Introduction

Under political pressure, presidential candidate Mitt Romney reluctantly released his 2010 federal income tax return. His gross income was an eye-popping $21.6 million, [1. Actually, his gross income was closer to 26.4 million, but he claimed $4.84 million in capital loss carryforwards. If the 26.4 million figure is used, his effective tax rate drops to 11.74%.] yet his tax bite was $3.1 million or about 15% of his adjusted gross income. He’s since declared he will not release his pre-2010 tax returns.

Romney used a variety of controversial, but currently legitimate, tax breaks [2. Congress has addressed many of these tax breaks and the President has vowed to eliminate them, but any moves in this direction have been blocked by Congressional Republicans, who are opposed to any changes in the status quo to the detriment of high income taxpayers.] to lower his payroll and income taxes below the average percentage paid by workers earning $50,000 – $100,000. Because tax returns are confidential, Romney’s release provides a glimpse as to how Wall St. tycoons game the system and wind up with a fraction of the tax rate imposed on the middle-class.

In addition to tax loopholes, Romney’s return contains intriguing entries for charitable deductions and a mysterious Swiss bank account. His return refers to a series of “blind trusts” for himself and his wife that turn out be blind in name only.

Romney’s IRA and estate planning illustrate how the super-rich manipulate the rules to their advantage. Again, there is nothing illegal about his planning, it merely exposes the glaring loopholes in our current tax system.

However, Romney was indirectly involved in a patently bogus corporate tax shelter, as well as other questionable, but legal, ploys that secreted millions of corporate taxable dollars offshore and outside the reach of the U.S. taxman.

2010 Tax Return

Romney’s tax return contains $21,646,000 of adjusted gross income, $4,500,000 of itemized deductions, mostly charitable deductions and state income taxes, taxable income of $17,127,000 and a tax of $3,106,000, which included alternative minimum tax of $233,000. He earned $540,000 in speaker’s fees and another $114,000 in director’s fees from the Marriott corporation (more about this later). His tax return runs 203 pages, including 67 pages of supplemental attachments.

Charitable Deduction

His contribution to the Church of the Latter Day Saints of $1.525 million or about 7.2% of adjusted gross income, instead of the tithe of 10% that is required. Sure enough, on his 2011 tax return, Romney donated the full 12.2% of his adjusted gross income, which indicates that he stiffed his church about $640,000 in 2010. As suspected, this was probably the reason for his reluctance to make his returns public. [3. There are press reports that Romney may be making additional donations to his church through his private foundation, but see footnote 9, infra.]

Errors and Mistakes

According to the New York Times, Romney actually overpaid about $44,000 in taxes, because his accountants incorrectly calculated the gain on the sale of Goldman Sachs stock. [4. The accountants used an extremely low basis in the calculation of a stock sale of $286,500, when the basis of the stock was approximated the selling price so no tax is owed; in fact, there should have been a capital loss of about $20,000. Although $286,500 could be considered just a rounding error on a tax return showing AGI of $21.6 million, the Romney’s actually claimed a $1.00 credit on the return for hiring disadvantaged youth. The cost in time to complete the form would surely outweigh the $1.00 credit.] In a bizarre document attached to Romeny’s return, his blind trust made two IRC Sec. 83(b) elections –relevant only when a taxpayer receives property (in this case, a partnership interest) for personal services [5. The blind trust could not have provided personal services and even if it could, why is the election on Mr. Romney’s personal return?] and the ownership of the stock is subject to future contingencies (subject to a substantial risk of forfeiture) – neither of which applied to Mr. Romney’s acquisition in 2010, raising the issue of why the blind trusts made an unnecessary and irrelevant election on the Romney’s personal tax return.

Romney’s tax return disclosed an ownership interest or signature authority over a Swiss Bank account. [6. In addition, Romney was required to file a foreign bank report (an FBAR) for each year he owned or had signature authority over the account. These reports, if filed, have not been made public.] This account was omitted from his financial disclosure documents and his explanation raises a host of questions (see below).

Swiss Bank Account

On Schedule B, Part III, Romney declares that he or his wife had ownership or signature authority [7. Signature authority means the right to access the account, including the right to withdraw funds, usually under a power of attorney or similar document. The bank will recognize the authority of the person to access the account.] over a Swiss bank account. As noted above, the account was omitted from his federal financial disclosure documents filed with the Department of Governmental Ethics last year. When asked about the discrepancy, the trustee of Ann Romney’s blind trust, Brad Malt [8. Mr. Malt is the Romney’s personal attorney, business attorney, political advisor and chairman of Boston’s largest law firm, Ropes and Gray. He is considered and expert in complex leveraged buyouts and private equity deals. He has made investment decisions for Romney since 2003, when Romney became governor and put his money into a blind trust to avoid conflicts of interest.], stated that the account was: (i) held in Swiss francs (worth $3.0 million US); (ii) with UBS of Switzerland since 2003 and closed late in 2010; (iii) opened for “diversification”; and (iv) “closed to remove any possible source of embarrassment.”

In 2010, the account earned just $1,747 in interest (0.006%). UBS was criminally indicted by the U.S. government for perpetuating a massive tax evasion scheme and in 2009 UBS instructed its U.S. depositors to immediately close their accounts. Why it took Ann Romney’s blind trust another year to terminate the account is suspicious.

Moreover, Mr. Malt’s explanation makes no sense. First, if the Swiss account was truly in Ann Romney’s blind trust, it should not cause embarrassment to the Romneys because they are not supposed to have any knowledge or control over the trust’s investments. Closing the account for political reasons pertaining to a beneficiary is not the job of a trustee, the trustee is required to prudently manage the trust assets. In a blind trust, the beneficiary Ann Romney is not permitted to have any investment authority or communication regarding the trust’s operations or investments. According to the Code of Federal Regulations, 5 CFR 2634.403 (b)(1):

The primary purpose of the blind trust is to confer on the independent trustee and any other designated fiduciary the sole responsibility to administer the trust and to manage trust assets without the participation by, or the knowledge of, any interested party. This includes the duty to decide when and to what extent the original assets of the trust are to be sold or disposed of and in what investments the proceeds of sale are to be reinvested;

Paragraph (b)(7) reads:

(7) The trustee or his designee shall prepare the trust’s income tax return. Under no circumstances shall the trustee or any other designated fiduciary disclose publicly, or to any interested party, the trust’s tax return, any information relating to that return except for a summary of trust income in categories necessary for an interested party to complete his individual tax return, ….

Paragraph (b)(9) states:

“There shall be no direct or indirect communication with respect to the trust between an interested party and the independent trustee or any other designated fiduciary with respect to the trust” unless there is preapproval by the Director of the Office of Government Ethics and then under very limited circumstances. Potential political embarrassment is not one of the enumerated reasons.

Not So Blind Trust

This raises the most glaring problem with Mr. Malt’s explanation: How could Mitt and/or Ann Romney have signature authority or ownership of an account that was in a blind trust? Remember, on Schedule B of Form 1040, they checked the box “yes” to the question of whether they had ownership or signature authority over a bank account, and stated the account was located in Switzerland. The very essence of a blind trust is that the beneficiary has no knowledge or control over the assets, much less ownership or signature authority over a $3.0 million UBS Swiss account. Why would Romney list an asset on his personal tax returns that supposedly belonged to a blind trust, unless they retained a prohibited power over that asset? If the Swiss account belonged to the blind trust, it should have listed it.

Given the explanation by Mr. Malt and his personal and professional relationship with Mr. Romney, it is evident that the so-called blind trust was not blind at all, and that the Romney retained direct control over his assets. Since Mr. Malt was Romney’s personal attorney and political advisor, as well as trustee of his blind trust, there is a strong indication of a conflict of interest since an attorney owes his undivided loyalty to his client and that duty would be impaired if Mr. Malt, in his role as trustee of a blind trust, refused to take direction from his client. In short, the blind trust and Swiss bank account explanations are dubious and warrant further scrutiny.

Why the Swiss Account?

There is no rationale for the Swiss bank account, other than an attempt to hide money offshore. If Romney or Mr. Malt wanted to hedge the Swiss franc against the U.S. dollar, such an investment can be made in the U.S. (called a FOREX hedge) without opening an account in Switzerland. [9. Domestic banks have been permitted to offer foreign currency accounts since January, 1990, according to the Federal Reserve, SR 90-3 (IB), 14 years prior to the time the UBS account was opened.] Obviously, earning interest at the rate of 0.006% was not a prudent investment. So what was the rationale for “diversification” as claimed by Mr. Malt? The account was opened in 2003 when the President was George Bush and the U.S. economy was stable. Perhaps, the $3.0 million was just a blip in Romney’s net worth and he just forgot about it.

UBS pled guilty to U.S tax crimes in February, 2009, yet this account remained open until late 2010. Perhaps, the Romneys or Mr. Malt received the UBS letter sent to many other U.S. depositors directing them to immediately close their account, who knows? If the goal of closing the account was to avoid embarrassment and during 2009 UBS was blasted by the Justice Department and the news media as an outlaw bank engaged in hiding taxable income offshore for wealthy Americans, why wait until late 2010 to close the account?

Carried Interest

Lacking the international intrigue of the mysterious Swiss bank account, but still another hot topic of debate, Romney greatly benefitted from the “carried interest” characterization of his investments with his former investment firm, Bain Capital. Unlike doctors, lawyers, professional athletics, musicians, bankers, bakers, waiters, waitresses, plumbers and teachers, all of whom pay taxes at ordinary income rates which can reach as high as 35% federal, Romney and those operating and managing investment partnerships and hedge funds, are taxed on their labor at 15%, the long-term capital gain and corporate dividend rates. This is because they claim that they are investors in the enterprise and receive a percentage of the partnership, rather than individuals performing personal services, therefore, they claim they are entitled to receive profits and dividends (taxed at favorable rates) rather than compensation, even though they go to work every day, often clocking extremely long hours doing their job.

Those in favor of this loophole analogize the situation to an individual who buys a real estate as an investment, fixes it up, and then sells it for a profit. The problem with the analogy is that an individual whose full-time job is to purchase real estate, fix it up and then sell it, is not considered as having investment property eligible for preferential capital gains tax rates. Hedge fund managers are obviously engaged in the business of operating hedge funds on a full-time basis and are not merely investors looking for long-term returns.

Nevertheless, Romney’s ability to characterize his participation in the various Bain Capital investments as carried interest allows him to pay taxes on the income and gains from those investments at 15% federal, thereby lowering his taxes substantially. Approximately 73% of his gross income was classified as carried interest.

Stock Donation

Another tax break enjoyed by the wealthy is donating appreciated stock to charity. By doing so, the taxpayer receives a charitable deduction at the full fair market value of the stock and the gain on the appreciation goes untaxed. In contrast, if the taxpayer were required to sell the stock and pay the tax, the charitable deduction would be reduced by the amount of tax paid. Under current rules, the government loses the tax revenue from a sale and the taxpayer, in effect, obtains an additional deduction for the amount of unpaid tax! [10. Example: Taxpayer donates a stock purchased for $1.00 with a current market value of $101. If he sold the stock, the federal income tax would be $15.00 (15% of $100 gain). A contribution of the after tax amount would be worth $86.00 and the U.S. Treasury would have received $15.00. Instead, the taxpayer contributes the stock to a charity and takes a $100 charitable tax deduction. The upshot: The treasury loses $15.00 in come and the taxpayer gains another $14.00 in deductions.] In 2010, Romney donated $1.459 million in stock (mostly Domino’s Pizza) to his private foundation, the Tyler Foundation. [11. There have been several press stories that the Tyler Foundation donated millions to the Church of the Latter Day Saints on behalf of Romney. If so, this would appear to violate its mission, which is to provide financial support to families’ of children with epilepsy being treated at Children’s Hospital Boston and UMass Memorial Children’s Medical Center.] Operating a private foundation has distinct advantages, contributions can be made and deducted in full, but the funds can remain in the foundation. In contrast, those without private foundations must make the full payment directly to a charity to claim a deduction.

Offshore IRA

Another tax break not available to Joe Sixpack is an offshore IRA that permits investing in partnerships and hedge funds that use debt (leverage). A substantial portion of Romney’s wealth, estimated between $20.7 million and $101.6 million, is held in several offshore IRA accounts in the Cayman Islands. According to his financial disclosure reports, his IRA, generated income between $1.5 million and $8.5 million over a 19 month period. Also, investments such as gold, silver, foreign currencies, private stock, and foreign real-estate are available through the use of off-shore IRAs and are generally unavailable to those with conventional IRAs.

An IRA cannot directly invest in entities that use debt financing without adverse tax consequences (described below) so to circumvent this restriction, an offshore “shell” corporation (called a “blocker” corporation) is formed, the IRA invests in the blocker corporation and the corporation, in turn, acquires the prohibited investment. The theory is that the IRA did not invest directly in the prohibited transaction, consequently, the investment does not run afoul of the tax law. Blocker corporations are formed in tax havens (Cayman Islands, British Virgin Islands – countries that do not tax investment income or profits) usually to assist nonprofit corporations and retirement plans in avoiding the unrelated business income tax. [12. In general, this is a tax on 35% that is levied to prevent nonprofits (including retirement plans and IRAs) from venturing into debt-financed profit-making activities that compete with taxpaying companies.] Although not illegal, blockers cost the Treasury nearly $1 billion a decade.

Defective Grantor Trust

Romney created a “intentionally defective grantor trust,” which allows him to shift wealth to his five sons in a tax efficient manner. The trust is now valued at $100 million. Romney transferred assets to a trust for their children, but he continues to pay taxes on the income generated by the trust. The tax payment is not considered additional gifts to the children and upon death, the trust assets are not considered part of either Mitt or Ann Romney’s estate for estate-tax purposes. While Mitt or Ann Romney is alive, the trust for the children grows tax-free – the trust income is accumulated and added to principal for the benefit of children and descendants without the trust paying taxes. Assuming the trust earns 5% annually or $5.0 million and Romney gifted this amount to the trust to pay taxes, he would pay gift tax at a 35% rate or $1.75 million. With the intentionally defective grantor trust, Romney does not pay gift taxes; instead he pays personal income taxes on the $5.0 million at his low rate of 15% million or $750,000 on carried interest income and gains, [13. The trust could pay the taxes as well, but this would deplete the trust assets by the amount of the taxes paid, in our example $750,000, thus shifting less wealth to the children.] thus saving $1,000,000 in taxes.

Bogus Tax Shelters

Romney’s close personal and business relationship with the Marriott family goes back a generation. Willard Mitt Romney was named after his father’s good friend, Marriott hotel magnate J. Willard Marriott. Romney has served on Marriott International Inc.’s Board of Directors for 11 of the past 16 years since 1993 and six times he served as chairman of its audit committee, placing him in charge of reviewing the company’s financial reporting. As a director, he oversaw the company’s tax planning. While serving as a director and chairman of the audit committee, Marriott engaged in what has become the most notorious tax shelter to date, the infamous “Son-of-Boss” tax scam [14. Invariably, these shelters use an artificial and inflated basis in assets that are purported sold at a loss, and the loss is used to offsets legitimate taxable gains and income. For details, see my website, www.son-of-boss.com.] that generated $71 million in bogus tax deductions for the company.

Given Romney’s background as owner and CEO of Bain Capital, with business experience with leverage buy-outs and hedge funds, it is not credible that he believed the tax shelter was legitimate. Under Romney’s watch, IRS disallowed the deductions and Marriott fought the case in court. The U.S. Department of Justice denounced the shelter as “fictitious,” “artificial,” “spectral,” an “illusion” and a “scheme.” Both the Court of Claims and the Federal Circuit Court of Appeals, siding with the Department of Justice, soundly rejected Marriott’s contention that the transaction was proper and permissible under the tax code. [15. Note: Years later, the international accounting firm, KPMG, pled guilty to tax crimes in association with the Son of Boss tax shelter and entered a deferred prosecution agreement with the government. Also, there have been criminal indictments of others who aggressively promoted the scheme, although to date, none of the clients who participated in the tax shelter, including Marriott, has been implicated in criminal activity.]

Luxembourg Tax Ploy

Also during Romney’s tenure as a director and chairman of the audit committee, Marriott used a Luxembourg company to siphon taxable income ($229 million in 2009) to an offshore account, a maneuver that dramatically lowered its corporate income tax. The offshore entity charged royalty, licensing and franchise fees for allowing hotel owners and operators to use Marriott’s various trademarks and intellectual property, including the Ritz Carlton brand. Through the end of last year, Marriott parked closed to $500 million in untaxed income in the Luxembourg tax haven.

During the time Romney served on Marriott’s board, the percentage of taxable income paid by the company fell to 6.7%, compared to the actual corporate tax rate of 35%. It should be noted that Facebook, Apple and Google, as well as many other international corporations, use a variation of Luxembourg tax scheme with the result that billions, if not trillions of dollars in untaxed corporate profits sit offshore.

Conclusion

Romney’s tax return offers a small peek into the tax savings and financial transactions available to the super rich and how they use legal loopholes to avoid paying taxes on much of their wealth. The use of the carried interest and charitable deduction rules, along with offshore IRAs, and a trust for his children that grow tax-free illustrates how the affluent structure their finances to avoid income, gift and estate taxes.

On the corporate side, Romney’s role as chairman of the audit committee offers insight on how Marriott International arranged to lower its tax bite dramatically through the use of a Luxembourg subsidiary to stash close to $500 million in income offshore, as well as engaging in a bogus tax shelter transactions.

Our current tax system is in disarray and the Republicans pledge of no tax increases has prevented any movement towards eliminating these loopholes. Romney’s tax returns bring into clarity Warren Buffet’s famous quip, “There’s class warfare, all right, but it’s my class, the rich class, that’s making war, and we’re winning.”