IRS Guidance on Source of Gain Under Section 937

The IRS has issued definitive advice on the sourcing of capital gains to a bona fide resident of Puerto Rico (a “BFR”) who own S corporation stock or interests in partnerships.  In Chief Counsel’s Memorandum AM2024-005 (the “CCM”), released December 17, 2024, the IRS addressed the taxation of a U.S. citizen (the “Taxpayer”) who owns a portfolio of securities that the Taxpayer transfers to an S corporation before becoming a BFR.  The CCM discusses both (i) the BFR’s subsequent sale of the shares in the S corporation; and (ii) the BFR’s receipt of an allocation of gain from the S corporation’s sale of the securities.  The IRS ruled that gain on the BFR’s sale of S corporation shares is subject to the ten-year rule of Treasury Regulation Section 1.937-2(f) and is only exempt Puerto Rico source income to the extent specified in that regulation, but that gain allocated to the BFR from the S corporation’s sales of securities is entirely U.S. source.  The CCM goes on to apply the same reasoning to the Taxpayer’s transfer of securities to a partnership.

The CCM’s explicit conclusions are unsurprising.  What is surprising is that the IRS felt the need to issue the CCM, suggesting that some BFRs have taken contrary positions.  Perhaps of greater interest, however, is that the CCM’s reasoning implies that certain other situations involving partnerships may produce Puerto Rico source income.  This Alert summarizes the CCM, explains why we agree with its conclusions, discusses certain fact patterns not addressed directly in the CCM and identifies actions a BFR might consider to remedy incorrect positions taken on past returns. 

Summary of the CCM

Sale of S Corporation Stock

The CCM explains that:

• A BFR is exempt from U.S. federal income taxation on Puerto Rico source income.
• Gains from the sale of personal property ordinarily are sourced to the residence of the seller. Since a BFR is a resident of Puerto Rico, a BFR’s gains from the sale of S corporation stock – which qualifies as personal property – ordinarily would be exempt Puerto Rico source income.
• An exception to this general rule applies, however, if the Taxpayer owned the shares prior to becoming a BFR and sells the shares within ten years of becoming a BFR. In that case, none of the gain is Puerto Rico source unless the BFR elects to split the gain between Puerto Rico source and non-Puerto Rico source based on the relative length of his Puerto Rico and non-Puerto Rico holding periods. 
• If the BFR owns securities before becoming a BFR and later transfers those investments to a newly formed S corporation, the same result generally would obtain. The BFR would have the same holding period and basis (carryover) in the S corporation stock as in the transferred securities.  Consequently, the Taxpayer would be deemed to own the stock during the pre-BFR period in which he owned the securities and the ten-year rule would apply.

These rules should be well known to BFRs who have, or have applied for, an Act 22 or Act 60 capital gains decree. 

Sale by an S Corporation of Portfolio Securities

The CCM explains that:

• Only an entity organized under U.S., law may elect to be an S corporation. An S corporation is therefore a U.S. resident and its gains are U.S. source under the general sourcing rules. 
• No exception exists to cause the income to be sourced based on the residency of the S corporation’s shareholder. A statutory look-through rule that sources a partnership’s gains at the partner level does not apply to S corporations and their shareholders. And while the S corporation statute does provide for look-through treatment for certain purposes, those purposes do not include sourcing of capital gains from the sale of personal property like securities.  

While these rules may be less well known to the typical capital gains decree holding BFR, they are black letter law.  We do not see a basis for reaching different conclusions.     

Sale by Partnership of Portfolio Investments

The CCM then addressed the situation in which the Taxpayer transfers the securities to a partnership in which the Taxpayer owns a 10% or greater interest (by value) taking into account certain attribution rules.  The CCM explains that:

• A sale of the partnership interest within ten years of the Taxpayer becoming a BFR would be U.S. source income under the principles discussed above unless the Taxpayer elects split sourcing.
• Because the partnership received the securities in a tax-free transaction, any gain recognized upon a disposition of the property by the partnership within ten years of the Taxpayer becoming a BFR is treated as U.S. source gain if any gain recognized upon a sale of the Taxpayer’s interest in the partnership would be treated as U.S. source gain.
• The CCM explicitly declines to discuss whether or how the split-sourcing election would apply to a sale of the securities by the partnership. One might speculate that the IRS may have felt constrained by the regulations, which call for the gain to be U.S. source if any of the gain on sale of the partnership interest would be U.S. source.

Unaddressed (?) Fact Patterns

Many tax practitioners have been concerned that the application of the ten-year rule could be determined at the partner level under common law principles of partnership taxation and/or by the attribution rule of Treasury Regulation Section 1.937-2(j) if the property sold is corporate stock.  That is, a partner could be treated as holding his share of each partnership asset for so long as he was a partner, and the partnership owned the asset.  Thus, a Taxpayer who was a partner in a partnership before moving to Puerto Rico would be treated as owning a portion of each security held by the partnership prior to his becoming a BFR whether or not the Taxpayer transferred the securities to the partnership and regardless of the Taxpayer’s interest in the partnership.  Under that theory the Taxpayer would have U.S. source gain if the partnership sold the asset within ten years of the Taxpayer becoming a BFR unless the split-sourcing election applied.  By explicitly focusing on the fact that the Taxpayer owns 10% of the partnership to which the securities were transferred, the CCM seems to reject this partner level determination of the application of the ten-year rule and adopt an entity level approach that limits the application of such rule.  The CCM thus implicitly holds that if the Taxpayer were to transfer securities to a partnership in which the Taxpayer owns less than 10% interest and harvest that investment after becoming a BFR, the gain would be Puerto Rico source, subject to the application of the step-transaction doctrine, and even if the property sold is corporate stock that is subject to the attribution rules contained in the regulation.  This implication may well have been unintended, but is no less relevant even if unintended. 

If we can read the CCM as rejecting a partner level determination of the application of the ten-year rule, and therefore limit the scope of that rule, a BFR who does not transfer property to a partnership would have Puerto Rico source gain on all partnership dispositions, even dispositions of securities held by the partnership before the Taxpayer became a BFR.  This should be of particular interest to Taxpayers who held carried interests in hedge funds, VC funds or private equity funds before became BFRs and who have harvested those gains after becoming BFRs.  One should note that the CCM in no way addresses this fact pattern, which does not involve a transfer to a partnership, and the IRS may yet assert that such gains are, in whole or in part, U.S. source.  To reach that conclusion, however, the IRS would have to take a fundamentally different approach from the entity approach it took in the CCM.

Compliance with the CCM

Taxpayers who have filed federal income tax returns taking positions contrary to those in the CCM should consider whether or not to file amended returns and whether or not to make voluntary disclosure.  Such decisions should only be made after careful consideration of all relevant factors.  The attorneys at Caplin & Drysdale are available to discuss specific circumstances.

If you have any questions concerning the Alert, or for more information, please contact the Caplin & Drysdale attorney below.