Could Romney Use His Own Return to Call Obama's Bluff on Carried Interest ?

Originally Published on forbes.com on January 4th,2012

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Mitt Romney’s refusal to release his tax return has brought the “carried interest” controversy back into the news.  The speculation is that since Mr. Romney is a retired partner in a venture firm, that much of his income will be capital gains giving him an effective tax rate as low as Warren Buffett’s.   Steve Benen of Washington Monthly, citing a Boston Globe story, refers to the situation as Romney’s “carried interest problem”.  A New York Times story gives a good amount of detail on Mr. Romney’s arrangement with Bain Capital.  A related theme, taken up in the New York Times, by Paul Krugman is the idea that the activity that Romney and his Bain partners profited from has not been good for the rest of us.  If that is the case, the fact that the profits were taxed at favorable rates is rubbing salt in the wound.  Although, I do often stray from my tax beat, I am not inclined to get into the latter debate.  I really cannot make a judgment about whether my community would be better off if there were five or six small stationery stores within an easy drive rather than one big Staples.  I do have a perspective on the tax issue, though (I am assuming for the sake of argument that it is the “carried interest” benefit that is so embarrassing.)

What is the Big Deal ?

Despite the sometimes heated commentary the “carried interest” benefit is not some obscure provision snuck into the Code by clever lobbyists.  It is based on fundamental principles of partnership taxation.  One of those principles is that even though the partnership does not pay taxes, it is a “taxpayer”.  It has its own year end and its own accounting methods.  The nature of the transactions are determined at the partnership level.  So even though you are an investor your share of the partnership’s business income is business income to you.  Conversely, if the partnership is an investor then it flows investment income to the partners, even those who work there.  If you were a partner in such a partnership and were stricken by pangs of conscience and wanted to pay tax at ordinary income rates on your share of the capital gains, you would need to include with your return a notice of inconsistent treatment.  If, perhaps more likely, an IRS agent examined your return and got the notion that you should get ordinary income treatment on your share of the partnership’s income, she could not propose an adjustment to your return, she would have to get somebody to open up an audit of the partnership.  I don’t think Mr. Romney is claiming that he invented the venture capital industry.  I doubt that he has anything to do with preparing Bain Capital’s partnership return (maybe not even his own return), so can an administration with a Secretary of the Treasury who could not prepare his own tax return correctly criticize an opponent for following the tax law ?

Carried Interest Might Not Be Easy to Fix

I think that President Obama’s attack on the “carried interest” benefit is phony.  The fact that the benefit is based on fundamental principles is best illustrated by the legislation that has been proposed to get rid of it.  ProposedCode Section 710, which has been kicking around for a couple of years, would have added over 3,000 words to the Internal Revenue Code and would have applied to many ordinary partnerships that have nothing to do with venture capital or hedge funds.  A revised version that was included in the President’s last proposal did not do as much collateral damage, but could probably be beaten by larger hedge funds that adjusted their asset mix.  In the interest of full disclosure, I should say that the passage of  either one would be great for me professionally.  I could spend the twilight of my career unscrambling eggs.  Of course, nobody, including the people introducing it, expected the legislation to pass.

Then Again Maybe it is Very Easy to Fix

In the early nineties the IRS issued a regulation about the nature of Subchapter K (the portion of the Internal Revenue Code concerning partnerships):

Subchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax.      …………

Accordingly, if a partnership is formed or availed of in connection with a transaction a principal purpose of which is to reduce substantially the present value of the partners’ aggregate federal tax liability in a manner that is inconsistent with the intent of subchapter K, the Commissioner can recast the transaction for federal tax purposes, as appropriate to achieve tax results that are consistent with the intent of subchapter K.

Among the things the IRS says it can do, if you are being nasty is:

The purported partnership should be disregarded in whole or in part, and the partnership’s assets and activities should be considered, in whole or in part, to be owned and conducted, respectively, by one or more of its purported partners.

 A hedge fund or venture capital fund could organize in a variety of different ways.  If the reason it is picking the partnership form is to convert the business income of the working partners into capital gain, well that is not what Subchapter K is there for, so maybe the IRS can treat the fund as a co-ownership and the carried interest as an incentive management fee.

Professor Michael Graetz of Columbia University, a former treasury official, has suggested that a recent Tax Court decision would support the IRS in treating the “carried interest” capital gain of venture capital partners as business income.  The case was about a vc partner who wanted to take an ordinary deduction for a bad loan he had made to someone who helped him find investments.  The Tax Court ruled that his vc interest was business income for purposes of taking the deduction.  Professor Graetz suggests that the IRS could pull a major victory out of the ashes of that defeat by embracing that concept for all purposes.

Calling the President’s Bluff

Romney has already indicated that he might not be all that embarrassed by taking advantage of the carried interest benefit:

“I can tell you we follow the tax laws, and if there’s an opportunity to save taxes, we like anybody else in this country will follow that opportunity,’’

Learned Hand put it more eloquently:

Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

So assuming that “carried interest” is the only potenital embarassment in his return Mr. Romney could release it and say:

Here is my return.  Unlike that of your Treasury Secretary it was prepared in accordance with the instructions provided by the IRS.  I was required to report capital gains from the partnership as capital gains.  If you believe that the “carried interest” benefit is an abuse then instruct the IRS to change the regulations.  You have the power.  If you do, I promise that when I am elected I will not reverse that regulation.