Mitt Romney pushes the envelope on his taxes

Originally published in Politico

By now, every literate American is probably familiar with former Massachusetts Gov. Mitt Romney’s 14 percent federal tax rate, the result of most of his income coming via capital gains.

Romney should be grateful to fellow Republicans for that low tax rate. Former President George W. Bush led the successful fight to lower the capital gains tax rate to 15 percent in 2003. And get this, former Speaker Newt Gingrich played a central role in 1997, when the capital gains rate was lowered from 28 percent to 20 percent.

As offensive as it is to many Americans that someone with $21.7 million in income last year pays such a low rate — famously, a lower percentage than Warren Buffett’s secretary — that’s far from the only way that Romney has taken advantage of the nation’s twisted Tax Code.

He’s pushed the envelope on how much of his income qualifies for that 15 percent rate; engorged his individual retirement account to postpone millions in taxes and applied peculiarities of trust and estate law to funnel tens of millions to his sons and future descendants free of inheritance tax.

Ironically, Republican members of the Senate Finance Committee have routinely blocked confirmation of Obama administration nominees with tax questions that were an infinitesimally small fraction of those surrounding Romney’s returns.

In fairness, let’s give Romney a chance to defend himself. “I paid all the taxes that are legally required,” he told a Florida debate audience, “and not a dollar more.”

That may be. Though he stretched the Tax Code to its outer extremities — and possibly beyond.

Here’s what you haven’t heard as much about:

For starters, a large chunk of Romney’s income (about $7.4 million last year) is derived from the famous carried interest, the 20 percent of the profits that private-equity investment managers (I was previously one) receive.

That income is taxed as capital gains, though it’s from Romney’s work as a partner at Bain Capital. So what most of us would consider income from labor, the Internal Revenue Service has deemed income from capital, taxed at less than half the rate of ordinary income.

Still more startling is that Romney believes he is entitled to that treatment even though he left Bain in 1999. He now almost certainly derives the vast preponderance of that $7.4 million from investment vehicles that weren’t even in existence when he left the firm.

That puts him in a gray area. In 1993, the IRS ruled that individuals would be entitled to the capital gains rate on carried interest if they provide services to their firm — but said nothing about after retirement. There has been no suggestion that Romney provided any services to Bain Capital since his departure.

Next, there’s his IRA, which began life as a 401(k). Many Americans have them, generally modest in size. But Romney’s has a current value of $20.7 million to $101.6 million — one of the largest ever recorded.

With annual contributions to 401(k)’s and IRAs subject to relatively low caps, how on earth did Romney’s get so large? He may be a good investor, but there’s no chance that he took those small amounts, bought some publicly traded stocks and turned it into $20 million, let alone $100 million.

In all likelihood, he “sold” some of his Bain investments to his IRA. Because they are not publicly traded, and therefore “illiquid,” under the tax law, he would be allowed substantial discounts on their valuation — effectively increasing his IRA contribution.

More amazingly, he may well have “sold” some of his Bain carried interest to his IRA. If he did so at the outset of the fund, he likely put little or no value on that transfer — though it was potentially worth millions. Such a transfer would be of questionable legality, according to a recent Tax Analysts article by Lee A. Sheppard.

Then there is the trust for his sons. Tax law limits lifetime gifts to $10 million per couple, plus $26,000 per year per child. The trust for Romney’s children is currently valued at $100 million — another unexplained disparity.

Romney probably used the same loopholes as with his IRA: put in assets at unrealistically low values, perhaps close to zero in the case of the carried interest. Indeed, Brad Malt, attorney for the Romneys, has confirmed that carried interest went into the trust.

But Romney is using one more loophole with his trusts. Unlike IRAs, with their tax-deferral attributes, the income on investments in trusts is taxed exactly like income earned directly by individuals.

By setting up his trusts as “grantor trusts,” Romney is permitted to pay the taxes due on the trusts’ income himself, in effect making a further gift to the trusts. In each of the past two years, that appears to have amounted to slightly less than $2 million.

Romney’s trusts are not only going to avoid inheritance taxes that his estate would have owed. In all likelihood, the trusts are set up as “generation skipping,” which means his sons’ estates won’t owe taxes either. That arrangement can last for decades and decades — as much as a century.

Let’s not end our tour of Romney’s taxes without mentioning one other smaller benefit: the decrease in dividend tax rates orchestrated by Bush. Until 2003, dividends were taxed like ordinary income — now 35 percent.

Bush reduced it to 15 percent — the same as for capital gains. Romney paid $1.1 million in taxes on dividends last year. Before 2003, that figure would have been $800,000 higher.

Romney’s tax returns raise as many questions as they answer. The public is entitled to know more about things like how his IRA and trusts came to be so large.

Whether or not Romney releases that information, his taxes offer President Barack Obama real-life, campaign-ready examples of how the Tax Code favors the rich.