Territorial Tax Tweak: New Residency Rules for U.S. Possessions Kick in for 2025

The "Territorial Tax Equity and Economic Growth Act of 2025" revises tax rules for U.S. territories—Guam, American Samoa, the Northern Mariana Islands, Puerto Rico, and the Virgin Islands—starting in the 2025 tax year. It's all about who counts as a "bona fide resident" and how income linked to these territories gets taxed.

Residency Remixed

This bill changes up who qualifies as a "bona fide resident" of these territories for tax purposes. Now, you've got to be physically present in one of these locations for at least 122 days each year. So if you were spending around 4 months in a territory before, that might not cut it anymore. This part could directly impact, say, a contract worker who splits time between Puerto Rico and the mainland—they'll need to carefully track their days to meet the new requirement (SEC. 2).

Sourcing the Source

The bill clarifies how to figure out where income is "sourced" when it comes to businesses operating in these territories. Basically, if your income is earned outside the territory, it'll be treated as connected to your business in the territory, using rules similar to section 864(c)(2) of the existing tax code. That section deals with whether income from outside the U.S. is effectively connected with a U.S. trade or business. It considers whether the income is derived from assets used in the conduct of the U.S. business, or if the business activities were a material factor in realizing the income. This could get tricky, and might mean more paperwork for some businesses, and potentially higher taxes.

There's also a bit about "preparatory or auxiliary activities" done in the U.S. not being counted as U.S.-sourced income. Think of a company with a small office in Miami handling some back-office tasks for a business primarily based in, say, Guam. Under this bill, the income tied to that Miami office wouldn't be considered U.S. income. This could be a plus for some companies, but it also raises questions about how exactly "preparatory or auxiliary" will be defined (SEC. 2).

Real-World Ripple Effects

These changes could shake things up in a few ways. For individuals, the stricter residency rule might make it harder to claim tax benefits tied to living in a territory. For businesses, the income sourcing rules could be a mixed bag. It may affect how companies are structured, and it might lead to more back and forth with the IRS about what income counts where. The "preparatory activities" clause could be a loophole, or it could just be a way to keep things simple – it'll depend on how it's enforced. Finally, the bill amends section 865(j)(3) by inserting ", 932, after 931." This is a small, but important change, and it is important to keep this in mind.

Ultimately, this bill is trying to make tax rules clearer for these territories. Whether it actually simplifies things, or just shifts the complexity around, remains to be seen. It's one of those bills where the devil is really in the details—and in how the IRS interprets those details down the line.