IRS Auditing Your Act 60 Decree? What Your Attorney Needs to Know

The IRS has made Act 60 enforcement a priority. Over 100 criminal investigations have been opened targeting decree holders, and civil audits are increasing in both frequency and scope. If you have received an audit notice — or if you suspect one is coming — understanding the legal dimensions of this process is just as important as getting your tax numbers right.

Your CPA prepares your returns and can represent you before the IRS in many contexts. But an IRS audit of an Act 60 decree holder is not a routine tax matter. It involves questions of legal residency, income sourcing under federal law, and potential criminal exposure that require legal counsel.

Why the IRS Is Targeting Act 60 Holders

Act 60 offers legitimate, significant tax benefits: exemptions on Puerto Rico-sourced capital gains, interest, and dividends for qualifying individuals. The program has attracted thousands of relocatees to the island.

But the IRS has identified a pattern of abuse. Some decree holders claim Puerto Rico residency while maintaining their primary lives on the mainland. Others mischaracterize mainland-sourced income as Puerto Rico-sourced to claim exemptions that do not apply. Some fail to properly document their bona fide residency status.

The result is a sustained enforcement campaign. The IRS Criminal Investigation division, working with the Puerto Rico Department of Treasury, has devoted substantial resources to identifying decree holders who are not in compliance. The stakes are not limited to back taxes and penalties — they include potential criminal prosecution for tax fraud.

This enforcement environment means that even compliant decree holders need to take audit preparation seriously.

What Triggers an Act 60 Audit

While no one can predict exactly when the IRS will select a return for audit, several factors increase the likelihood for Act 60 holders:

Large deductions or exclusions tied to Puerto Rico sourcing. If your return shows significant income excluded from federal taxation based on Puerto Rico sourcing, the IRS is more likely to examine the basis for that exclusion.

Inconsistent residency indicators. The IRS cross-references multiple data sources: flight records, credit card transactions, social media activity, cell phone location data, children's school enrollment, and voter registration. If your claimed residency in Puerto Rico does not match your actual presence, it raises red flags.

Prior mainland income sources that continue. If you earned income from mainland clients or businesses before relocating and continue to do so after, the IRS will scrutinize whether that income is genuinely Puerto Rico-sourced.

Tips and referrals. The IRS receives information from multiple sources, including disgruntled business partners, ex-spouses, and competitors. Whistleblower rewards incentivize reporting.

Industry-wide sweeps. The IRS sometimes audits clusters of taxpayers in a particular program or industry. Act 60 decree holders are a defined population, making them susceptible to coordinated audit campaigns.

Income Sourcing: The Central Battleground

The most contested issue in Act 60 audits is income sourcing. Act 60 exemptions apply only to Puerto Rico-sourced income. The IRS will aggressively challenge whether income you have treated as Puerto Rico-sourced actually qualifies.

The general rule: Income is sourced based on where the income-producing activity occurs. For services, that means where the services are performed. For sales of property, it depends on the type of property and where the sale occurs. For investment income, the rules vary by type of investment.

Where Act 60 holders get into trouble:

• Performing services for mainland clients while physically on the mainland (even briefly) can recharacterize income as mainland-sourced
• Managing mainland investments from Puerto Rico may not make the income Puerto Rico-sourced if the underlying assets are mainland-based
• Business income from entities with mainland operations requires careful allocation between Puerto Rico-sourced and mainland-sourced components
• Passive income from mainland partnerships or S-corporations is generally not Puerto Rico-sourced regardless of the partner's residency

Your CPA models the income sourcing analysis. But if the IRS disagrees with your position, the dispute becomes a legal matter — potentially litigated in Tax Court or federal district court.

Residency Documentation: What You Need and What the IRS Checks

Bona fide Puerto Rico residency is the threshold requirement for Act 60 benefits. The IRS applies a multi-factor test, and no single factor is dispositive. The three statutory tests are:

The Presence Test. You must be present in Puerto Rico for at least 183 days during the tax year. The IRS counts days meticulously, and partial days may or may not count depending on the circumstances.

The Tax Home Test. Your tax home — the general area of your principal place of business or employment — must be in Puerto Rico. If your primary business operations are on the mainland, this test fails.

The Closer Connection Test. You must not have a closer connection to the United States or any foreign country than to Puerto Rico. This is the most subjective test and the one where the IRS has the most room to challenge your position.

Documents that support your residency claim:

• Puerto Rico driver's license and voter registration
• Puerto Rico property ownership or long-term lease
• Local bank accounts and credit cards
• Children enrolled in Puerto Rico schools
• Membership in local organizations, clubs, or religious institutions
• Puerto Rico medical and dental providers
• A Puerto Rico-based business with local employees

Documents that undermine your claim:

• Maintaining a residence on the mainland (even if you call it a "vacation home")
• Continued use of a mainland driver's license
• Children enrolled in mainland schools
• Spending significant time on the mainland, even for business
• Social media posts showing mainland activities during claimed Puerto Rico presence days
• Voter registration on the mainland

Why You Need Both a CPA and an Attorney

Your CPA and your attorney serve different functions in an audit, and you need both.

What your CPA provides:

• Preparation and review of tax returns and supporting schedules
• Income sourcing calculations and documentation
• Representation before the IRS in examination proceedings (if enrolled agent or CPA)
• Financial modeling of potential audit outcomes
• Amended return preparation if adjustments are needed

What your attorney provides:

• Legal analysis of residency and domicile under federal and Puerto Rico law
• Attorney-client privilege protection for communications (CPA-client privilege is more limited)
• Representation if the audit escalates to criminal investigation
• Negotiation with IRS counsel if the case is referred to litigation
• Defense in Tax Court or federal district court proceedings
• Analysis of Fifth Amendment protections and self-incrimination risks
• Coordination with Puerto Rico Department of Treasury if parallel proceedings arise

The privilege issue is critical. Communications between you and your CPA have limited protection from IRS subpoena. In contrast, communications with your attorney are protected by attorney-client privilege, which is broader and more robust. If there is any possibility that your audit could escalate to a criminal investigation, involving an attorney early protects the confidentiality of your communications and strategy.

What Legal Counsel Provides That Tax Advice Does Not

An Act 60 audit is not just about numbers on a tax return. It involves legal questions that require legal analysis:

Domicile determination. Domicile is a legal concept, not an accounting concept. Where you are domiciled affects your tax obligations, your estate planning, and your legal rights. An attorney analyzes domicile under the applicable legal standards and prepares the legal arguments to support your position.

Constitutional and statutory arguments. The tax treatment of Puerto Rico residents involves constitutional provisions (the Territorial Clause, the Uniformity Clause), federal statutes (Section 933 of the Internal Revenue Code), and Puerto Rico statutory law. These are legal arguments that require legal expertise.

Criminal defense. If the IRS refers your case for criminal investigation, you need a criminal defense attorney — not a CPA. The transition from civil audit to criminal investigation changes everything: your rights, your obligations, your strategy, and the potential consequences.

Coordination of multi-jurisdictional issues. Act 60 holders often have legal obligations in multiple jurisdictions — federal, Puerto Rico, and their prior state of residence. An attorney coordinates the legal strategy across all jurisdictions.

How to Prepare Before an Audit Hits

The best time to prepare for an audit is before you receive the notice. Here is what proactive preparation looks like:

Organize your residency documentation now. Create a contemporaneous record of your presence in Puerto Rico. Keep a calendar tracking your location each day. Save flight records, hotel receipts, and other travel documentation. Document your Puerto Rico connections comprehensively.

Review your income sourcing positions with both your CPA and attorney. Make sure the legal basis for your sourcing positions is sound, not just the numbers. If any position is aggressive, understand the risk and document the legal authority supporting it.

Ensure your Act 60 decree is in good standing. Confirm that you have met all decree conditions, filed all required reports with the Puerto Rico Department of Economic Development and Commerce (DDEC), and maintained your annual charitable contribution and employment requirements.

Identify and address vulnerabilities. Do you still own a home on the mainland? Do your children attend mainland schools? Do you spend significant time outside Puerto Rico? These are the issues the IRS will target. Address them proactively rather than reactively.

Establish your legal team. Have an attorney engaged before the audit begins. Trying to find qualified legal counsel after you receive an audit notice puts you at a disadvantage from the start.

Preserve all records. Document retention is critical. Tax returns, supporting schedules, bank statements, investment records, business records, travel records, and correspondence should all be preserved in an organized, accessible format.

What to Do If You Receive an Audit Notice

If you have already received an IRS audit notice:

1. Do not ignore it. Deadlines in IRS audit notices are real and enforceable.
2. Contact your CPA and your attorney immediately. Both should be involved from the beginning.
3. Do not speak to the IRS directly. Let your representatives handle all communications.
4. Do not destroy or alter any records. Document destruction after receiving an audit notice can result in criminal charges independent of the underlying tax issues.
5. Gather your residency documentation. Your attorney will need to review it promptly.
6. Review your Act 60 decree terms. Ensure you understand exactly what benefits your decree provides and what conditions it requires.

The Cost of Getting This Wrong

The consequences of a failed Act 60 audit are severe:

• Back taxes: Full federal tax liability on income that was improperly excluded, potentially going back multiple years
• Penalties: Accuracy-related penalties of 20-40% of the underpayment, or fraud penalties of 75%
• Interest: Compounding daily from the original due date
• Criminal prosecution: In cases involving fraud, willful evasion, or false statements — potential imprisonment
• Loss of Act 60 decree: The Puerto Rico government may revoke your decree if you are found to be non-compliant
• Collateral consequences: Professional licensing issues, reputational damage, and complications with future tax positions

Schedule a Free Strategy Call

Whether you are facing an active audit or want to ensure you are prepared if one comes, legal counsel should be part of your team now — not after the situation escalates.

Hans E. Riefkohl works with Act 60 decree holders and their CPAs to build audit-ready legal positions and defend against IRS challenges to residency and income sourcing.

Call (787) 236-1657 or email hans@riefkohllaw.com to schedule a free strategy call.

Learn more: - Act 60 Tax Incentives - Estate Planning