Bain Capital's tax breaks: Are they legal?
A cache of Bain Capital documents reveals details about Mitt Romney's Cayman Islands investments. / David Rogers/Getty Images
(MoneyWatch) Gossip website Gawker released 950 pages of Bain Capital records Thursday, shedding light on two controversial campaign issues: Mitt Romney's financial portfolio and the sometimes aggressive strategies used by Bain Capital, which he founded, and other private equity firms to reduce taxes that partners pay on income from their investments.
The document dump will stoke the political fires, as partisans call attention to documents such as Bain Capital Fund VII, a $515 million Cayman Island-based limited partnership in which Ann Romney has at least $1 million, according to financial disclosure forms. In the words of the writer, John Cook, the documents "reveal the mind-numbing, maze-like, and deeply opaque complexity with which Romney has handled his wealth, the exotic tax-avoidance schemes available only to the preposterously wealthy."
Reaction ranged from an angry Bain statement decrying the release of confidential documents to a yawn from a Fortune blogger who claimed this was old news to an accusation by a Colorado University law professor who argued that the documents revealed evidence of an illegal tax dodge. What's not in dispute: The documents show that Bain, like other private equity firms, goes to great lengths to reduce its tax liability, and they show how tax loopholes are available to wealthy investors that less affluent, salaried workers can't use.
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To understand why someone like Mitt Romney, who is worth an estimated $250 million, can pay a tax rate in the range of 13 percent (the top income tax rate, 35 percent, applies to that portion of income over $388,350, for married couples filing jointly), it helps to understand how private equity fund partners are paid. Fund managers earn a management fee, typically 2 percent of assets under management, and a share of the profits, typically 20 percent. (This structure, often referred to as 2 and 20, is also used in hedge funds, and that's why it's better to manage a hedge fund than invest in one.) In some cases, Bain charged 2 and 30.
The 2 and 20 structure makes for a nice tax deal: While the 2 percent management fee is taxed as ordinary income, the 20 is treated as a long-term capital gain, which is taxed at 15 percent. In private equity lingo, the income from profits is called "carried interest." Many people, including Warren Buffett, have criticized the tax treatment of carried interest, arguing that it's simply compensation, and ought to be taxed as such. President Obama has called for a change in the law that would treat carried interest as income.
Not surprisingly, private equity investors guard their tax break fiercely. In a widely reported remark in 2010, one of the biggest names in private equity equated such a tax hike with Nazism. "It's war. It's like when Hitler invaded Poland in 1939," said Blackstone chairman and co-founder Steve Schwarzman, who has a net worth of $5.5 billion, according to Forbes.
Here's where the fun begins. Not satisfied with only paying low rates on the carried interest, private equity partners, and their tax advisors, have come up with a tax strategy to pay the lower tax rate on their 2 percent management fee as well. The recently revealed Bain documents show that Bain Capital has used a strategy, known as management fee conversion, to convert their fees into carried interest. Also known as a management fee waiver, the strategy has been popular among private equity firms for years, and is dissected in this 2007 article in a tax journal. (page 18, for the intrepid)
Bain Used Strategy
The documents released yesterday suggest Bain used the fee waiver strategy. In the financials for Bain Fund X, the managers state that in 2009, they waived $89 million of the $214 million in fees owing that year. They further state that they waived a total of $338 million of fees for years up to and including 2009. In the financials for Bain Fund VII, the managers admit to having waived fees in the past.
In a widely cited blog post Thursday, a University of Colorado law professor opined that "Bain's management fee conversions are not legal." Victor Fleischer wrote that "If challenged in court, Bain would lose."
While it's hard to find anyone who agrees with the spirit of the fee conversion, interviews with tax experts suggest it's far from clear that the strategy amounts to breaking the law. "This is an aggressive tax tactic," said Lee Sheppard, a corporate lawyer and legal commentator, reflecting the attitude of most observers.
David Kautter, managing director of the Kotuk tax center at American University and a partner at Ernst & Young for 28 years, said that if you cobble together various IRS rulings and principals as established over the past 40 years, you can justify the fee waiver strategy. For example, the concept of "constructive receipt," he says allows managers to delay tax liability as long as they waive their fees before the tax year begins. And then, "what turns lead into gold," he says, is the longstanding IRS practice of treating general partner income according to the nature of the distribution. In this case, the income is distributed as capital gains from the fund, and therefore it's taxed as such. Indeed, you could use the same strategy in any general partnership structure, he argues. (Feeling wonky? Here's a presentation explaining the legal issues and citing IRS rulings.)
In accusing Bain of breaking the law, Fleisher, according to Kauttner, is "arguing what should be, rather than what is."
Not So Fast
Michael Graetz, a professor of tax law at Columbia University, isn't so fast to dismiss the spirit of the law. "I couldn't go to my dean and say instead of giving me next year's salary give me a partnership interest and it will some how magically turn into a capital gain," he says. "You can't take compensation and somehow magically transform it into capital gains."
All of the experts I consulted said that, as far as they knew, the IRS has not ruled on this strategy. An IRS attorney referred me to a spokesperson, who would only say that "federal law prohibits the IRS from discussing any particular taxpayer or case." Private equity firms have apparently flown under the IRS radar, at least when it comes to this issue. The 5-year-old tax journal article even stipulates that the strategy has yet to be upheld, so tax advisors appear to have taken the approach that it's better to beg for forgiveness than to ask for permission.
"You're playing an audit lottery," says Graetz. "Your tax return becomes your opening bid."
Romney appears to have benefited from the carried interest tax treatment, but it's not clear if he benefited from the management fee conversion. "Mitt Romney might have benefited from these fee waivers to the extent that he had profits interests in the funds awarded to him under his 10-year retirement deal," Sheppard says. Romney has released tax returns for 2010 and an estimate of his 2011 return. Democrats, and even some Republicans, have urged him to release returns for earlier years as well. In an article in Saturday's New York Times, my former colleague Jim Stewart suggests that even looking at just 2010, you can learn some details about Romney's returns from earlier years.
Because of the political implications of this issue, many experts refused to discus it. The American Institute of Certified Public Accountants told me to get back to them when I had a non-campaign related question. I called a nonpartisan think tank, which referred me to a left-leaning think tank, which declined to be quoted. A couple of corporate lawyers never called back.
But it's probably a safe bet that the IRS will take a look at management fee waivers sooner, rather than later.
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I wonder what Mitt might have said?
"I wouldn't have chosen those words" ... ?
50% of Americans don't pay ANY federal income taxes. THAT DISTORTS tax policy.
_____
I call BS.
TAXES & Soul...-they unravel the Character of any one
individual's pretense or true-nature...: so it is with
any 'Opportunist'...!
*********************
IANAL, accountant, tax expert, etc. could you please explain to ppl that speculating about what the Obama Campaign can release about Romney's taxes is accusing the President of a felony, one that the RW regularly accuses him of when someone they know is the object of an audit.
googling " audit enemies president" will give you plenty of examples of RW accusations.
Maybe if you tell them that in saying so they are equating him with Richard Nixon during Watergate, who planned to use the IRS to harass the people on his enemies list, they will understand their speculation does real harm to the President's reputation.
Anyway ((gchaucer2)) who has tried to straighten ppl out on this.
"Are you bluish? You don't look bluish," attributed to poet Roger Joseph McGough, for the Beatles' Yellow Submarine (1968).
by BlueStateRedhead on Fri Aug 24, 2012 at 11:10:24 AM PDT
[ Parent ]
BSR - you make a good point(7+ / 0-)
that the Obama administration is not going to break the law to use Romney's tax returns against them and no one should be encouraging them to use the IRS as a political tool. I also think that post Watergate the IRS has put in place policies that make it nearly impossible for the IRS to be used as a political weapon.
"let's talk about that"
by VClib on Fri Aug 24, 2012 at 11:43:27 AM PDT
[ Parent ]
Misuse of IRS was one of Nixons' impeachables(8+ / 0-)
The articles of impeachment, Article II, Abuse of power:
(1) He has, acting personally and through his subordinated and agents, endeavored to obtain from the Internal Revenue Service, in violation of the constitutional rights of citizens, confidential information contained in income tax returns for purposes not authorized by law, and to cause, in violation of the constitutional rights of citizens, income tax audits or other income tax investigation to be initiated or conducted in a discriminatory manner.
Obtaining personal IRS info is not only a felony, it's an impeachable offense.
Do you think that will help?
"Are you bluish? You don't look bluish," attributed to poet Roger Joseph McGough, for the Beatles' Yellow Submarine (1968).
by BlueStateRedhead on Fri Aug 24, 2012 at 12:17:09 PM PDT
[ Parent ]
The prohibition exec. agent influence on audits...(4+ / 0-)
...is now part of the US Code, cited below by me.
Executive branch agents, the Pres, veep and AG by name.
sigh.
"Are you bluish? You don't look bluish," attributed to poet Roger Joseph McGough, for the Beatles' Yellow Submarine (1968).
by BlueStateRedhead on Fri Aug 24, 2012 at 12:20:48 PM PDT
[ Parent ]
Knowing Romney's penchant for avoiding(2+ / 0-)
taxes at all costs, maybe his running for president is not because he knows what to do when he gets the job, but he's looking at it as a preemptive strike to avoid having any IR S audit of his taxes!
As an opponent of the POTUS it would look really funny if he suddenly gets an audit.
As POTUS, he might be able to avoid an audit by doing things for those who might push for one.
by fastwacks on Fri Aug 24, 2012 at 10:06:58 PM PDT
[ Parent ]
very funny thought n.t. except not so funny(0+ / 0-)
..if the exec branch not influencing an audit and obeying the law allowed the law to be broken.
"Are you bluish? You don't look bluish," attributed to poet Roger Joseph McGough, for the Beatles' Yellow Submarine (1968).
by BlueStateRedhead on Sat Aug 25, 2012 at 04:41:45 PM PDT
[ Parent ]
But profits in the partnership have to be "realized". If the partnership got into a stock in a private entity (as most Bain holdings are) at the entry price, it can pretty much value that stock at a valuation price (as of last private round) rather than the "public price" which is what it would realize if sold publicly.
This difference could be ENORMOUS in VC and PE circles.
48forEastAfrica - Donate to Oxfam
by whenwego on Fri Aug 24, 2012 at 11:24:46 AM PDT
[ Parent ]
whenwego - you are definitely correct (3+ / 0-)
There is no tax event until appreciated capital assets are sold, just like for individuals. Appreciated assets can be kept within the partnership for its entire term. However, unlike corporations, partnerships have a finite life and the institutional investors in the Bain Capital funds pressure the managers to wrap these up within a ten year period.
"let's talk about that"
by VClib on Fri Aug 24, 2012 at 11:35:07 AM PDT
[ Parent ]
Bain Holdings(3+ / 0-)
Some of those holdings may be corporations, but to the extent the holdings in the partnerships are partnerships (or LLCs taxed as partnerships), then the income flows through two tiers of entities. Moreoever, the VC and PE funds harvest gains and losses throughout the life cycle of the fund. I find it hard to believe that the Bain funds had no ordinary flow through income at all and had not realized at least some gain/loss.
That being said, they are unique in the world of taxpayers in that they have a signficant amount of control over the timing, source, and character of their own income.
by ElaineinIN on Fri Aug 24, 2012 at 04:09:58 PM PDT
[ Parent ]
It is actually tax deferred and then never paid. (14+ / 0-)
This entity acts like a business with the Romney's as "stockholders".
Because the Romney's don't sell the stock and there are no dividends there is no income so no taxes of any kind.
The value of the entity does rise over time so Mitt and Ann become richer, but no taxes paid. As long as they don't need the money they pay no taxes.
When Mitt and Ann die the "basis" is reset so there is no capital gains so no taxes are paid then.
If there are no inheritance taxes no taxes are ever paid (therefore the "death tax" nonsense).
Because they control the entity the entity can do a lot of things that benefit the shareholders that are not taxed in any way.
Everything will be okay in the end. If it's not okay, it's not the end.
by NCJim on Fri Aug 24, 2012 at 10:34:23 AM PDT
Mitt has done his damndest to do the least for(4+ / 0-)
his country his whole life:
With his country at war, he protests for it then goes to France
He loads established companies with debt and plunders their pensions.
He ships american jobs to China
He then takes his immense plunder, and through a byzantine series of entities and trades, he pays very little tax.
What more does Obama need?
These capitalists generally act harmoniously and in concert to fleece the people, and now that they have got into a quarrel with themselves, we are called upon to appropriate the people's money to settle the quarrel. Abraham Lincoln
by Nailbanger on Fri Aug 24, 2012 at 10:29:09 PM PDT
AND
The problem is that Romney can argue for ZERO tax.(0+ / 0-)
The IRS might not even audit this.
Even if they do, he might win.
Only if they audit, and if they win, does he have to pay up.
I am willing to bet $10,000 that he and his tax advisors will take the risk of CLAIMING zero tax liability, and hope that the IRS doesn't even look at this.
In my experience, politicians get off easy with the IRS, because any audit will immediately raise the accusation of the IRS being PARTISAN.
"The battle, sir, is not to the strong alone; it is to the vigilant, the active, the brave." -- Patrick Henry
by BornDuringWWII on Sat Aug 25, 2012 at 12:00:15 AM PDT
Info to Reid and now the docs to Gawker. Remember, CNN confirmed Reid's source as credible.
You guys have all done a great job trying to explain the possibiliities but we'll never know all the info if Willard keeps hiding his tax returns. I admit I skimmed some of the responses and saw a quick mention of Amnesty. Could he be hiding an amnesty issue? I don't know, but I do know that hiding his tax returns goes back to 1994. Whatever he's doing that he doesn't want us to know has been going on for over 18 years and bits and pieces of releases aren't showing the pattern several years in a row might show.
Since he's destroyed records of the 02 Olympics, the MA Governors office (and had employees buy their hard drives) and won't release info to the public in this run, it's obvious he was taught to be deceptive, secretive and destroy evidence early in his life/career and he's just following the script.
Only now, he's got a "rat" releasing the "hidden" info.
Make the lie big, make it simple, keep saying it, and eventually they will believe it.--Adolph Hitler
by hwstormer on Sat Aug 25, 2012 at 06:50:04 PM PDT
AND
by the dogs sockpuppet on Fri Aug 24, 2012 at 11:06:06 AM PDT
To paint the scene, everyone does this.(14+ / 0-)
Every single fund I've ever worked at has been organized in the Caymans. Every single man with more than $5M in assets not including house has cash in something like this. Holy sht, I just realized that normal people don't know this. I consider you all normal.
Seriously every pot of cash out there is organized in the Caymans. When you read the words "hedge fund" or "private equity" you should hear in your head "pot of cash organized as a limited partnership organized in the Caymans, or other tax friendly place."
That's how all this works. That's how cash moves about now. Seriously, if your friends and neighbors didn't know that please tell everyone. This isn't controversial (except if you're running for pres), or illegal. If you are running a fund, you have at least one LP in the Caymans. I mean,
http://caymanhedgefundworld.com/...
I don't even know who those people are. There are so many companies that provide directors and registration for Cayman entities it's insane. It's an industry, like being a DE corp.
Every single fund that only takes accredited investors is organized in the Caymans. That is only mild hyperbole.
When we talk about war, we're really talking about peace.
by genethefiend on Fri Aug 24, 2012 at 11:10:33 AM PDT
Now I understand why Fox News deleted comments on their articles. With comments like this, CBS will be next.
Yea... Someone from the Sanitation Department likely complained that FOX was not disposing of the FOX garbage correctly....