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Management Fee Conversion Saved Romney Millions in Taxes

Mitt Romney made a statement last night that “big business is doing fine,” largely because “they know how to find ways to get through the tax code, save money by putting various things in the places where there are low tax havens around the world for their businesses.” This comes weeks after the entire media spun their heads around completely when President Obama made a comment about the private sector “doing fine.”

But the focus ought to be on the admission that big businesses use tax havens, from a man who should know a thing or two about them. In fact, we just found out through Gawker’s cache of Bain Capital documents that Romney’s old company engaged in tax avoidance on a regular basis:

Management Fee Conversion. Current law on carried interest is already a sweetheart tax deal for private equity, but why not make it better? Private equity folks are not the type to walk past a twenty-dollar bill lying on the sidewalk. In the 2000s it became common for private equity fund managers to “convert” their management fees into carried interest. There are many variations on the theme, but here’s how many deals worked: each year, before the annual management fee comes due, the fund manager waives the management fee in exchange for a priority allocation of future profits. There is minimal economic risk involved; as long as the fund, at some point, has a profitable quarter, the managers get paid. (If the managers don’t foresee any future profits, they won’t waive the fees, and they will take cash instead.) In exchange for a minimal amount of economic risk, the tax benefit is enormous: the compensation is transformed from ordinary income (taxed at 35%) into capital gain (taxed at 15%). Because the management fees for a large private equity fund can be ten or twenty million per year, the tax dodge can literally save millions in taxes every year.

The problem is that it is not legal. Because the deals vary in their aggressiveness, there is some disagreement among practitioners about when it works and when it doesn’t. But in my opinion, and the opinion of many tax practitioners, the practices that were common in the private equity industry in the 2000s became very, very questionable, and it’s unlikely that they would have stood up in court.

The Gawker documents show that Bain converted their management fees into capital gains, benefiting from the tax advantage.

First of all, the know-it-all financial writers who scoffed at the Gawker documents can shut up now. They apparently show tax evasion, according to this professor at the University of Colorado. “Bottom line: Mitt Romney has not paid all the taxes required under law,” Victor Fleischer writes.

This puts a new spin on Romney’s Wall Street Journal op-ed today, entitled, “What I Learned at Bain Capital,” doesn’t it? Strangely, Romney doesn’t impart his wisdom tax evasion there. I guess that’s more of a trade secret.

UPDATE: Just because the IRS has never bothered to prosecute management fee conversion doesn’t mean that it’s not an illegal practice. This saved Bain partners, including Romney, over $200 million in taxes.

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David Dayen

David Dayen