Potential Trap for the Unwary: Form 8898 is Due Soon – A Special IRS Information Filing for Taxpayers Who Relocated to Puerto Rico or U.S. Virgin Islands in 2014

By William L. Blum

Did you take the plunge and relocate to Puerto Rico, the U.S. Virgin Islands or one of the other U.S. territories in 2014? Perhaps to take advantage of PR’s Act 20 or Act 22, or the USVI’s EDC (Economic Development Commission) tax exemption programs?

If 2014 was your first year as a “bona fide resident” of one of the territories, then you are required to file an IRS form 8898 with the IRS by April 15, 2015, or on such extended date for filing a U.S. form 1040 return which may be applicable to you.

Reportedly, the number of U.S taxpayers who moved to Puerto Rico in 2014 to take advantage of the Act 20 and Act 22 tax exemptions there was the highest since those laws were enacted in 2012. Likewise, the USVI remains a popular destination for U.S. citizens who wish to lower their federal tax burden. So there are likely many hundreds, if not thousands, of taxpayers who will need to file form 8898 in 2015.

There are articles elsewhere on this website, and throughout the Internet, describing these programs, but the focus here is on possible future IRS enforcement activities and how to minimize the likelihood of an audit as a result of your move, or the negative results from an audit if one is ultimately commenced.

Form 8898, first published in 2007, was designed to collect information from taxpayers who move from the U.S. mainland to a U.S. territory (or from a different territory, but the focus here is on the former). Those who move to territories are either not required to file a U.S. return at all (this is the case with the USVI, Guam, and the Northern Marianas) or only have to file a return with the IRS which reports non-territory source income (applicable in Puerto Rico and American Samoa). The IRS seeks data from such taxpayers to let them determine whether they consider the taxpayer’s relocation legitimate. If the facts reported on the 8898 hint that a taxpayer may not be a “bona fide resident” of a territory, as that term is defined in IRC section 937 and related regulations, then the chance of an IRS audit will increase substantially.

So a taxpayer is well-advised to pay close attention to the answers to the questions in the 8898 to avoid raising a red flag that could lead to a residency audit, or which could actually be used against the taxpayer later if such an audit is commenced.

A close reading of the instructions to the form and the form itself make it clear that the IRS will use the form to test the legitimacy of the taxpayer’s residency claim using the three tests set forth in IRC section 937. The form closely follows the law and regulations and it has sections on both physical presence and the “closer connection” concepts. Although not separately labeled, the closer connection section of the form also contains questions relating to the third test, the “tax home” test.

For those well versed in the tests of section 937, the types of answers that will “red flag” a taxpayer as possibly not a legitimate bona fide resident may be fairly obvious in some cases. For example a “Yes” answer to the following is bound to attract additional scrutiny: “Did you have a closer connection to the United States or a foreign country than to the possession [territory] at any time during the tax year?”

But some of the questions are a bit more obscure and may require a more nuanced response. For example, if you relocated to Puerto Rico on January 1, 2014 and made eight one-week business trips to New York City during the year to visit with clients and conduct marketing activities, you may want to provide an explanation with your positive answer to the following question: “Did you conduct business activities in a location other than your tax home? If ‘Yes’, where?” A good response here would include not only the location of the non-Puerto Rico activities, but also a brief explanation of the activities to make it clear that Puerto Rico was the taxpayer’s principal business location and that also mentions the type of activities conducted elsewhere as this may have an impact on source of income issues.

Many taxpayers, and their stateside accountants, will not have much familiarity with form 8898 and the types of answers that will best prepare them to defend against possible IRS activity. Our firm’s familiarity with these types of issues on an everyday basis can be a resource to clients who wish to ensure that their form 8898 is filed with responses that not only are true and accurate, but also will minimize potential future issues.