifying income.
Enrollment has nearly quadrupled over the past five years to more than 5,000, but fewer than 3,000 of them actually received the tax benefits in the most recent year for which records are available.
Those who signed up include well-known investors, executives and lawyers, including Dan Morehead, CEO of the major cryptocurrency investment firm Pantera Capital, Mike and Tina Hodges, the husband-and-wife team behind payday loan company Advance Financial, class-action lawyer Paul Napoli and Eric Swider, who ran the shell company that merged with former President Donald J. Trump's social media business.
Swider said he registered but did not receive the tax break. The other two either declined to comment or did not respond to requests for comment. None are suspected of wrongdoing.
If a person becomes a resident of Puerto Rico and later sells the business, he or she will be eligible for the tax exemption only on the portion of the investment gains that occurred in Puerto Rico while the person was a resident of Puerto Rico.
In theory, monitoring the tax break should be relatively easy: Does the recipient live in Puerto Rico, and were the benefits he or she wants to avoid tax earned while living in Puerto Rico?
“Because high-income business owners self-report to the IRS, they're a ready-made target for the IRS to audit,” said Jay Nanavati, a former federal prosecutor who is now a criminal lawyer at the tax law firm Kostelanetz. “I think this is a low-hanging fruit.”
A typical transaction in question looks like this: An investor buys stock in a company in 2013, moves to Puerto Rico in 2020, and sells the stock in 2023 at a large profit. The first seven years of profit should be taxed by the U.S. government at the maximum capital gains tax rate of 23.8%. The remaining three years of profit should be attributable to Puerto Rico and be exempt from federal tax.
There have been concerns for years that the tax break is open to abuse, with some investors arguing that all of their gains, including those made while living on U.S. soil, are tax-free, tax advisers say.
Nanavati said he received a call from a potential client who was about to sell his business asking if they could make the profits tax-free by relocating to Puerto Rico just before the sale.
In 2020, federal prosecutors indicted Gabriel Hernandez, who ran the Puerto Rico office of accounting firm BDO Puerto Rico, on wire fraud charges. The indictment accused Hernandez of misappropriating a 2012 law on behalf of wealthy Americans.
The case “should serve as a warning to anyone seeking to illegally exploit federal and Puerto Rican tax laws to commit tax evasion,” W. Stephen Muldrow, the U.S. attorney for the District of Puerto Rico, said at the time the indictment was filed. (Hernandez has pleaded not guilty. He declined to comment for this article.)
Three months after the indictment, the IRS said it was launching a broader effort to scrutinize whether such breaks were used to commit tax evasion in Puerto Rico. The agency said it would investigate taxpayers who claimed the 2012 tax break without meeting eligibility requirements.
The success of that effort is now in doubt.
In November, 12 Democratic lawmakers sent a letter to the IRS expressing concern that the 2012 law “enables wealthy Americans to evade taxes.”
The letter sparked a series of recent letters to lawmakers and IRS officials written by an agency insider who identified himself as an “Internal Revenue Service official.”
The letter writers said fewer than 20 people — less than 1% of tax cut recipients — have been contacted as part of the IRS investigation. “To my understanding, no evaluation has been conducted by any office across the country regarding the campaign, which has been ongoing for three years,” the letter said.
In enforcement campaigns like this one, the IRS can use what are called “soft letters” – less formal audit methods to alert taxpayers to possible problems and encourage them to fix them voluntarily. The whistleblowers write that the IRS never sent soft letters to Puerto Rico tax cut recipients.
“Given the amount of taxes at issue, this is completely absurd,” the letter said, adding that revisiting the residency requirements (which include spending more than half the year in Puerto Rico and having a “closer connection” to the island than to the mainland) “would reveal that more than half of those enrolled are ineligible.”
Wurfel acknowledged that the IRS hasn't sent out soft letters, but said the agency has audited several dozen taxpayers. Another IRS official said the number was about 20.
Warfel also said the agency had assessed “millions of dollars” in unpaid taxes related to Puerto Rico vacations, but he did not say how many people had received such bills. In any case, no taxes have actually been collected yet, according to a person familiar with the agency's efforts.
One accountant said he had reported dozens of cases of taxpayers who had improperly claimed benefits to the IRS but no audits were ever conducted. Accountants who specialize in IRS disputes said they saw little sign the agency was taking action.
In addition to the whistleblower letter, the Senate Finance Committee had received separate information that raised concerns about possible misuse of Puerto Rico's tax breaks, according to a committee aide.
Last month, investigators from the committee contacted the IRS to ask how many audits it was conducting as part of its enforcement efforts, how much money it had recovered, and how many people were under criminal investigation. Senator Wyden said he was concerned that billions of dollars in tax evasion could be at stake.
Laura N. Perez Sanchez Contributed report.