Gov. Mitt Romney's 2011 tax return highlights the use of a questionable tax planning technique that may have avoided Medicare tax liability on up to $2 million of services income derived from his past employment at Bain Capital.
When Mr. Romney formally left Bain Capital in 2002, he entered into a severance agreement that covered the period from 1999, when he left Bain to work for the Olympics, until 2009. The severance agreement entitles him to receive a percentage of the profits, or “carried interest,†from Bain funds organized during that period, as well as cash payments equal to a percentage of capital committed to the Bain funds. The severance agreement technically ended in 2009, but continues to pay out additional amounts.
The notes to Mr. Romney's financial disclosures in June reported what it called “ordinary course true-up†payments totaling just over $2 million in income in 2011. These payments were from management companies that provided i nvestment advisory services to the Bain funds: Bain Capital Inc., Bain Capital II, Bain Capital NY and Bain Capital L.L.C.
It has not been disclosed how much Mr. Romney earned through his severance agreement in previous years. It is also unclear what “ordinary course true-up†payments are, as it is not a common legal term. The term most likely refers to payments based on a formula that, for some reason, could not be calculated accurately when the agreement ended in 2009, and pursuant to the agreement can now be calculated and paid out to Mr. Romney.
In short, Mr. Romney continues to receive cash payments from the companies that manage Bain Capital's funds. A couple of weeks ago in this column, I described how private equity firms like Bain Capital convert management fees, which would normally generate ordinary income, into investments that yield capital gain.
R. Bradford Malt, the trustee who manages Mr. Romney's Bain holdings, has stated that Mr. Romne y did not participate in the fee conversion program. One might have logically inferred, then, that Mr. Romney's share of the management fee income would be reported as wage income on Mr. Romney's tax return.
Not so. Instead, the payments are reported on Schedule E of the return as distributions from S corporations - the largest being $1,961,325 from Bain Capital Inc. The distinction between wage income and an S corporation distribution is meaningless from a business standpoint, but it's important for tax purposes.
Current law imposes a 2.9 percent Medicare tax on all wages and self-employment income. To avoid this tax, taxpayers have an incentive to characterize as much labor income as they can as investment income (like carried interest) or as a distribution from an S corporation.
Most corporations are classified as C corporations and are taxed under Subchapter C of the tax code. But under Subchapter S of the tax code, corporations can elect to be taxed o n a pass-through basis, avoiding one layer of tax. Only certain corporations with a limited number of individual shareholders can make the election.
Normally, the benefit of the S corporation is that it avoids the “double tax†on corporate earnings; instead, when the corporation makes distributions to its shareholders, the income flows through and is reported on the shareholder's return.
In the case of a closely held service business like a law firm, the corporate “double tax†can be easily avoided by organizing as a partnership or sole proprietorship. Here, the main benefit of organizing as an S corporation is to avoid employment taxes.
Imagine a trial lawyer who makes $10 million in a particular year, after expenses. That $10 million in wage income would generate $290,000 in Medicare tax liability.
But rather than providing legal services directly, the trial lawyer incorporates his legal practice as an S corporation, becoming its sole shar eholder. The corporation pays the lawyer a minimum wage salary, and the lawyer pays employment taxes on that salary. The S corporation is the nominal provider of legal services and pays expenses, distributing what's left (almost $10 million) to the lawyer as its sole shareholder.
That $10 million retains its character as ordinary income, but because it is treated as a shareholder distribution rather than wage or self-employment income, the distribution avoids the Medicare tax, and saves the trial lawyer nearly $290,000 in tax liability.
This strategy, more or less, was made famous by the trial lawyer and former presidential candidate John Edwards, giving rise to what is sometimes known in tax policy circles as the Edwards Loophole. (It has been employed more recently by Newt Gingrich, who has provided speaking and consulting services through an S corporation.)
The I.R.S. has challenged this abuse of S corporations, finding some success in the courts. In Sp icer Accounting Inc. vs. United States, for example, the United States Court of Appeals for the Ninth Circuit held that “regardless of how an employer chooses to characterize payments made to its employees, the true analysis is whether the payments are for remuneration for services rendered.â€
The problem is that the line between return on human capital and return on investment capital is difficult to draw. By paying themselves a (modest) salary, the owners of S corporations put the I.R.S. in the difficult position of having to estimate what a reasonable wage is.
In a recent article, the law professor Richard Winchester noted that under current law, the government can rightfully attack these distributions “as being nothing more than disguised compensation.†But because the government is ill equipped to perform the kind of audits that would help detect all potential instances of disguised compensation, Mr. Winchester notes that “the vast majority of thes e cases probably go unchallenged.â€
The use of the S corporation as a tax shelter is widespread. A 2002 Treasury inspector general report stated that of 84 S corporation returns under audit, the average shareholder wage was only $5,300, while the average shareholder distribution was nearly $350,000. Obviously, in many of these cases the wage portion is being deliberately understated.
In the case of Mr. Romney, the issue of his Medicare tax liability is complicated because he no longer provides services to Bain Capital. Some portion of the payment represents payment for past services rendered, but perhaps some amount could be attributed to nonwage income.
Existing case law gives the I.R.S. ample authority to challenge at least some amount of the “true up†payments as remuneration for services rendered. If the entire amount were attributed to past services, then Mr. Romney's use of the S Corporation avoided $58,000 in Medicare taxes. Without knowing the terms of the severance agreement, however, determining Mr. Romney's proper tax liability is difficult.
In reality, the $58,000 in Medicare taxes is small beer for Mr. Romney, who voluntarily paid an extra $250,000 in taxes in 2011 to keep his effective federal income tax rate above 13 percent. The Medicare taxes avoided on earlier severance payments might have been much greater. But more important, from a tax policy perspective, it highlights one of the many ways that partnerships and S corporations can be manipulated to help business owners avoid the taxes that normal wage earners pay.
For further reading on using business entities to avoid employment taxes, see Richard Winchester, “The Gap in the Employment Tax Gap,†Stanford Law and Policy Review (2009).
Victor Fleischer is a professor at the University of Colorado Law School, where he teaches partnership tax, tax policy and deals. His research focuses on how tax affects the structuring of venture capital, private equity, and corporate transactions.
