WSJ: The Story Behind Mitt Romney's $100 Million IRA

Wall Street Journal, Bain Gave Staff Way to Swell IRAs by Investing in Deals, by Mark Maremont:

Bain, like many other private-equity firms, allowed employees to co-invest in its takeover deals. This posed a risk they could lose their whole investment, as they sometimes did. But because of the firm's success during the Romney era, employees ended up able to share in returns for Bain investors that averaged 50% to 80% annually.

Bain added a couple of unusual twists that made co-investing even more rewarding. It allowed employees to co-invest via tax-deferred retirement accounts, and to do so by buying a special share class that cost little but yielded much larger gains than other shares when deals proved successful. ...

Bain's co-investment arrangements, not previously reported in detail, offer a possible explanation of the large size of Mr. Romney's IRA. ... Documents analyzed by the Journal show that Mr. Romney co-invested in Bain deals via his IRA. ...

[S]welling the IRA to the size Mr. Romney's reached has "created a tax problem" for the former Massachusetts governor, said a Romney campaign official. Tax-law changes since Mr. Romney's Bain tenure mean that long-term capital gains in regular accounts now are taxed at 15%. But IRA gains are taxed at ordinary-income rates upon withdrawal, which for Mr. Romney, under current law, would be 35%. "Who wants to have $100 million in an IRA?" said the campaign official. ...

[T]he firm Mr. Romney ran until 1999 provided its employees with tax-planning options not widely available, even within its own industry. Several tax lawyers who work with private-equity firms said it was rare for such firms to let employees co-invest in deals via tax-deferred accounts, and even rarer to let them do so using a special share class.

Victor Fleischer—a tax-law professor at the University of Colorado who has advocated stiffer taxation of private-equity executives' compensation—said the arrangement at Bain allowed for "the sort of aggressive tax planning" not available "to ordinary taxpayers." ...

The tax-deferral opportunity stemmed from the way Bain often chose to structure the shares of companies after taking them over. Even if the companies had only one share class, Bain frequently gave them two classes, usually called Class L and Class A. ... Because Bain controlled the companies, it had flexibility in assigning values to the classes.

Class L shares, akin to preferred stock, were safer and had a higher initial value. They had priority if the company paid dividends, and holders of these shares were the first to receive proceeds from a sale or liquidation. The shares also accrued interest, often at 10% to 12%. Bain assigned a much lower value to Class A shares, which were riskier but potentially more profitable. If Bain sold or liquidated a company it had taken over for less than was owed to Class L shareholders, the Class A shares lost all of their value. But once Class L shareholders got their money, Class A shareholders received the bulk of additional gains, often as much as 90% of them. ...

The dual-share structures used by Bain aren't common at private-equity firms, but some others do use them. Often the main purpose, lawyers say, is to create a class of shares with a low initial value but high potential that can be given or sold to executives of an acquired company as an incentive to enhance its value.

For Bain employees, the structure also provided tax-planning opportunities. Some senior executives put the high-upside shares into family trusts for estate-planning purposes, where the potential appreciation would occur outside their estates, ex-employees say. Others donated greatly appreciated Class A shares to charity. ...

Several former employees said a common strategy in the 1990s was to invest in the inexpensive, risky but potentially lucrative shares in a tax-deferred IRA, and the safer but lower-upside shares through a taxable account. ...

A deal for Sealy Corp. shows how this could work if all went well. Bain led a group that took over the mattress maker in 1997. ... In 2004, after Sealy's value had been sharply raised by Bain and its partners, they sold most of Sealy for a large gain. ... Three-quarters of the gain was in the inexpensive A shares stashed in the employee's IRA account. Their value rose 34-fold. The L shares, in the taxable account, merely doubled.

Tax experts say the strategy of placing the high-upside A shares into an IRA made more sense during the 1990s, when maximum tax rates on long-term capital gains were higher than today—28%, for much of the period, versus today's 15%. The higher tax rate increased the attractiveness of deferring taxes and thus permitting gains to compound, unimpeded, year after year. ...

Bain often ascribed 90% of the equity value of a company it had taken over to the safer shares and just 10% of the value to the risky shares—in other words, a 9:1 ratio of all of the L shares to all of the A shares.

Some tax lawyers and private-equity experts said that was a low valuation for the A shares, particularly by today's standards. ... Jason R. Factor, an attorney at Cleary Gottlieb Steen & Hamilton who advises private-equity firms, said, "I personally would be careful about using a ratio as high as nine to one," because an aggressive valuation can "create issues" in any kind of IRS audit. ...

David S. Miller, a tax attorney at Cadwalader, Wickersham & Taft in New York, said that while setting the value of private shares entails inherent uncertainty, if the IRS did challenge such valuations it could use hindsight, such as how large a gain ultimately flowed to the shares, as a weapon. "The IRS would try to show the tax court judge that a 30-times return for the common shares means that the common should have been valued a lot higher and the preferred shares a lot lower," he said.