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Carrying The Political Burden Of “Carried Interest”

A person’s income tax returns paint a pretty vivid portrait if you know what to look for, and the picture of Mitt Romney that emerged last week is that of a successful investor and politician who does his best to make his financial affairs bulletproof.

Romney and his wife Ann have very intricate finances, owing to his involvement in the private equity vehicles operated by Bain Capital. When you consider the complexity of U.S. tax laws even for individuals in average circumstances, it takes an almost Herculean effort for people like the Romneys to satisfy the law’s demands. Yet nothing shady was apparent in the 2010 returns that the former Massachusetts governor released, nor in the early-draft version of his 2011 returns (which are not likely to be completed until autumn, when his partnership holdings report their final figures).

The Romneys engaged the international accounting firm PricewaterhouseCoopers to prepare their returns, and their tax counsel is a partner at Ropes & Gray, a prominent Boston law firm. I have worked with both organizations over the years, and both typically do top-flight work. Their services, naturally, don’t come cheap. You can be sure that no expense was spared in making sure that the Romneys’ tax returns would not ultimately cause any avoidable headaches, either legal or political.

Yes, the Romneys are very wealthy. Yes, they benefit from the 15 percent federal tax rate that applies to long-term capital gains and to dividends from corporations that have already paid federal income tax on their profits. Yes, they give away large sums of money, mostly to the Church of Jesus Christ of Latter-day Saints. We knew all this without needing to see the specifics on their tax returns. If we are going to disqualify a candidate for the White House because he has been highly successful in business and became wealthy as a result, the shame is ours - not the candidate’s.

But there is one aspect of the Romney returns that I believe will create political fallout, and not just for the Romneys. The majority of Mitt Romney’s capital gains ($12.9 million over the past two years, out of a total of $21.7 million, CNN reported) came from “carried interest” in various Bain partnerships - which means that this income was taxed at the 15 percent capital gains rate, even though it does not meet the traditional definition of capital gains at all.

A capital gain results when a taxpayer disposes of a “capital asset,” as defined in the tax code, at a profit. A capital asset is generally property or a property right, excluding inventory, which the taxpayer acquired through purchase, gift or bequest. If I write a book, my copyright in that book is not a capital asset, because I obtained it through my own labor rather than by purchase. If I sell the copyright to you, I will report ordinary income, taxed at up to 35 percent. But the copyright you just purchased is a capital asset in your hands. If you hold it longer than one year and sell it to someone else at a profit, you pay tax at 15 percent. (I’m smoothing out a few wrinkles in the law here, but this is how the concept operates.)

Bain Capital is in the business of buying companies, trying to expand or improve them, and then selling them. Most of the cash that Bain uses to acquire companies comes from lenders or from investors who, in effect, hire Bain to buy and run companies for them. Bain and its competitors typically charge investors an initial fee of 1 or 2 percent to get into the investments, and another 1 or 2 percent or so per year on the capital that investors commit to Bain’s investment funds. This creates a decent but unspectacular stream of income.

Bain makes its serious money by taking a disproportionate cut of the profits when companies are sold. Typically, the investors keep their entire share of the profits if the investment generates an unspectacular return of, say, 8 percent or less. But if the investor clears that hurdle rate, Bain is typically allowed to take 20 percent of the entire gain. So if an investment yields a 20 percent annualized gain, and Bain takes 20 percent of that profit, the net profit to the investor is 16 percent.

For Bain, the financial kicker in all this is that the company and its partners need put up very little of their own money. They get outsiders to supply the cash, while they supply the savvy and connections that get the deals done and the profits made. Call it payment for services, or call it “sweat equity.” But when all is said and done, it is a payment for Bain’s services, not a gain resulting from Bain’s capital. Remember, the tax law normally treats payment for one’s labor as ordinary income, not capital gain.

The rules allow carried interest to be treated differently. On one level, this makes sense. If Bain only took its annual management fee, its investors would report larger capital gains. The carried interest merely shifts this capital gain from the people who put up the capital initially to Bain, which put up the smarts. Bain also took a risk, since if the investment performed poorly, Bain would not receive the carried interest. Employees typically get paid regardless of whether their efforts are successful; business owners, aka investors, bear the risk of failure. So carried interest is not without logic.

But it also is very difficult to defend this practice in the current environment. Mitt Romney has plenty of capital, and he is entitled to capital gains treatment when he puts it at risk. But it is hard to argue that he is entitled to capital gains treatment for profits he receives without putting any personal wealth into the pot.

President Obama and congressional Democrats have targeted the carried interest rules for several years. Republicans have resisted, but I suspect the Romney tax returns will put an end to that. That end may come soon. Congress must act within the next month to prevent Social Security taxes on wage-earners from rising. Both parties want to extend the current rate through the end of this year, but they are far apart on how to pay for this extension.

Don’t be surprised if Republicans give up on protecting the carried interest rule. For that matter, don’t be surprised if Romney himself supports a change. He did nothing wrong when he paid his taxes the way the law demands, but carried interest is going to be a political burden this year, and it is one the Republicans may no longer be willing to carry.

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