Mitt Romney’s tricky taxes

January 18, 2012, 12:52 AM UTC

Romney’s tax issue goes beyond the 15%.

Mitt Romney today admitted the obvious: His effective tax rate is closer to 15% than to the 35% charged on top incomes.

But there is still a lot we don’t know, and Romney’s eventual answers could spark a long-overdue change to the way that private equity and venture capital investors pay taxes.

To begin, Romney’s “admission” should have been self-evident to anyone who had taken a look at the candidate’s financial disclosures, or realized that he hasn’t pulled a significant salary since leaving Bain Capital in 1999.

The vast majority of Romney’s income is of the investment variety, which gets charged at the 15% capital gains rate. This includes a large stock portfolio and positions in dozens of private equity, real estate and structured finance partnerships. Totally legal, and appropriate if you believe that the tax code should be used to incentivize business investment (i.e., risk-taking that can benefit the nation’s economy).

But then it gets very, very tricky.

Within Romney’s private equity portfolio are dozens of funds managed by Bain Capital and Bain Capital affiliates (including Brookside Capital, Bain Capital Ventures and Brookside Partners). Approximately half of them were formed while Romney was still at Bain, while the remainder were formed afterward. Those latter investments were per a retirement agreement Romney signed with Bain in 1999, which has since expired.

But what we don’t know is how much money Romney actually invested in any of those funds. In fact, it is entirely possible that Romney didn’t personally invest a dime into any of those funds, but still receives capital gains tax treatment. That’s right, Romney could be receiving a massive IRS reward for risk-taking without having actually taken any risk.

Here’s why: Private equity executives like Romney basically make their money in two different ways:

  1. 1. Management fees: Private equity firms raise funds from institutional investors (pension funds, endowments, etc.), and then charge those investors an annual fee. Usually around 2%. The money is used to cover overhead (travel, office space, etc.), and PE pros pay ordinary tax rates on any income derived from management fees.
  2. 2. Carried interest: When private equity funds complete a successful investment, they split the profits between their investors (called limited partners) and the fund managers (called general partners). Usually an 80/20 split, although Bain historically has been 70/30. Both the limited partners and general partners get to pay capital gains tax rates.

As I’ve argued extensively, carried interest should not be treated as capital gains. It is a fee for service, in which private equity executives neither take real financial risk nor have actual company ownership. Unfortunately, legislative efforts to close this loophole have repeatedly failed — due to Democratic mismanagement and Republican inanity. So we have an imperfect system that has helped create Romney’s 15% tax rate.

For the Bain funds formed prior to Romney’s 1999 departure from the firm, Romney is generating carried interest. In other words, income without actual investment. It is possible that he also did personally invest in the funds — often general partners put up 1% or 2% of a fund’s capital — but that’s not where his big money is being generated (and no one disputes that such investments deserve continued capital gains treatment, save for those who don’t believe in any sort of capital gains treatment).

For Bain funds formed after Romney’s departure, we have absolutely no idea. Neither Romney nor Bain have explained the retirement package signed in 1999. Is Romney’s income for these funds all carried interest? Was he required to make any co-investment in the funds? Did he choose to make additional investments in the funds, or on particular deals? In other words, does he really deserve the 15% tax rate — or does he just get to use it because of a giant loophole?

My guess is the latter, which might help explain why the son of George Romney has been so hesitant to release his tax returns. Not only for his own sake, but also for the sake of former private equity colleagues who don’t want their own tax bills revisited by Congress.

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