A Tax Tactic That\'s Open to Question

“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes.”

- Judge Learned Hand, 1934

That quotation has become sacred to opponents of taxes, and has often been invoked this year to rebut criticism of for paying relatively low tax rates.

But nothing in it says the government is required to make it possible to avoid paying taxes. Nor does it provide that all efforts to avoid taxes are legal.

In fact, the appeals court ruling by Judge Hand concluded that the taxpayer - who had concocted an elaborate scheme to convert ordinary income into capital gains, and therefore pay less in taxes - had violated the law.

The Supreme Court unanimously upheld Judge Hand's decision. Certainly there is a rule saying that a motive to avoid taxes is permissible, wrote Justice George Sutherland, but that was irrelevant because the strategy used by the taxpayer “upon its face lies outside the plain intent of the statute. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.”

There is no evidence that Mr. Romney has violated the law. The principal means he used to pay low taxes on his hundreds of millions of dollars in income was the technique known as carried interest, which allows managers of funds to treat most of the fees they receive for running the funds as capital gains rather than ordinary income.

The technique strikes some - including President Obama - as outrageous, but it is legal under current law. Unless and until the Congress changes the law, Mr. Romney has every right to take advantage of the technique.

But there is a related tactic to avoid taxes that is used by some private equity firms, including Bain Capital, whose legality is less clear. The Internal Revenue Service has not challenged it - at least not publicly - but some legal scholars say it is not justified, and some private equity firms have not chosen to use it.

The fact that Bain uses the technique became public last month when the Gawker Web site posted annual reports from a number of Bain funds in which Mr. Romney, or his family trusts, have interests. It is clear that some Bain partners saved hundreds of millions of dollars in taxes from its use, but the Romney campaign says he did not benefit from it personally. The technique is complicated - I'll get to the details later - but the effect is not. It concerns the management fees that sponsors of private equity funds, such as Bain Capital, are paid. Those fees are separate from the fund profits that the managers are able to treat as carried interest.

Instead of paying ordinary income taxes on those fees, the partners and employees of the fund sponsors pay taxes at much lower capital gains rates. In fact, they do even better than that. In some cases, they defer paying those capital gains taxes for years, itself a substantial benefit.

How good a deal is that? Annual reports from 2009 for four Bain funds showed that over the years the funds converted $1.05 billion in management fees from ordinary income into capital gains.

That directly benefited the Bain partners who shared in the management fees. Assuming they paid the capital gains tax of 15 percent, rather than the ordinary income tax rate of 35 percent, they saved about $210 million in income taxes and $28 million more in taxes.

And that reflects what happened at a few funds run by one manager. All told, it is likely that private equity and venture capital fund managers save billions each year.

They do this through the technique of waiving the management fees and converting them into a preferred profit standing in the funds. The deals are structured so that they are all but certain to get the payout, assuming the fund makes money in any quarter, even if it loses money over all.

If they took the money out then - and some do - they would pay capital gains taxes immediately. But even that is more than many managers are willing to do. At many private equity funds, managers are required to put up more money, along with other investors, whenever the fund makes an acquisition. The managers use the waived management fee to make the required investment, and defer paying any taxes on it.

When that investment eventually is withdrawn, perhaps years later when the fund liquidates, the manager owes taxes on the management fee, but at the low 15 percent capital gains rate.

Some tax experts think the I.R.S. could win if it challenged the practice.

“It is not legal,” said Victor Fleisher, a tax law professor at the University of Colorado, in an interview this week. He noted that different money managers used variations, some of which he said were less likely than others to withstand an audit. “Bain,” he said, “is on the aggressive end of this.”