In Part 1 of this story, I said that Mitt Romney had made aggressive use of loopholes in IRA legislation to accumulate $20 to $100 million of his assets in an IRA "retirement" account and thus avoid any taxation on this compensation and its future earnings until it is withdrawn which must begin when he reaches 70 ½ years of age. If one can defer paying taxes on compensation for decades and it compounds tax free, it is almost as good as not paying them at all on a present value basis.
And, it has recently been reported that Romney made extensive use of off-shore vehicles in places like the Cayman Islands that traditionally have been centers for tax avoidance. It was also disclosed that Romney had a Swiss bank account that he closed in 2010 on the advice that it might look bad if he were to run for president.
Romney has said that he has paid every dollar of tax that he owed, and not a dollar more. His supporters have said that he never entered into aggressive tax shelters that were structured to avoid paying his fair share of taxes. And Romney has argued that his assets are held in a blind trust managed by Goldman Sachs, and not himself, so he is not responsible for the investment decisions that led to his having a Swiss bank account or monies held in multiple offshore funds.
But the New York Times today is reporting that Goldman "helped him execute an aggressive and complex tax-deferral strategy known as an 'exchange fund' in 2002." This is a critical date because it was on Jan. 2, 2003, that Romney was sworn in as governor of Massachusetts and it was in 2003 that he began to utilize blind trusts to manage his assets. If Romney participated in an "aggressive and complex tax-deferral strategy" in 2002 it must have been done under his instruction and supervision and not that of a blind trust.
Exchange funds are enormously complex so I cannot expect the reader to become expert in them in this short article. But here is an overview of why Romney may have found investing in exchange funds to be so attractive. Much of this is taken from an article entitled "Understanding Exchange Funds" that appeared in the November 2004 issue of Financial Advisor magazine:
Successful business owners and corporate executives often share a similar problem -- a large part of their wealth may be tied up in a single company's stock... Nevertheless, many are unwilling or unable to sell their shares, generally because they are either restricted or have such a low cost basis that selling them would result in huge capital gains taxes.
Here's how exchange funds work. A financial institution, usually a large bank or investment company, establishes a fund and opens it for contributions. Investors with concentrated stock positions then transfer some of their shares to the fund, which are pooled together to create a diversified portfolio. Once the fund reaches its target size and portfolio composition it closes, and each investor receives an ownership interest in the new fund in proportion to the value of their original contribution.
Exchange funds come with a twist, though. Unlike most stock transactions, the transfer of stock to an exchange fund does not trigger any capital gains tax liability. Instead, these transfers are considered nontaxable partnership contributions under Internal Revenue Code section 721. Although this section ordinarily does not apply to contributions of stocks or other securities, an exception exists for funds meeting certain criteria.
If he wanted to diversify his holdings, Romney could have sold his shares in his company and then bought a diversified portfolio of stocks, but that would have been a taxable event and given the low cost basis for the shares he held in his own company would have triggered a sizable tax bill due. Instead, Romney himself, and not any blind trust or advisor, chose to enter into a complex and aggressive tax deferral scheme structured solely so that Romney could avoid and defer paying the taxes he owed. In addition, any earnings in the exchange fund compound tax free to Romney if there are no distributions.
If this has some appeal to you as a taxpayer, not so fast. As Financial Advisor magazine suggests:
Like hedge funds and other unregistered securities, exchange funds are generally only open to "qualified investors" with a liquid net worth of at least $5 million and, in many cases, an annual income of $200,000 or more for the past two years. Most exchange funds also require a minimum investment of $1 million in stock, although a few require substantially more.
Finally, even when Romney leaves the exchange fund there is no taxable event so no taxes are due then either:
When investors leave an exchange fund they do not receive a cash distribution. Instead, they get a basket of individual stocks. Like the investor's original stock contribution, this closing distribution is a nontaxable event. It's only when these distributed shares are actually sold that the investor must recognize a capital gain or loss.
The question is not whether or not what Romney did was legal. The question is, do we want a president who aggressively used arcane areas of the tax code to avoid and defer paying his fair share of taxes? And, because the capital gains rate is at 15 percent, and because much of Romney's income was either capital gains or subject to the "carried interest" rules applicable only to private equity funds like Romney's and taxable at only 15 percent, we are not talking about avoiding onerous levels of taxation. No, Romney went out of his way to avoid even paying 15 percent of his compensation in taxes to the government.
When all of Romney's retirement and exchange fund and off-shore income is included, his effective tax rate is estimated to be more like 7 percent. We know who made up the difference. Either you paid more or the country went further into debt to fund Romney's tax avoidance and deferral schemes.
John R. Talbott, previously a Goldman Sachs investment banker, is a bestselling author and economic consultant to families whose books predicted the economic crisis. You can read more about his books, the accuracy of his predictions and his financial consulting activities at www.stopthelying.com.