Introduction
On August 23, 2012, the Gawker website released more than 950 pages of confidential Bain Company documents, illustrating how Mitt Romney’s former company games the tax system. When Gawker released the documents, Forbes magazine smugly announced that it had the same documents and they were “worthless.” Oh, really?
Transformation
Catching the attention of tax professionals was $1.0 billion in professional fees, usually taxed as ordinary income (maximum federal rate 35%), that were magically and improperly transformed into long-term capital gains (15% federal tax rate), thereby saving $200 million in taxes. The tax ploy has been questioned by Victor Fleischer, a noted expert on fee waivers. [1. Fleischer, stated that, “If challenged in court, Bain would lose. The Bain partners, in my opinion, misreported their income if they reported these converted fees as capital gain instead of ordinary income.”]
Fee Waiver
The Bain fee conversion tax-dodge rests on the dubious premise that partners providing services to a partnership can choose whether to receive compensation income earned and owed to them or waive it, thereby transforming the fees into additional partnership equity taxed as capital gains.
Carried Interest
The Bain technique involves a distortion of the “carried interest” rule, currently under fire in Congress as an abuse. The carried interest concept is derived from a quirk in partnership law. Partners are considered co-owners, not employees, of the partnership, although they provide personal services indistinguishable from any other employment relationship.
Thus, partners who commute full-time to the same office, work 60-80 hours a week under the direct supervision and control of their supervisors, and receive compensation for personal services, are not considered employees of the partnership. As owners, they may receive a profits interest (the “carried interest”) in the partnership in exchange for rendering personal services without immediate taxation. [2. This interest is sometimes called “sweat equity.” IRS permitted the carried interest concept in Revenue Procedure 93-27, but it only applied to receipt of a profits interest in the partnership and not to the waiver of earned management fees.]
Fee Waivers
However, there is nothing in the carried interest exception that suggests a voluntary waiver of fees already earned and owed is permissible. In fact, IRC Section 707(a)(2)(A) was enacted to disallow transactions that lacked economic risk.
Because the Bain partnerships were earning income or were profitable, there was little or no actual risk economic risk to the partners who waived their fees; therefore, the attempted fee waiver failed and the partners were immediately taxable at ordinary income rates on the fees.
Conclusion
Bain’s fee-waiver gambit was invalid and its partners owe an additional $200 million in federal income taxes on the $1 billion in fees they received. [3. Note: The New York Attorney General is investigating fee waivers by Bain and other major private equity firms.]
