White Paper 09.08.25
White Paper
White Paper
By Mark Leeds
09.22.25
While “safety first” is a mantra that ensures so many things we do don’t end in disaster, the snarky Burning Man version of this admonition is “safety third.” What comes first and second is left unsaid, but let’s just say relegating safety to the third consideration virtually ensures calamity (often a hallmark of a Burning Man experience). Many U.S. individuals are attracted to Puerto Rico for its beaches, natural beauty and, of course, tax benefits. But before a U.S. individual claims that they are a bona fide resident of Puerto Rico and excludes Puerto Rico-source income from their U.S. taxable income, they should prioritize proper tax compliance above their third consideration. Being subject to an Internal Revenue Service (IRS) residency audit can result in the same type of adverse consequences that occur when one leaves safety concerns to an afterthought.
For those of us who practice tax law in the cross-border U.S.-Puerto Rico realm, the week of September 15, 2025, was pretty busy. First, the tax press featured an article stating that a major U.S. law firm received a Department of Justice subpoena to disclose to the government the names of their clients that sheltered “potentially billions of dollars from taxes under Act 60, a statute that lures wealthy people to Puerto Rico with promises of total or near-total tax exemptions.”[1] A day later, the IRS released Chief Counsel Advice 202538025 (September 19, 2025) (the “2025 CCA”). The CCA offers very helpful guidance on determining when income earned through a partnership is Puerto Rico-source income. The CCA tempers the negative guidance that the IRS had issued last year in Advice Memorandum 2024-005.[2]
Summary of the 2024 Advice Memorandum
The transactions addressed by the IRS in AM 2024-005 were undertaken by an S corporation. The IRS stated, however, that “the conclusion would be identical” if the transactions were undertaken by a partnership. In the AM, the IRS considered the consequences of a contribution of “split holding period” securities by a bona fide resident of Puerto Rico to an S corporation. The securities are split holding period securities when the contributor has both a U.S. holding period and a Puerto Rico holding period. Following the contribution, the S corporation sold the stock. In the author’s view, the IRS ran roughshod over an S corporation rule that could have been interpreted to allow the S corporation to take advantage of its shareholder’s Puerto Rico holding period. Instead, the IRS held that none of the gain from the disposition of the securities by the S corporation could qualify as Puerto Rico-source income. Curiously, the IRS did not cite to a Treasury Regulation that provided a clearer path to the same conclusion. As we’ll see below, the IRS used the regulation that it overlooked in AM 2024-005 to provide a path to treat gains on dispositions of assets by partnerships as Puerto Rico-source income.
The 2025 CCA
The 2025 CCA addresses when gain from property sold by a partnership can be Puerto Rico-source income. The 2025 CCA is predicated on several facts being true. First, it posits that the property being sold consists of property that can be held by an investment partnership, such as stocks and securities. Second, the 2025 CCA assumes that the property being sold is split holding period property, but no guidance is provided if the split holding period was at the partner level, the partnership level or both. Third, the individual is a bona fide resident of Puerto Rico for the year in which the property is sold but was not a bona fide resident of Puerto Rico in one or more of the 10 preceding years.
There are two curious omissions from the stated facts in the 2025 CCA. First, there is no indication as to whether the partnership was a U.S. or Puerto Rico partnership. Second, under Internal Revenue Code Section 865(e) (often referred to as the “office rule”) as applied to Puerto Rico income sourcing, if gain from personal property sales is attributable to an office located in the United States, the income is treated as U.S.-source income in whole (regardless of the Puerto Rico holding period). There is no mention of the office rule in the 2025 CCA, so it appears that the sale of partnership property was not attributable to a U.S. office. Alternatively, one could infer that the existence of a U.S. office is immaterial since, as described below, the gain would be sourced at the partner level. This inference, however, might be a step too far.
It appears from the 2025 CCA that the auditing agent sought to prevent the taxpayer, who was a partner in the partnership that recognized the gain, from asserting that they could elect to apply the rule that would have allowed them to bifurcate the gain on split holding period property between U.S. and Puerto Rico sources.[3] The IRS Chief Counsel, however, expressed a contrary view. Chief Counsel held that the partner could determine the Puerto Rico-source portion of any gain from a disposition of the asset by the partnership by applying the fiction that the partner had held and disposed of the asset directly. Chief Counsel relied on the rule in Internal Revenue Code § 865(i)(5). This rule, as modified for the cross-border Puerto Rico context, “provides that when a bona fide resident of Puerto Rico is a partner of a partnership and the partnership sells personal property, that partner’s distributive share of such gain is sourced to Puerto Rico.” Chief Counsel implicitly rejected the auditing agent’s position that the principles of AM 2024-005 applied and that no portion of the gain could be treated as Puerto Rico-source income.
Take Aways
The 2025 CCA provides a welcome limitation on the IRS’s position as expressed in AM 2024-005. One could have (as the auditing agent apparently did) read that holding to prevent bona fide residents of Puerto Rico from treating gains from the dispositions of partnership assets as generating any Puerto Rico-source income. Unfortunately, 2025 CCA does not shed light on whether gains earned through a hedge fund operated in the United States are always U.S.-source income under the office rule or whether the office rule is immaterial if the gain is sourced at the partner level. Sometimes, lessons in tax are like lessons in safety—it’s better to take it seriously before you start the project.
[1] Bologna, “Baker MeKenzie Pulled Into Probe of Puerto Rico Tax Shelter,” Bloomberg Law News (September 19, 2025).
[2] As of the writing of this White Paper, a copy of an article that I wrote on AM 2024-005, entitled, “Going in Circles: The IRS Limits Source Rules in Responding to Aggressive Tax Positions,” can still be accessed on LinkedIn under my biography.
[3] Treas. Reg. § 1.937-2(f)(1)(vi).