I.R.S. Failed to Police Puerto Rico Tax Break, Whistle-Blower Says

For the past decade, thousands of wealthy Americans have been flocking to Puerto Rico to take advantage of a tax break that can cut their tax bills to zero. For nearly as long, there have been allegations that the benefit enables multimillionaires to avoid paying what they owe when they reap big investment profits.

Now, an Internal Revenue Service insider has accused the agency of failing to police the tax break. Despite a high-profile campaign announced more than three years ago to unearth possible abuse, the agency has audited barely two dozen people and has collected back taxes from none, according to a letter that an agency insider wrote this year to lawmakers and that has been reviewed by The New York Times, as well as interviews with I.R.S. officials.

Senate officials have begun an investigation into the whistle-blower’s allegations about the Puerto Rican tax benefit.

“It’s been three years since the I.R.S. announced its enforcement campaign on this issue,” said Senator Ron Wyden, Democrat of Oregon and chairman of the Senate Finance Committee. “It needs to pick up the pace.”

Hamstrung by decades of budget cuts, the I.R.S. has regularly struggled to crack down on tax avoidance by the wealthiest Americans and large companies. Audits of millionaires have declined more than 80 percent over the past decade, reaching record lows. The agency rarely examines giant private equity firms. And the annual “tax gap” — the difference between taxes that are owed and what is paid — is estimated to be $600 billion.

In an interview, Danny Werfel, the I.R.S. commissioner, said the agency’s enforcement campaign in Puerto Rico, while still in its “early chapters,” was accelerating because of the $80 billion in new funding that the 2022 Inflation Reduction Act provided to the agency.

“We’re still coming out of our period of underinvestment, and we are still building muscle that atrophied,” he said. “If you look at a given campaign, you can come up with the conclusion that this feels slow out of the gate, and you wouldn’t be wrong.”

In addition to the roughly two dozen audits of people taking advantage of the Puerto Rican tax break, the I.R.S. has said its criminal division identified about 100 people who may have committed tax evasion. The division is focusing on so-called promoters of potential crimes.

The creation of the tax benefit was part of a decades-long effort by Puerto Rico — and the U.S. federal government — to refashion the island as an offshore tax haven. (Since the 1950s, for example, American citizens who move to Puerto Rico have been exempt from federal taxes on income and capital gains earned in the territory.) The goal was to entice wealthy Americans and big corporations to move there and to accelerate the island’s economic growth.

In 2012, Puerto Rico enacted a series of tax breaks that permitted new residents to also avoid local taxes on their investment income while they reside on the island.

To be eligible for the tax break, residents need to apply to the Puerto Rican economic development agency, which publicly discloses their identities. Once they are registered, they can receive a tax break only if they report eligible income.

The number of registrants has nearly quadrupled over the past five years, to more than 5,000, though fewer than 3,000 of those people actually received any tax benefits in the most recent year for which records are available.

Prominent investors, business executives and lawyers are among those who have registered. They include Dan Morehead, the chief executive of Pantera Capital, a large cryptocurrency investment firm; Mike and Tina Hodges, who run the payday lender Advance Financial; Paul Napoli, a mass-tort lawyer; and Eric Swider, who led the shell company that merged with former President Donald J. Trump’s social media business.

Mr. Swider said he had registered but had not received the tax break. The others declined to comment or did not respond to requests for comment. None of them have been accused of wrongdoing.

If someone becomes a resident in Puerto Rico and later sells a business, that person is eligible for tax exemption only on the portion of investment profits that were generated in Puerto Rico while the person lived there.

In theory, the tax break should be relatively easy to monitor. Does the recipient live in Puerto Rico? And were the profits on which the person wants to avoid taxes generated while the person lived in Puerto Rico?

“You’ve got high-income business owners self-identifying to the I.R.S., so that’s a nice ready-made population” for the agency to audit, said Jay Nanavati, a former federal prosecutor who is now a criminal defense lawyer at Kostelanetz, a tax-focused law firm. “I would think this would be low-hanging fruit.”

A typical, problematic transaction goes like this: An investor buys a stake in a business in 2013, moves to Puerto Rico in 2020 and then sells the stake in 2023 for a big profit. The first seven years of profits are supposed to be taxed by the U.S. government at the capital gains rate of up to 23.8 percent. The remaining three years of profits get attributed to Puerto Rico, where they are exempt from federal taxes.

For years, there have been concerns that the tax break is easy to abuse. Tax advisers say some investors are simply claiming all of those profits are exempt — even the portion generated while living on the U.S. mainland.

Mr. Nanavati said he had fielded calls from prospective clients who were on the verge of selling their businesses, asking if they could make the profits tax-free by moving to Puerto Rico shortly before the sale.

In 2020, federal prosecutors indicted Gabriel Hernández, who was running the Puerto Rico office of the accounting firm BDO USA, on wire fraud charges. The indictment accused Mr. Hernández of fraudulently exploiting the 2012 law on behalf of wealthy Americans.

The case should “serve as a warning to anyone considering seeking to evade taxes by illegally exploiting federal and Puerto Rico tax laws,” W. Stephen Muldrow, the U.S. attorney for the District of Puerto Rico, said at the time of the indictment. (Mr. Hernández has pleaded not guilty. He declined to comment for this article.)

Three months after the indictment, the I.R.S. said it would begin a broad effort to scrutinize the possible use of such breaks in Puerto Rico to evade taxes. The agency said it would look at taxpayers who claimed benefits through the 2012 legislation without meeting the eligibility requirements.

The success of that initiative is now facing questions.

In November, a dozen congressional Democrats wrote to the I.R.S. about their concerns that the 2012 law “is enabling tax evasion by the American wealthy.”

That letter was the impetus for the more recent letter to lawmakers and I.R.S. officials, which was written by the agency insider who self-identified as “an individual affiliated with the Internal Revenue Service.”

The writer said fewer than 20 people — or less than 1 percent of the beneficiaries of the tax break — had been contacted as part of the I.R.S. review. “My understanding is that no assessments have been made by any office nationwide for a campaign that has been open for three years,” the letter said.

In enforcement campaigns such as this one, the I.R.S. can use what is known as a “soft letter.” Less than a formal audit, it alerts taxpayers that they may have a problem and encourages them to rectify it voluntarily. The whistle-blower wrote that the agency had not sent any soft letters to beneficiaries of the Puerto Rican tax break.

“This is completely absurd in light of the amount of tax dollars at issue,” the letter read. It added that a review of the residency requirements — including living in Puerto Rico for more than half the year and having a “closer connection” to the island than to the mainland — “would reveal that more than half” of registrants were ineligible.

Mr. Werfel confirmed that the I.R.S. had not sent any soft letters but said the agency had audited dozens of taxpayers. Another I.R.S. official said the figure was about 20.

Mr. Werfel also said the agency had assessed “millions of dollars” in back taxes related to the Puerto Rican break, though he would not say how many individuals had received such bills. In any case, no taxes have actually been collected yet, according to a person familiar with the agency’s efforts.

One tax lawyer said he had alerted the I.R.S. to dozens of examples of taxpayers who improperly claimed the benefits, but none had been audited. Several tax advisers specializing in disputes with the I.R.S. said they had seen little indication that the agency was taking action.

In addition to the whistle-blower’s letter, the Senate Finance Committee had separately received information that set off concerns about the potential improper use of the Puerto Rican tax break, according to a committee aide.

Last month, the committee’s investigators contacted the I.R.S. asking how many audits it is conducting as part of the enforcement campaign, how much money has been recovered and how many people are under criminal investigation. Senator Wyden said he was worried that people were potentially evading billions of dollars in taxes.

Laura N. Pérez Sánchez contributed reporting.