Editor’s Note: This article is the third in a series offering helpful tips to navigate this year’s tax return filing process, considering the many changes brought on by the government’s Tax Reform.
On Jan. 31, 2011, Puerto Rico enacted a new Internal Revenue Code (the “2011 Code”), which reformed the island’s tax system, containing significant changes for individual and corporate taxpayers. This tax reform included a reduction of the income tax rates, which should result, in many cases, in a lower tax liability.
However, the 2011 Code provides taxpayers a binding option to be taxed under the provisions of the Internal Revenue Code of 1994 (the “1994 Code”) during taxable years 2011 through 2015, in lieu of being taxed under the provisions of the 2011 Code (the “94 Election”).
Individuals, corporations, limited liability companies, corporations of individuals, partnerships, special partnerships, estates and trusts are all allowed to opt for the 94 Election. However, exempt trusts and exempt nonprofit entities are not allowed to be taxed under the provisions of the 1994 Code.
How is the election made?
The 94 Election is made by filing the tax return duly identified as the 94 Election tax return. The 94 Election can only be made for taxable year 2011, and the election shall be binding through taxable year 2015. An amendment to a tax return cannot revoke a 94 Election or create a new “94 Election,” if the choice was not exercised in the original return.
Additionally, every partner, shareholder and member of a partnership, special partnership, LLC and corporation of individuals, shall make the “94 Election,” for the decision to be valid for the entity. Partnerships, special partnerships, LLCs and corporations of individuals shall include the unanimous consent to the entities election by the execution of every partner, member or shareholder of Schedule C94.
In the case of married taxpayers, both spouses shall make the election for it to be valid. Married taxpayers filing separate returns are not allowed to make a valid election if one of the spouses does not make a “94 Election.”
Effects of changes in civil status in 94 Election
As a general rule, changes in civil status do not affect the binding nature of 94 Elections. However, if an individual that had made a 94 Election in a previous year weds an individual that did not make such election, without a pre-nuptial agreement expressly providing for a total separation of property economic regime, the marriage will prospectively revoke the 94 Election of the electing spouse, unless the spouses elect to file their tax returns under the filing status of “married filing separately.”
Tax consequences ending election period for partnerships, LLCs
Termination events of a partnership under a 94 Election may dissolve the partnership and terminate the 94 Election. If a new partnership is created after the dissolution it shall be under the provisions of the 2011 Code. However, the partners will continue to be taxed under the 94 Election during the election period.
Distributions from partnerships under the 2011 Code to partners under a 94 Election will be taxable as ordinary income. Upon termination of a partnership’s or limited liability company’s 94 Election, the entity will be subject to the transition costs under the 2011 Code.
In conclusion, the 2011 Code contains significant changes for individual and corporate taxpayers, including the reduction of the income tax rates, which should result in many cases, in a lower tax liability. Moreover, taxpayers may choose to be taxed under the provisions of the 1994 Code.
Keep in mind, however, that the choice must be made for the year 2011 and the next four years. Additionally, 94 Elections of certain partnerships and their partners may be subject to certain transition costs, which should be taken into account before making such election.
Given the new options provided under which a taxpayer may choose to file their tax return under the provisions of the 2011 Code or the 1994 Code, and the costs associated with 94 Elections, you may consider visiting your tax advisor to determine which option would be better suited for your specific situation.