WASHINGTON -- Mitt Romney has repeatedly insisted during the presidential campaign that layoffs and other controversy surrounding Bain Capital companies for the past decade are not his responsibility, because he retired in 1999. When tax experts charged that he benefited from legally dubious tax avoidance strategies employed by Bain, his campaign noted that the investments are kept in a blind trust completely out of his control.
"As we have said many times before, Governor and Mrs. Romney's assets are managed on a blind basis. They do not control the investment of these assets. The investment decisions are made by a trustee," spokeswoman Michele Davis said.
But according to his 2010 tax return, when the Internal Revenue Service comes calling in April, Romney has a different answer: The presumptive GOP nominee reaps lucrative tax breaks for "active" participation in the private equity firm he founded, as well as a host of other investments.
As David Kautter, a tax expert at American University, explains, the concept of active investment has different meanings for the IRS and for regular people. "When you say you're actively involved in all these businesses, people do think, OK, you're actively involved. But the tax law has its own definition," he said.
The IRS advises that "[f]actors that indicate active participation include making decisions involving the operation or management of the activity, performing services for the activity, and hiring and discharging employees. Factors that indicate a lack of active participation include lack of control in managing and operating the activity, having authority only to discharge the manager of the activity, and having a manager of the activity who is an independent contractor rather than an employee."
Even if Romney could persuade the IRS his involvement was legitimately active, that still leaves him in a rhetorical jam: For tax purposes, he claims an active status; for political purposes, he claims to have zero to do with the investments.
The distinction is valuable, for the IRS treats passive and active income and losses differently. If a passive investment loses money, the taxpayer can only write off that loss if passive gains have also been made. But active losses can be written off at a 35 percent rate and deducted from the taxpayer's ordinary income. In other words, a taxpayer wants active losses, not passive losses. So by describing many of his investments as active, Romney saves himself millions of dollars in taxes.
With those active investments, he is also securing a tax break few Americans enjoy: When he wins, he's paying a 15 percent rate on the gain. When he loses, he's writing it off at 35 percent, meaning that tax policy is subsidizing Romney's risk in his Bain investments.
In other words, Romney didn't build that, at least not without taxpayer backing.
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Federal rules allow many of these tax loopholes. But under the technical terms of the retirement package that Romney negotiated for himself, he has borne a lighter tax load than most other retired financial professionals. And the unusually large scope of his deductions and the generous rate at which they are recognized have some tax experts questioning their validity.
Romney's 2010 tax return lists $301,630 in "trade or business interest" deductions and $503,737 in "trade or business expense" deductions -- all of it described as expenses from his business partnerships, including Bain. Specifically from his various Bain-related activities, Romney scored a total of $547,525 in such deductions.
These kinds of deductions are only available to "active" participants in business partnerships. While Romney filed as an active participant for tax purposes, there is no evidence that he took part in Bain management decisions in 2010, and he has denied doing so.
The sophistication with which Romney used Bain's later efforts to boost his own income could serve as fodder for political campaign advertisements. Since Romney has been willing to profit from Bain's later activity, the Obama campaign may well argue that such practices are fair game for attack ads. Some Democrats are already on the attack.
"Governor Romney appears to be saying one thing to the American people and one thing to the Internal Revenue Service," Rep. Brad Miller (D-N.C.) said to The Huffington Post. "Right now we are just seeing inconsistent statements. The American people are entitled to know more than that. If there's a legalistic distinction, we are entitled to know what that is. ... Has he played too close to the line or over the line?"
It is also possible that these deductions are all legitimate expenses for Bain and the handful of Goldman Sachs subsidiaries in which Romney is a partner. But listing personal expenses as business expenses is not allowed.
In addition, some tax experts are surprised by the size of the deductions he takes as business expenses and the aggressive nature of the deductions.
"One question is just the amount of the expenses," said Rebecca Wilkins, senior tax policy counsel at Citizens for Tax Justice. "At half a million dollars, you have to wonder what all of that is."
Romney's income can basically be divided into two parts. His "ordinary" income triggers the top 35 percent tax rate to which America's wealthiest earners are subject. But most of his income comes in the form of capital gains, which are taxed at only 15 percent. According to the Washington Post, 50 percent of all capital gains in the United States flow to the top 0.1 percent of taxpayers.
These two different tax rates present a tempting opportunity: By applying deductions to the pool of money taxed at 35 percent, rather than the pool of money taxed at 15 percent, Romney can reduce his overall tax bill. The $805,367 in deductions from his partnerships all receive exactly this useful treatment -- which may or may not be appropriate, depending on the nature of the expenses incurred.
"What's problematic is that these expenses are being deducted at the ordinary income tax rate of 35 percent, while the related income is mostly subject to the preferential long-term capital gain tax rate of 15 percent," Wilkins said.
Whether these expenses rightly apply to the pool of money taxed at 35 percent can only be determined by accessing the tax returns of Romney's Bain partnerships, which are not public documents. But many investment partnerships recognize stock losses that could not receive this favorable treatment.
In the years after Romney insists that he ended any active role at the firm, Bain Capital companies suffered huge job losses, plant closures and bankruptcies. KB Toys may be the saddest example. The New York Times has reported that after Bain bought the toy company in 2000, KB Toys filed for bankruptcy, laying off more than 3,000 workers. Bain's aggressive financial maneuvering, however, scored a 370 percent return on its investment.
Romney's own testimony and Securities and Exchange Commission filings demonstrate that he might not have been as hands off decision-making during those later years as he's suggested. Either way, his sophisticated tax practices show that he continued to benefit not only from Bain's profits but, at least in his tax bill, from Bain's losses.
This story was updated to include IRS guidance on active investment, and to correct a reference to Schedule E.