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Tax Avoidance -- Or Evasion? Bain's Tricky Accounting

David Callahan

It's not often that we get a detailed look inside the tax strategies of a private equity firm, so Gawker's publication of a trove of documents related to Bain Capital is a welcome event.

The documents show -- once again -- how sophisticated business people have myriad ways to avoid taxes -- and, in the case of Bain anyway, will readily skirt or break the law.

The main revelation so far is that Bain seems to have pushed the envelope and misrepresented some of its income -- saying that management fees, which would be taxable as regular income, were actually capital gains, which are taxed at a much lower rate thanks to the infamous "carried-interest" loophole.

About that loophole. Hedge funds and private equity firms make their big money by taking a cut of the returns on client money they invest. So if I invest $10 million with a hedge fund or private equity firm, and they make a 30 percent return on that money next year -- or $3 million -- they would typically take 20 percent of that return, or $600,000. In addition, they would charge me an annual management fee of probably 2 percent, or $200,000. Thanks to the carried-interest loophole, the $3 million cut is treated as capital gains earnings by the firm, and taxed at a mere 15 percent, and only the management fee is taxed as regular income.

The reason the carried-interest loophole is so outrageous is that, of course, that $3 million cut is not capital gains made by the firm. It is the firm's cut of somebody else's capital gains -- the investor who actually took the risk. The theory behind low taxes on capital gains is that it incentivizes risk-taking investment by people who might otherwise stash their wealth in safer but less productive places. But hedge funds and private equity firms are not risking their own money; they are risking somebody else's and their cut simply is not a capital gain. It is regular income and should be taxed as such.

All this is bad enough. One reason that private equity types like Mitt Romney have such large fortunes is because their taxes are so low, leaving other taxpayers to pay more.

But the Bain documents show something worse. Apparently, Bain's partners resented paying regular income taxes on their management fees, and so maneuvered to represent those fees as capital gains and pay a lower rate. As reported today in the New York Times:

Bain private equity funds in which the Romney family’s trusts are invested appear to have used an aggressive tax approach, which some tax lawyers believe is not legal, to save Bain partners more than $200 million in income taxes and more than $20 million in Medicare taxes.

Annual reports for four Bain Capital funds indicate that the funds converted $1.05 billion in accumulated fees that otherwise would have been ordinary income for Bain partners into capital gains, which are taxed at a much lower rate.

Although some tax experts have criticized the approach, the Internal Revenue Service is not known to have challenged any such arrangements.

In a blog post Thursday, Victor Fleischer, a law professor at the University of Colorado, said that there was some disagreement among lawyers, but that he believed: “If challenged in court, Bain would lose. The Bain partners, in my opinion, misreported their income if they reported these converted fees as capital gain instead of ordinary income.”

You would think that the super wealthy might shrug at paying taxes they can easily afford, but here the opposite appears to be the case: Bain's wealthy partners have been hyper-aggressive about lowering their tax bill.

The Medicare dodge is especially notable, given how conservatives endlessly trumpet the financial troubles of that program. Capital gains are not subject to payroll taxes, which means that one effect of the carried-interest loophole -- which the right defends -- is that it weakens the financial situation of Medicare and Social Security.

Also notable in this story is that the IRS has not moved more aggressively to crack down on tax cheats who misrepresent management fees as capital gains. Presumably that is because the IRS doesn't have firepower to go up against some of the best tax attorneys in the nation in legal disputes that could take years.

All in all, the revelations about Bain's taxes confirm what New York Times tax reporter David Cay Johnston told us eight years ago in his book Perfectly Legal: The Covert Campaign to Rig Our Tax System to Benefit the Super-Rich–and Cheat Everybody Else.

Only in this case, it's not clear that what Bain did was, in fact, perfectly legal.