Editor’s Note: This article is the first in a series offering helpful tips to navigate this year’s tax return filing process.
The tax season is again upon us, and with it, as taxpayers, we begin to wonder how much tax we are going to pay. Some of you might have done some preliminary calculations based on your expected income and based on the transactions that took place during the year. But be aware that you may need to consider the impact of the Alternate Basic Tax (“ABT”) in your calculations, and that in some cases this tax could even double your tax bill.
What is the alternate basic tax?
The ABT was originally structured to impose at least a minimum tax on certain taxpayers that had a high amount of deductions in comparison to their taxable income. However, due to recent legislation and changes to our tax system, the ABT now also looks to tax certain exempt and preferential tax rate income and to disallow certain deductions in the case of self-employed individuals and shareholders/partners in pass-through entities.
How does it work?
In general terms, the Puerto Rico Internal Revenue Code of 2011, as amended (“the Code”) imposes a tax of 10 percent to 20 percent to be paid by any individual on their net income subject to ABT of $150,000 or more when said amount is higher that the regular income tax. The net income subject to ABT is the taxpayer’s gross income as determined by the Code, reduced by certain exempt items and certain deductions.
If the net income subject to ABT is:
– From $150,000 to $250,000, the ABT will be 10 percent
– In excess of $250,000 but no more than $500,000 the ABT will be 15 percent
– In excess of $500,000 the ABT will be 20 percent
How can it affect you?
If you are an individual with a net income subject to ABT of $150,000 or more you should be aware that you could be subject to taxation on exempt income or to additional taxation on income subject to preferential tax rates. This means that certain exempt income, for example, the special compensation received for liquidation or closing of business under Article 10 of Act 80-1976, could be subject to taxation, and, depending the amount, it could be subject to an income tax of up to 20 percent.
In the case of exempt income:
For example, taxpayer X has a net income subject to regular income tax of $50,000 and a regular income tax of $8,010. But in addition, has income exempted from regular income tax rates but subject to ABT of $150,000. This means that taxpayer X has a net income subject to ABT of $200,000. Since this amount is more than $150,000, said net income will be subject to an ABT rate of 10 percent for a total of $20,000 of ABT. Since the ABT is higher than the regular income tax of $8,010 the taxpayer has to pay an ABT of $11,990.
In the case of preferential tax rate income:
The ABT not only affects taxpayers with exempt income but also could affect you if you have income subject to preferential tax rates, such as, dividends, interests and/or long-term capital gains. For instance, if you usually are not subject to ABT you may not know about its implications, and since most of this income subject to p
referential tax rates is subject to income tax withholding at source, you may think you are covered with the withholding, and will have a big surprise come April.
In the case of certain deductions for the self-employed:
In the case of the self-employed, individuals should be aware that there are certain deductions that will not be allowed for ABT purposes. Specifically last year, due to growing concerns, this issue was also addressed by the Puerto Rico Treasury Department through Administrative Determination 12-08 (“AD”).
The allowable deductions against gross income to arrive to the net income subject to ABT, specifically in the case of necessary and ordinary expenses related to the taxpayer’s trade or business (self-employed individuals)are the following:
- Salaries or other compensation for personal services rendered
- 50 percent of the Federal Tax on self-employment
- Health insurance deduction
- Property taxes
- Volume of business tax and other licenses
- Utilities, such as telephone, water and electricity
Among other, the following expenses will also be deductible expenses to determine the Net Income subject to ABT under the provisions of the AD:
- Professional services (as reported in Forms 480.6A, 480.6B and 480.6C)
- Certain fringe benefits to employees
- Automobile expenses (applicable only to automobiles subject to limitation and other motor vehicles, such as trucks used for distribution of goods, ambulance, etc.)
- Rent and royalty payments
- Direct costs that are indispensable for the trade or business. Examples include: malpractice insurance; marketing expenses in the case of sale of goods; interest on debt for acquisition of inventory or other real or personal property used in the trade or business; write-off of uncollectible accounts from the sale of goods or services rendered.
The AD specifically states that the following expenses will not be considered Direct Indispensable Costs under any circumstances:
- Travel, meals and entertainment expenses
- Public Relations and representation expenses
- Lobbying expenses
In the case of partners and shareholders in pass-through entities:
As for pass-through entities, the Treasury Department established that they have to report separately those items of income or expenses that at shareholder or partner level should be included in the calculation of ABT, as if the shareholder or partner had earned the income or incurred in the expense directly. Hence, the informative tax returns of said entities and their corresponding instructions provide for the reporting of said adjustment.
You want to be prepared come April 16. Hence, you need to be aware that having exempt income, income subject to preferential tax rates, and/or certain expenses in the case of self-employed individuals or partners/shareholders of pass-through entities, could have an impact on your income tax liability.