What to Expect During an Act 60 Compliance Examination

Receiving an IRS examination notice is unsettling for any taxpayer. For Act 60 decree holders, the experience carries additional complexity because the issues under examination — bona fide residency, income sourcing, and compliance with Puerto Rico tax incentive rules — involve overlapping federal and territorial law, factual investigations that reach into your daily life, and potential consequences that go beyond additional tax liability.

This post walks through the stages of an Act 60 compliance examination, what the IRS requests, how the key legal tests are examined, the mistakes that hurt decree holders most, and the role of legal counsel.

The IRS Campaign Audit Structure

Act 60 audits are not handled by your local IRS office. They originate from the IRS Large Business and International Division (LB&I), which designated Puerto Rico tax incentive compliance as a formal campaign. Understanding this structure matters because it shapes how the audit is conducted.

Centralized Campaign Management

The LB&I campaign model assigns centralized leadership to coordinate examinations. A campaign director develops the audit approach, identifies the legal theories to test, and creates standardized Information Document Requests and interview protocols. The questions you face are not improvised — they are drawn from a playbook developed through prior examinations of other decree holders.

Dedicated Examiners

The agents assigned to Act 60 cases are trained in the specific legal and factual issues these cases present. They understand the bona fide residency tests under IRC Section 937, the income sourcing rules, and the common positions decree holders take. Do not expect a generalist auditor who might overlook a nuance. The examiner will know exactly what questions to ask and what inconsistencies to look for.

Coordination with Puerto Rico

The IRS coordinates with the Puerto Rico Department of Treasury (Hacienda) and DDEC during many examinations. This means the IRS may have access to your Puerto Rico tax returns, your decree application, and correspondence between you and Puerto Rico tax authorities. Inconsistencies between your federal and Puerto Rico filings will be identified.

The Four Stages of Examination

Stage 1: The Initial Contact Letter

The examination typically begins with a letter from the IRS notifying you that your return has been selected for examination. This letter will identify the tax year or years under review and the general issues to be examined.

What to know: The initial letter sets important deadlines. Do not ignore it. Do not call the number on the letter and begin discussing your tax situation without first consulting legal counsel.

Everything you say to the IRS from this point forward is on the record. If you have not yet engaged an attorney, this is the moment — before you make any contact with the examining agent.

Stage 2: Information Document Requests (IDRs)

After initial contact, the examiner will issue one or more Information Document Requests. IDRs are formal requests for specific documents and information. In Act 60 cases, IDRs are extensive and invasive by design.

Typical IDR requests in Act 60 cases include:

• Travel records: Airline itineraries, boarding passes, flight booking confirmations, passport stamps, Global Entry or TSA PreCheck records for the examination years
• Cell phone records: Location data, call logs, and text message records that establish where you were physically located on specific dates
• Credit card and bank statements: Transaction records showing where purchases were made, particularly focusing on geographic patterns
• Voting records: Voter registration status in Puerto Rico and on the mainland, including whether you voted in mainland elections
• Driver's license records: Whether you hold a Puerto Rico driver's license and whether you maintained or renewed a mainland license
• Club and organization memberships: Gym memberships, country club memberships, professional organization affiliations, and social club memberships in both Puerto Rico and the mainland
• Property records: Deeds, leases, and mortgage statements for all properties owned or rented, in Puerto Rico and elsewhere
• Business records: Entity formation documents, operating agreements, client contracts, invoices, and records showing where business activities were performed
• Medical records: Doctor and dentist appointments, showing where you receive routine healthcare
• School enrollment records: If you have children, records showing where they attend school
• Utility bills: Electricity, water, internet, and cable bills for your Puerto Rico residence, showing usage patterns
• Tax returns: Federal, Puerto Rico, and any state returns for the examination years and potentially prior years

How to respond to IDRs: The instinct to provide everything and more, hoping volume demonstrates good faith, is almost always a mistake. IDR responses should be curated to provide what is required without volunteering unrequested information. An attorney experienced in Act 60 examinations knows the difference between a document you must produce and one you should not.

Stage 3: The Examination Interview

In many Act 60 cases, the IRS will request an in-person or virtual interview with the decree holder. This interview is one of the most consequential stages of the examination, and it is where decree holders most frequently damage their own cases.

What the IRS asks during the interview:

The examiner will walk through your daily life in detail. Where do you wake up on a typical day? Where do you go to work? Who do you see socially? Where does your family live? Where do you go to the doctor? Where do you worship? Where do you keep your car? Where is your dog?

These questions seem casual. They are not. Each answer is being evaluated against the bona fide residency test factors, and each answer will be compared against the documentary evidence you have already provided. An answer that contradicts a credit card statement or a flight record creates an inconsistency that the examiner will use.

The examiner will also ask about your business: How do you generate income? Where are your clients? How do you deliver services? Do you travel to meet clients? Where do your employees work? These questions build the income sourcing analysis.

Stage 4: Determination

After completing the document review and interview, the examiner will issue a determination. There are several possible outcomes:

• No change: The IRS accepts your returns as filed.
• Proposed adjustments: The IRS proposes changes, typically recharacterizing income as non-Puerto Rico-sourced or determining that you did not satisfy the bona fide residency test. You can contest these through IRS Appeals and, if necessary, Tax Court.
• Criminal referral: In cases involving suspected fraud, the examiner may refer the case to IRS Criminal Investigation. This underscores why attorney-client privilege matters from the start.

The Bona Fide Residency Examination

The IRS tests your bona fide residency claim under the three-prong test of IRC Section 937. Failure on any single prong can defeat your residency claim and disqualify your Act 60 benefits for the year in question.

The Physical Presence Test

You must be present in Puerto Rico for at least 183 days during the tax year. The IRS counts days meticulously. A day of presence means you were physically in Puerto Rico at any point during a 24-hour calendar day. Transit days — where you depart Puerto Rico or arrive in Puerto Rico — require careful analysis.

The IRS reconstructs your calendar using the travel records, cell phone data, and transaction records obtained through IDRs. If your self-reported day count differs from the IRS reconstruction, the discrepancy will need to be explained.

The Tax Home Test

Your tax home must be in Puerto Rico. Under established tax law, your tax home is the general area of your principal place of business or employment. If you work in multiple locations, the IRS evaluates where you spend the most time working, where you earn the most income, and where your principal place of business is located.

The IRS will examine your office lease in Puerto Rico, your Puerto Rico business license, where your business bank accounts are held, and where the majority of your income-producing activities occur. If you maintain a mainland office, even a small one, the examiner will probe whether it represents a second tax home.

The Closer Connection Test

Even if you satisfy the physical presence and tax home tests, the IRS can deny residency if you have a closer connection to the mainland (or any location outside Puerto Rico) than to Puerto Rico. This is a facts-and-circumstances test that evaluates the totality of your personal and economic ties.

The IRS evaluates: where your permanent home is, where your family lives, where your belongings are located, where you vote, where your driver's license is issued, where you maintain bank accounts, and where you designate as your residence on official forms.

For a detailed discussion of the residency requirements and how they interact with your Act 60 tax incentive planning, review our comprehensive guide.

The Income Sourcing Examination

Independent of the residency analysis, the IRS will examine whether income you reported as Puerto Rico-sourced actually qualifies.

Service Income

For personal service income, the sourcing rule follows where the services are physically performed. If you perform consulting work for a New York client while sitting in your San Juan office, the income is Puerto Rico-sourced. If you fly to New York and perform that same work from the client's Manhattan office, the income earned during that trip is mainland-sourced.

The IRS will review your calendar, travel records, and client communications to map where you were physically located when specific income was earned. This mapping exercise is painstaking and factual — it does not depend on how you characterized the income on your return.

Business Income

If you own a business, the sourcing analysis is more complex. The IRS examines where the business activities that generate income take place, where employees and contractors perform their work, and where key business decisions are made. A Puerto Rico-based entity with mainland employees performing the core revenue-generating work may not generate Puerto Rico-sourced income to the extent the decree holder assumes.

Investment Income

Investment income sourcing depends on the type of income and the nature of the underlying assets. Interest, dividends, and capital gains each follow different sourcing rules. Gains on appreciated property acquired before establishing Puerto Rico residency present particular challenges, as discussed in our analysis of audit triggers.

Common Mistakes During Examination

Talking Too Much

The single most damaging mistake decree holders make during an examination is volunteering information the IRS did not ask for. In an interview setting, the instinct to explain, contextualize, and justify is strong. Every additional statement is an additional data point the IRS can use. An experienced attorney will prepare you for the interview and, where appropriate, handle communications with the examiner directly.

Providing Unnecessary Documents

The same principle applies to document production. Responding to an IDR with a comprehensive document dump may feel thorough, but it often provides the IRS with evidence it would not have obtained otherwise. Each document should be evaluated for relevance and potential impact before production.

Making Conflicting Statements

If your interview answers contradict your IDR responses, or if your federal return positions contradict your Puerto Rico return positions, the inconsistency becomes an exhibit in the IRS case. Consistency across all communications, filings, and document productions is essential, and it requires coordination between your attorney, your CPA, and you.

Waiting Too Long to Engage Counsel

Some decree holders wait until the examination is well advanced before engaging an attorney. By that point, they may have already made statements, produced documents, or taken positions that limit their options. Engaging legal counsel at the earliest stage — ideally before the first response to the IRS — preserves the broadest range of strategic options.

The Role of Legal Counsel During the Examination

An attorney experienced in Act 60 examinations serves several functions that go beyond what a CPA can provide.

Privilege protection. All communications between you and your attorney regarding the audit are protected by attorney-client privilege. This protection does not extend to CPA communications, particularly if the case involves potential criminal exposure.

IDR management. Your attorney reviews each IDR and ensures that responses are complete without being overinclusive.

Interview preparation and attendance. Your attorney prepares you for the examination interview and attends to interpose objections and manage the scope of questioning.

Appeals and litigation. If the examination results in proposed adjustments, your attorney handles the Appeals process and, if necessary, litigation in Tax Court or federal court.

For decree holders integrating Act 60 compliance with broader wealth preservation strategies, coordinating audit defense with estate planning ensures that the examination does not create unintended consequences for your overall financial structure.

If You Have Received an IRS Letter About Your Act 60 Decree

Time matters. The earlier you engage legal counsel after receiving an IRS examination notice, the more options you have and the better protected your communications will be.

Schedule a free strategy call with Riefkohl Law to discuss your examination notice, review your compliance posture, and develop a defense strategy before your first response to the IRS.

Hans E. Riefkohl Riefkohl Law | San Juan, Puerto Rico Phone: (787) 236-1657 Email: hans@riefkohllaw.com

Attorney-client privilege applies to all consultations. Your information is protected from the first conversation.