When Mitt Romney conceded on Jan. 17 that he pays a tax rate of about 15 percent—far less than millions of wage earners whose votes he’s trying to win—he deflected criticism by employing what might be called the Ordinary Rich Guy Defense: Like a lot of people who are wealthy enough not to work, Romney said his income “comes overwhelmingly from investments made in the past.” That’s not quite the whole story. What he left out is that, because of the way he made his money, he is eligible to take advantage of a special tax provision that even some of his richest friends would envy.
Private equity executives such as Romney, who spent 15 years running Bain Capital, arrange to receive much of their compensation in the form of “carried interest.” This enables them to treat what would be work income for most people, taxed at rates up to 35 percent, as capital gains, taxed at just 15 percent. “It’s a method of converting one’s labor into capital gains in a way that’s unusual outside the investment management industry,” says Victor Fleischer, an associate law professor at the University of Colorado at Boulder whose 2007 paper on the topic helped spur calls in Congress to change the law. “Ordinary people wouldn’t be able to do this.”
For months, Romney dodged questions about his effective tax rate. “I paid the taxes required under the law,” he said on Jan. 11. That only increased curiosity. On Jan. 17, Romney conceded his effective rate was “probably” close to 15 percent. Though he retired from Bain in February 1999, Romney negotiated a settlement that has allowed him to continue benefiting from the firm’s lucrative private equity funds and to invest alongside them in so-called co-investment vehicles, both of which generate income taxed at the 15 percent rate. The tax code’s treatment of income from partnerships in private equity, hedge funds, and real estate development means that some of the richest people in the country are taxed as if they made the wages of a bus driver or health aide. Last year three founders of the Washington-based Carlyle Group each earned $275,000 in salary. But they took home $134 million apiece in distributions from their funds, according to a Securities and Exchange Commission filing, making them eligible to pay low rates on much of their compensation.
Private equity firms gather large sums from pension funds, universities, and wealthy individuals, and typically use the money to acquire privately held companies or subpar units of public companies. After improving the companies’ performance, often while working in hands-on management roles or serving on the board of directors, they sell their acquisitions to other investors or take them public. The tax code treats those gains as if the private equity partners were risking their own money—like average Americans who invest in mutual funds—instead of counting it as salary for running or advising the companies they acquire. In most cases, the private equity firms put up only a sliver of the fund’s capital.
In May 2004, Bain circulated a private-placement memorandum to investors for “Bain Capital Fund VIII.” Marked confidential, the document boasted that Bain had completed more than 200 deals as of March 2004. The firm’s first six funds had realized an 82 percent return, according to the document. In all, 274 investors signed on to the fund, including Romney and his wife, Ann, and pension funds for Texas teachers and Pennsylvania state employees.
The VIII fund, registered in the Cayman Islands, shows how special tax provisions allowed Romney to accumulate wealth both while running Bain and in the 13 years since he left the firm. The Romneys received more than $1 million from the fund in 2010, according to his most recent financial-disclosure form. Though Bain put up just 0.1 percent of the $3.5 billion fund’s capital, it drew 30 percent of the profits once investors were repaid their initial investment, better than the industry standard of 20 percent and a reflection of the firm’s stellar track record. The fund’s investment successes included the parent company of Dunkin’ Donuts, which paid investors a $500 million dividend after a successful November 2010 refinancing. A month later, the initial public offering of FleetCor Technologies in Norcross, Ga., brought in an additional $61 million.
The Bain fund derives more than 99.9 percent of its income from investment gains or dividends, according to copies of Fund VIII’s 2010 and 2011 financial statements obtained by Bloomberg News. Under current tax law those gains and dividends are regarded as the partners’ share of the profits, or carried interest. The fund had just $13,056 in interest income in 2010 compared with $249.8 million in dividends and $665.1 million in realized investment gains, according to the fund’s confidential financial results. In the first nine months of 2011, it had just $6,539 in interest, $111.9 million in dividends, and $445.1 million in capital gains.
The Romneys likely paid tax of 15 percent on the vast majority of the $1 million-plus they received from the fund, according to Joann M. Weiner, a tax analyst with Bloomberg Government and former senior economist with the Treasury Dept.’s Office of Tax Analysis. Measured against the 35 percent tax on ordinary income, that means the Romneys may have saved at least $200,000 in taxes on this single investment—an amount equal to four times the annual income of the typical American household.
Bain Capital Fund VIII is just one of 31 Bain-related funds that, under the deal Romney struck upon leaving Bain in 1999, generated income last year either for Ann Romney’s blind trust or her husband’s individual retirement account. Combined, those investments in 2010 provided the Romneys between $5.5 million and $21.5 million in income, according to the disclosure form.
It’s impossible to say precisely how much Romney saved in taxes without knowing the details of his agreement with Bain and his tax returns. Andrea Saul, a spokeswoman for his campaign, declined to comment for this story. If carried interest made up half of the Romneys’ Bain-related income, they would have paid between $550,000 and $2.2 million less in taxes than they would have if that income had been taxed at ordinary rates. In business, it’s called limiting tax liability. In a Presidential campaign, it’s just a liability.