NY Times: A Tax Tactic That’s Open to Question

New York Times:  A Tax Tactic That’s Open to Question, by Floyd Norris:

There is no evidence that Mr. Romney has violated the law. The principal means he used to pay low taxes on his hundreds of millions of dollars in income was the technique known as carried interest, which allows managers of private equity funds to treat most of the fees they receive for running the funds as capital gains rather than ordinary income.

The technique strikes some -- including President Obama -- as outrageous, but it is legal under current law. Unless and until the Congress changes the law, Mr. Romney has every right to take advantage of the technique.

But there is a related tactic to avoid taxes that is used by some private equity firms, including Bain Capital, whose legality is less clear. The IRS has not challenged it -- at least not publicly -- but some legal scholars say it is not justified, and some private equity firms have not chosen to use it.

The fact that Bain uses the technique became public last month when the Gawker Web site posted annual reports from a number of Bain funds in which Mr. Romney, or his family trusts, have interests. It is clear that some Bain partners saved hundreds of millions of dollars in taxes from its use, but the Romney campaign says he did not benefit from it personally. ... It concerns the management fees that sponsors of private equity funds, such as Bain Capital, are paid. Those fees are separate from the fund profits that the managers are able to treat as carried interest.

Instead of paying ordinary income taxes on those fees, the partners and employees of the fund sponsors pay taxes at much lower capital gains rates. In fact, they do even better than that. In some cases, they defer paying those capital gains taxes for years, itself a substantial benefit.

How good a deal is that? Annual reports from 2009 for four Bain funds showed that over the years the funds converted $1.05 billion in management fees from ordinary income into capital gains.

That directly benefited the Bain partners who shared in the management fees. Assuming they paid the capital gains tax of 15%, rather than the ordinary income tax rate of 35%, they saved about $210 million in income taxes and $28 million more in Medicare taxes.

Some tax experts think the IRS could win if it challenged the practice.

“It is not legal,” said Victor Fleisher, a tax law professor at the University of Colorado, in an interview this week. He noted that different money managers used variations, some of which he said were less likely than others to withstand an audit. “Bain,” he said, “is on the aggressive end of this.”

In an article that appeared in the journal Tax Notes in 2009, Gregg D. Polsky, a tax law professor at the University of North Carolina School of Law who formerly worked in the IRS office of chief counsel, said he believed the IRS had good arguments that would be likely to prevail in court.

In a statement issued by the Romney campaign, Brad Malt, the trustee for Romney’s blind trusts, said the tactic was “a common, accepted and totally legal practice,” although Mr. Romney had never used it personally....

It is quite possible that the maneuver is legal under current tax law, and that Bain and Apollo acted completely appropriately to arrange their affairs to make the taxes owed by their partners and employees as low as possible. Even if the IRS and the courts eventually concluded otherwise, that would not indicate the funds had done anything wrong in asserting the position.

But it is hard for me to see the difference between that and an arrangement under which my employer invested, on my behalf, money that it would otherwise have to pay me for writing this column. Then I would tell the I.R.S. that I owed no taxes until I liquidated the investment, and even then would pay only capital gains rates.

If I tried that, I could not get away with it. If the law lets those who work in private equity do it, Congress should change the law.

At the same time, it should end the carried-interest dodge. Managers are being paid for their services when they receive a share of profits from the fund. The amount may be based on profits, but that is no different from the situation at normal companies that pay bonuses based on company earnings. It is compensation, and should be taxed as such.

Mr. Romney’s former colleagues in private equity may come to regret his candidacy, whether or not he wins. Few in the public understood this particular maneuver before the Bain reports were disclosed. Now many do. If and when Congress decides to reform the tax law, this area is likely to be a prime target.

(Hat Tip: Mike Talbert.)