A nice story pointing out the flaw in the “I’m only following the law” argument.  Carried interest is taxed at a low rate because the private equity industry has made it so.  Needless to say, I can’t get a meeting with a Senator.  Rubenstein can meet with anyone he wants.

In a similar vein, the private equity chief David M. Rubenstein, who served in the administration of President Jimmy Carter, said during a panel discussion that businesspeople like Mitt Romney shouldn’t be blamed for paying low taxes — that’s the government’s fault. “You change the law, and they’ll pay the taxes,” said Mr. Rubenstein, a co-founder and managing director of the Carlyle Group. “Romney said — and I’m not his defender — he’s paying whatever the law required. If you change the law, change the law. But don’t criticize him for paying the taxes that the law requires him to pay.”

There’s some truth to that argument. After all, even Warren Buffett, the inspiration for Mr. Obama’s Buffett Rule, and the class traitor Mr. Soros today pay only those taxes required of them. Their point, as Mr. Soros told me, is that the tax rate should be higher. But of himself and Mr. Buffett, he added, “the Republicans are trying to save us from taxation — against our will.”

Yet the Rubenstein defense goes only so far. The low tax rates for millionaires are neither a natural law nor an act of God. They are the result of a political process that, since the late 1970s, has pushed rates, particularly at the top, hugely downward. Business has been instrumental in that shift, both as a matter of general ideology and in a dogged and skilled fight for sector-specific tax breaks, like the carried interest provision.

via Brake-Time Looms for Tax Breaks – NYTimes.com.

Good quote from the other Professor Fleischer:

From a tax perspective, it makes sense for the Romneys to use shares of stock to make charitable donations, Mayer said. If someone donates shares that have increased in value, they can deduct the contribution while avoiding the 15 percent capital gains tax they would have to pay otherwise.

“It’s a very common strategy,” Mayer said.

Still, the large amount of cash donations reflects that Romney wasn’t engaged in an aggressive strategy to use charitable contributions to lower his taxes, said Miranda Fleischer, an associate professor of taxation at the University of Colorado Law School.

“In 2011, about 75 percent of what he gave was in cash and that’s not necessarily the most tax-advantageous method,” she said.

via Romney Tax Returns Show $7 Million in Donations Over 2 Years – Businessweek.

Romney has acknowledged that he probably pays close to 15% of his income in taxes.  Here’s what to look for in the returns tomorrow.

1.  Carried Interest

As detailed in this NYT story, Romney continues to receive income from his days at Bain Capital.  His financial disclosure forms suggest that his payout came mostly in the form of interests in a wide variety of Bain funds, including private equity funds, mezzanine funds, and hedge funds.  Many of those distributions are in the form of carried interest, or a percentage of the profits that Bain receives in exchange for managing assets.  Because much of the profits allocated to Bain are capital gain, the income is mostly taxed at the long-term capital gains rate.  Some of the income may be dividend income, also taxed at 15%, and some of the income may be interest income taxed at 35%.

From an economic point of view, even the 15% rate overstates his tax liability.  There is a deferral benefit that’s hidden.  While the economic value of his investments have increased over time, he is only taxed on realized investments–that is, when Bain actually sells investments.  The longer that income is deferred, the lower the tax rate (from an economic point of view).  By contrast, if he had sold his founder’s equity in Bain back in 1999, he would have paid tax back then.

Of course, the only thing we’ll see on the return is a reporting of capital gains, not whether it was received in exchange for services provided in the past.

2.  Reinvested capital; Cayman Islands

It is common for investment fund managers to invest some of their own cash alongside other investors.  Some of Romney’s investments are true investments in Bain funds, not just carried interest received in exchange for services.  In many cases, however, private equity and hedge fund managers use cash from carried interest (or “incentive fee”) allocations to reinvest, pre-tax, in related investment funds.  The use of a Cayman Islands affiliate facilitates this tax deferral strategy.  While Congress enacted section 457A in 2008 in an attempt to shut down this deferral strategy, transition rules ensure that many of Romney’s investments in the Cayman Islands are grandfathered in and have never been taxed in the U.S.

Unlike most investments, then, Romney is using pre-tax money to make his investment — that is, his compensation was transformed into investment holdings without having paid tax on it.  Most of us can do this in our IRAs, but only up to $5,000 or less.  The Cayman islands deferral strategy is like an unlimited IRA.  If Romney ends up giving away the money to charity or bequesting it to heirs, no one will have ever paid any income tax on it.

The tax benefit of the deferral will not show up on Romney’s tax return for the same reason that the tax benefit of your IRA doesn’t show up in your effective tax rate: the income that is sheltered reduces your AGI, and it will be taxed later, if at all.  For this reason Romney’s reported effective tax rate is lower than his actual effective tax rate from an economic point of view.

The Romney campaign has denied that any tax benefit flows from the Cayman entities.  What about tax deferral benefits?  What is the non-tax purpose of the entities?  I recognize that the entities also help foreign investors and tax-exempt investors avoid paying tax on U.S. business income, something that’s not necessarily abusive of U.S. tax policy.  But that doesn’t mean that Romney isn’t helped too by deferring his income offshore.

3.  IRA

Romney has packed an awful lot of investments into his IRA.  Presumably, he was able to do so by rolling over a qualified retirement plan from Bain Capital, and the magic of pre-tax compounding and Bain’s impressive investment record has ballooned the IRA into the $100 million range.  How many people in the country have an 8 or 9 figure IRA?

4.  Charitable contributions

Romney makes considerable charitable contributions to the Mormon church and other organizations.  These contributions generally reduce his taxable income.  From an economic perspective, it’s as if a portion of his tax liability is instead re-directed from the public fisc to the Mormon church.  It’s like a government matching grant program, and the donor chooses the recipient.  There is nothing unusual about this arrangement, although one might question whether it’s good tax policy.  (See Miranda Fleischer, Generous to a Fault? Fair Shares and Charitable Giving, Minn L Rev 2008.)

5.  Speaking fees

Romney will have some ordinary income from speaking fees (although “not much”).  This income would be taxed at 35%, but it is probably offset by his charitable contributions.

6.  Something unexpected?

I doubt there will be any big surprises.  Romney has acknowledged that his tax rate is close to 15%.  I expect that the actual release of the returns will be anticlimactic.

If there are any surprises, I’ll try to post something here, or on twitter.

7.  Why this matters

We shouldn’t lose sight of why this matters in the first place.  We live in a country with two tax regimes, one for the sophisticated, rich, and well-advised, and another for the rest of us.  People who manage money for a living often enjoy a 15% tax rate, and they can often defer their tax liability through offshore vehicles or huge retirement plans and IRAs.  The rest of us pay up to a 35% tax on wages, plus considerable state and local taxes, plus a payroll tax.

That Romney personally paid tax to the government at a low rate as a percentage of his economic income is no surprise to those of us who study tax policy.  What we don’t know, and what really matters, is whether he thinks the status quo is good tax policy or not, and why.  Congress has tried to change the tax treatment of carried interest four times, but lobbying by the private equity industry, including Bain, has successfully blocked the effort.  We can continue to raise ordinary income taxes and payroll taxes, or we can broaden the tax base by closing loopholes and changing the structure of how we tax businesses and individuals.  Do we want a tax system that favors Wall St or Main St?

Reasonable people can differ about the size of government and how we should finance it.  But this is not a discussion that should be held in “quiet rooms.”  It should be held in the open.

Further reading:

Victor Fleischer, Two and Twenty: Taxing Partnership Profits in Private Equity Funds (NYU Law Review 2008)

Here’s a good roundup of the various Romney tax stories.  The newest thread is the reporting on his massive IRA:

Romney’s retirement account holds between $20.7 million and $101.6 million, and it’s “highly unusual to accumulate such a considerable sum in an IRA,” The Wall Street Journal’s Mark Maremont reports. IRAs with more than $100 million are “rare,” the Journal says, and while the size has enabled Romney to avoid paying a lot of taxes on his wealth now, he might have to pay big fees later, when he’s required by law to start withdrawing from the account six months after his 70th birthday. Romney got between $1.5 million and $8.5 million in income from his IRA between January 2010 and August 12, 2011.

His IRA probably got so fat through its investments in Bain Capital, the Journal reports, pointing out that it’s possible Romney avoided paying a large tax when his IRA invested in the private-equity fund by using offshore accounts. “Tax experts say that might explain why Mr. Romney’s IRA includes holdings in Bain entities based in offshore locations, including one Cayman Islands entity that Mr. Romney listed as having a value between $5 million and $25 million,” Maremont writes.

via Romney’s Funny Money – Politics – The Atlantic Wire.

Lots of carried interest news today, including this from Bloomberg.

Under pressure from his Republican opponents, former Massachusetts Governor Mitt Romney yesterday abandoned months of resistance and said he would make his 2011 tax return public in April.The hesitation to disclose is understandable given that Romney, one of the richest men to seek the presidency, probably benefits from a controversial tax break that allows him to pay a lower rate than do millions of American wage-earners whose votes he’ll need to capture the White House.That’s because private equity executives, as Romney was for 15 years when he ran Boston-based Bain Capital LLC, receive much of their compensation in what is known as carried interest. That enables them to treat what would be ordinary income for other service providers, taxed at rates as high as 35 percent, as capital gains taxed at 15 percent.

via Romney as Multimillionaire Gets Break for Taxes Less Wage-Earner – Bloomberg.

We’re getting nowhere with respect to deep reform of the tax code, but it’s back on the table, as it is during every presidential election campaign. If we’re serious about it, then we should start taking an ax not only to the mortgage-interest deduction but also to the charitable-donation deduction. Because every time I see reports of a family charitable trust which carefully makes only the minimum outlays each year, I wonder just how charitable a lot of these donations are.

via The problematic charitable-donation tax deduction | Felix Salmon.

From the NYT on Sunday:

Whether or not the I.R.S. agrees with Mr. Lauder’s contention that his contract is legitimate, some tax policy experts say the deal illustrates how the wealthy take advantage of the system.

“There’s real truth to the idea that the tax code for the 1 percent is different from the tax code for the 99 percent,” said Victor Fleischer, a law professor at the University of Colorado. “Any taxpayer lucky enough to have appreciated property is usually put to a choice: cash out and pay some tax, or hold the property and risk the vagaries of the market. Only the truly rich can use derivatives to get the best of both worlds — lots of cash and very little risk.”

via Estée Lauder Heir’s Tax Strategies Typify Advantages for Wealthy – NYTimes.com.

I’m curious what non-tax folks think.  The point I tried to get across is that what Lauder did was legal, but that we should not be satisfied with a tax system where planning options are so easily available to the rich and well-advised.

The final version is now posted on the UCLA website.

Taxing Founders’ Stock « UCLA Law Review.

I’m quoted in the Economist “Schumpeter” column today:

Victor Fleischer, associate professor at the University of Colorado Law School, says Carlyle may also want to go public sooner rather than later before potential changes to the tax treatment of private-equity firms, which would increase taxes on firms’ public shareholders and make it harder to exist as a publicly traded partnership. As the only large buy-out firm to be headquartered in Washington, DC, Carlyle is better than most at keeping its finger on the political pulse.

via Private-equity IPOs: The Carlyle swoop | The Economist.

In particular, *if* the carried interest legislation is enacted in 2012 — call that 50-50 at best — it will become difficult for PTPs that avoid the corporate tax by having 90% of their income count as “qualifying income” (passive income like capital gains).  But for firms that go public before any legislation is enacted, and for firms that are already public, they may benefit from “grandfather” rules that allow them to retain partnership status for a long time.

There has also been a provision in the carried interest legislation that would tax founders of PE firms at higher rate on the “goodwill” sold to the publicly-traded firm.  The rationale is that much of the value of the “goodwill” should really be treated as a partnership “hot asset” that gives rise to ordinary income, like inventory and accounts receivables.

Interesting op-ed from my colleague Preston Padden, an adjunct prof here at CU and a former Disney executive.

A territorial tax system would essentially codify the deferral regime and enhance its benefits by allowing earnings to be repatriated to the U.S. tax-free. So why on earth would Washington, D.C., adopt a system that continues to reward companies that shift operations and jobs offshore and continues to penalize companies that maintain their U.S. operations and workers?

Instead, Congress should reduce the corporate income tax rate to 20 percent to attain parity with most foreign countries and enact stricter anti-deferral rules. A tax rate comparable to foreign countries would greatly eliminate the incentives to move operations and jobs offshore because of rate differentials, and the anti-deferral regime would minimize the benefits to U.S. companies from offshoring operations and jobs.

Clearly the U.S. tax system should encourage companies to retain their valuable stock of highly mobile intellectual property, including high-tech property, drug patents and films, in the United States. Moving to a territorial system would have the opposite effect.

Maintaining the U.S. worldwide tax system and enacting stricter anti-deferral rules would stop rewarding companies such as GE for moving jobs overseas and stop penalizing companies like Disney that keep their income-producing property and their jobs here.

via Padden: Tax Code Hurts Firms That Keep Jobs in U.S. : Roll Call Opinion.