Table of Contents
In order to determine where to file your return and which form(s) you need to complete, you must determine the source of each item of income you received during the tax year. Income you received from sources within, or that was effectively connected with the conduct of a trade or business within, the relevant possession must be identified separately from U.S. or foreign source income.
This chapter discusses the rules for determining if the source of your income is from:
The Commonwealth of the Northern Mariana Islands (CNMI),
The Commonwealth of Puerto Rico (Puerto Rico),
The U.S. Virgin Islands (USVI).
Generally, the same rules that apply for determining U.S. source income also apply for determining possession source income. However, there are some important exceptions to these rules. Both the general rules and the exceptions are discussed in this chapter.
From sources within the United States, or
Effectively connected with the conduct of a trade or business within the United States.
|Item of Income||Factor Determining Source|
|Salaries, wages, and other compensation for labor or personal services||Where labor or services performed|
|Pensions||Contributions: Where services were performed that earned the pension
Investment earnings: Where pension trust is located
|Interest||Residence of payer|
|Dividends||Where corporation created or organized|
|Rents||Location of property|
|Natural resources||Location of property|
|Patents, copyrights, etc.||Where property is used|
|Sale of business inventory—purchased||Where sold|
|Sale of business inventory—produced||Allocation if produced and sold in different locations|
|Sale of real property||Location of property|
|Sale of personal property||Seller's tax home (but see Special Rules for Gains From Dispositions of Certain Property , later, for exceptions)|
|Sale of natural resources||Allocation based on fair market value of product at export terminal. For more information, see Regulations section 1.863-1(b).|
This section looks at the most common types of income received by individuals, and the rules for determining the source of the income. Generally, the same rules shown in Table 2-1 are used to determine if you have possession source income.
Income from labor or personal services includes wages, salaries, commissions, fees, per diem allowances, employee allowances and bonuses, and fringe benefits. It also includes income earned by sole proprietors and general partners from providing personal services in the course of their trade or business.
United States even if you perform services in a possession.
|Number of days you performed
services in the relevant
possession during the year
|Total number of days you
performed services during the year
Hazardous or hardship duty pay.
Moving expense reimbursement.
Are a U.S. citizen or resident,
Are not a bona fide resident of that possession,
Are not employed by or under contract with an individual, partnership, or corporation that is engaged in a trade or business in that possession,
Temporarily perform services in that possession for 90 days or less, and
Earned $3,000 or less from such services.
You are a U.S. citizen who worked in Puerto Rico for a U.S. company. All services were performed in Puerto Rico. Upon retirement you remained in Puerto Rico and began receiving your pension from the U.S. pension trust of your employer. Distributions from the U.S. pension trust must be allocated between (1) contributions, which are Puerto Rico source income, and (2) investment earnings, which are U.S. source income.
This category includes such income as interest, dividends, rents, and royalties.
The source rules for sales or other dispositions of property are varied. The most common situations are discussed below.
There are special rules for gains from dispositions of certain investment property (for example, stocks, bonds, debt instruments, diamonds, and gold) owned by a U.S. citizen or resident alien prior to becoming a bona fide resident of a possession. You are subject to these special rules if you meet both of the following conditions.
For the tax year for which the source of the gain must be determined, you are a bona fide resident of the relevant possession.
For any of the 10 years preceding that year, you were a citizen or resident alien of the United States (other than a bona fide resident of the relevant possession).
If you meet these conditions, gains from the disposition of this property will not be treated as income from sources within the relevant possession for purposes of the Internal Revenue Code. Accordingly, bona fide residents of American Samoa and Puerto Rico, for example, may not exclude the gain on their U.S. tax return. (See chapter 3 for additional filing information.) With respect to the CNMI, Guam, and the USVI, the gain from the disposition of this property will not meet the requirements for certain tax rules that may allow bona fide residents of those possessions to reduce or obtain a rebate of taxes on income from sources within the relevant possessions.
These rules apply to dispositions after April 11, 2005. For details, see Regulations section 1.937-2(f)(1) and Examples 1 and 2 of section 1.937-2(k).
In 2006, Cheryl Jones, a U.S. citizen, lived in the United States and paid $1,000 for 100 shares of stock in the Rose Corporation, a U.S. corporation listed on the New York Stock Exchange. On March 1, 2009, she moved to Puerto Rico and changed her tax home to Puerto Rico on the same date. Cheryl satisfied the presence test in 2009 and, under the year-of-move exception, she was considered a bona fide resident of Puerto Rico for the rest of 2009. On March 1, 2009, the closing value of Cheryl's stock in the Rose Corporation was $2,000. On January 5, 2012, while still a bona fide resident of Puerto Rico, Cheryl sold all her Rose Corporation stock for $7,000. Under the earlier rules, none of Cheryl's $6,000 gain will be treated as income from sources within Puerto Rico.
Assume the same facts as in Example 1, except that Cheryl makes the special election to allocate the gain between her U.S. and possession holding periods. Cheryl's possession holding period began March 1, 2009, the date her tax home changed to Puerto Rico. Therefore, the portion of gain attributable to her possession holding period is $5,000 ($7,000 sale price – $2,000 closing value on first day of the possession holding period). By reporting $5,000 of her $6,000 gain as Puerto Rico source income on her 2012 Puerto Rico tax return (and the remainder as non-Puerto Rico source income), Cheryl elects to treat that amount as Puerto Rico source income.
In addition to the stock in Rose Corporation, Cheryl acquired a 5% interest in the Alder Partnership on January 1, 2008. On March 1, 2009, when she established bona fide residency in Puerto Rico, her partnership interest was not considered a marketable security. On September 15, 2012, while still a bona fide resident of Puerto Rico, Cheryl sold her interest in Alder Partnership for a $100,000 gain. She had owned the interest for a total of 1,720 days. Cheryl's possession holding period (from March 1, 2009, through September 15, 2012) is 1,295 days. The portion of her gain attributable to Puerto Rico is $75,320 ($100,000 x (1,295 Puerto Rico days ÷ 1,720 total days)). By reporting $75,200 of her $100,000 gain as Puerto Rico source income on her 2012 Puerto Rico tax return (and the remainder as non-Puerto Rico source income), Cheryl elects to treat that amount as Puerto Rico source income.
The source of these types of income is generally the residence of the payer, regardless of who actually disburses the funds. Therefore, in order to be possession source income, the payer must be a resident of the relevant possession, such as an individual who is a bona fide resident or a corporation created or organized in that possession.
In limited circumstances, some kinds of income from sources outside the relevant possession must be treated as effectively connected with a trade or business in that possession. These circumstances are listed below.
You have an office or other fixed place of business in the relevant possession to which the income can be attributed.
That office or place of business is a material factor in producing the income.
The income is produced in the ordinary course of the trade or business carried on through that office or other fixed place of business.
An office or other fixed place of business is a material factor if it significantly contributes to, and is an essential economic element in, the earning of the income.
The three kinds of income from sources outside the relevant possession to which these rules apply are the following.
Rents and royalties for the use of, or for the privilege of using, intangible personal property located outside the relevant possession or from any interest in such property. Included are rents or royalties for the use of, or for the privilege of using, outside the relevant possession, patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and similar properties if the rents or royalties are from the active conduct of a trade or business in the relevant possession.
Dividends or interest from the active conduct of a banking, financing, or similar business in the relevant possession.
Income, gain, or loss from the sale or exchange outside the relevant possession, through the office or other fixed place of business in the relevant possession, of:
Stock in trade,
Property that would be included in inventory if on hand at the end of the tax year, or
Property held primarily for sale to customers in the ordinary course of business.
Item (3) will not apply if you sold the property for use, consumption, or disposition outside the relevant possession and an office or other fixed place of business in a foreign country was a material factor in the sale.
Marcy Jackson is a bona fide resident of American Samoa. Her business, which she conducts from an office in American Samoa, is developing and selling specialized computer software. A software purchaser will frequently pay Marcy an additional amount to install the software on the purchaser's operating system and to ensure that the software is functioning properly. Marcy installs the software at the purchaser's place of business, which may be in American Samoa, in the United States, or in another country. The income from selling the software is effectively connected with the conduct of Marcy's business in American Samoa, even though the product's destination may be outside the possession. However, the compensation she receives for installing the software (personal services) outside of American Samoa is not effectively connected with the conduct of her business in the possession—the income is sourced where she performs the services.
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