Mitt Romney’s Tax Return – An Inside View

Note:  Analysis of Bain Capital Profit Sharing Plan in Separate Post

A leading reporter recently asked me to take a look at Mitt Romney’s 502 page tax return.  What resulted was a fascinating journey that will hopefully initiate a common sense dialogue on needed tax reforms.   Newt Gingrich’s return was also analyzed, yet revealed no substantive tax policy issues.

To be clear, I am a strong critic of large private equity and hedge fund “buyout” firms.  To me they are clearly no more than sophisticated tax deduction pyramid schemes.   Others might argue they are the very definition of crony capitalism and via “club deals” are creating abusive monopolies that are destroying open markets.

That said, it is also true that these large private equity firms pay very close attention to my work and jokingly refer to me as Sherlock’s Sherlock when it comes to financial analysis.  So here we go.

Photo of Mitt Romney and former Sprint CEO Bill Esrey

My first advice to Romney, after reviewing his return, would be to read about Bill Esrey, pictured above, the former CEO of Sprint, and his current battles with the IRS over tax fraud.  Esrey paid his trusted advisor, Ernst and Young, millions of dollars to set up tax shelters that were later ruled to be illegal and abusive, leaving Esrey with a $100 million bill to the IRS.   Since Esrey’s primary asset, Sprint stock, has lost most its value, he may have little chance of repaying the debt.  He later resigned as CEO of Sprint.

The real tale of Romney’s tax return is not about his income, but rather his tax deductions taken and whether a significant accounting and tax fraud is being manipulated by his “trusted advisor,”  Pricewaterhouse Coopers (PWC).  This firm is also the auditor of record for both Bain Capital and Goldman Sachs in addition to preparing the tax returns for key partners such as Romney.  Pricewaterhouse Coopers also audits many key Bain portfolio companies including  Domino’s Pizza.

SEC & Hoover filings show PWC is the auditor of record for Goldman Sachs and Bain Capital, and also prepares Romney’s Tax Returns

Role of Accounting Firms In Financial Crisis Not Addressed

Before we examine the specifics of this situation, consider that four major accounting firms now have a virtual monopoly on providing audit and tax services to America’s largest corporations.  There once were eight, yet due to the failure of Arthur Andersen and mergers, it is now the final four.  They are Deloitte, PriceWaterhouse Coopers, KPMG and Ernst & Young.

There has been far too little discussion of these firms’ role in the recent financial crisis and if there were ever a case for anti-trust enforcement they could indeed be “exhibit 1.”  Afterall, we the public provide these firms with the capacity to render audit opinions that are vital to ensuring the healthy functioning of capital markets.  My personal opinion is that no one firm should be allowed to render audit opinions on more than 10 percent of the firms listed in the Standard and Poor’s 500 Index.

Pricewaterhouse Coopers Involvement

When it comes to tax work, in particular calculating and allocating tax deductions among partners in private equity funds, Pricewaterhouse Coopers dominates the market.  They prepare the key summary doument, what is called a K-1.  In addition to Bain Capital and Goldman Sachs, their clients include Blackstone, KKR, Fortress and Oaktree,  all now registered with the SEC.

Pricewaterhouse Coopers, the audit firm, boasts that its Asset Computation Subsystem (ACS) “simplifies the management and calculation of tax deduction allocations.”   This system works in tandem with its Nominee Bridge data repository system that “collects, analyzes and cleanses partner data in real-time via a secure internet portal.”   The third key system, its Investor Tax Reporting Subsystem (ITRS) then “pulls together the partner data from the Nominee Bridge system and tax allocations from the ACS system to create the investor package and related K-1.”

That may be far more information than you need to understand Mr Romney’s return yet for those wanting to understand the specific mechanics, that is the basic informational plumbing used by Pricewaterhouse Coopers.

K-1’s are to Partners what a W-2 Is to An Employee

Now back to the K-1. Think of the K-1 as equivalent to a W-2 for an employee.  If you are in a partnership you are required to receive a K-1.  This document summarizes key data including your ownership share of the partnership as a percent, total distributions made to you and total expenses/tax deductions allocated to you, etc.  One might ask, why are Romney’s K-1’s blank except for a box that indicates federal tax paid, the amounts of which are nonsensically trivial?

For comparison purposes, let’s take a look at a normal K-1, that received by Oregon PERS for a partnership investment it has with a leading private equity firm, the Texas Pacific Group (TPG).  Yes, there are a lot of confusing boxes but let’s just focus in on three basic things that collectively will tell us most of the story.

Normal K-1 Disclosure: Oregon PERS annual K-1 received for investment in TPG Private Equity Fund

Explaining Key Sections of Normal K-1 Using Oregon PERS Investment in TPG as an Example

1)  Part II Section J on the K-1 shows the partner’s share of profits, losses and capital.   What this means is that Oregon PERS is entitled to 14.07 percent of the profits and loss allocations/tax deductions generated by the partnership.  This is critical information that has been removed from Romney’s K-1’s.   We don’t know whether he has a 2 percent interest or a 20 percent interest in each of the various partnerships.  Why is no one asking this question, especially given Bain Capital’s significant media holdings?  Especially for those partnerships that are shell Cayman Island based entities.

Romney also notes that he is invested in mostly mutual funds, just like regular Americans, yet that is false.  His primary investment is in partnerships, each of which provides him a K-1.   His various returns reveal that he is invested in more than 20 Bain Capital funds, along with numerous Goldman Sachs funds.  Note that all funds that begin with the letter B in the following listing, including Brookside, are Bain funds.  The notion that these are all held in blind trusts is ridiculous.  He should have instructed the trustee to not invest in Bain or Goldman funds given their close ties to him.

Some years ago I was surprised when Bill Gates Sr. told me that the Gates foundation had sold every single share of Microsoft stock, more than $20 billion. At the time I thought that was a bad decision, thinking that retaining 10 percent of the assets in Microsoft would be a good sign to employees at the firm.  Gates Sr.’s perspective is a good lesson for Romney in that Gates clearly wanted to avoid potential conflicts of interest.

Romney owned private equity funds in just one trust.  Each provides him a K-1.

2)  Going back to a normal K-1, Part II Section L on the K-1 shows the capital account with respect to the partnership, including the net increase and related distributions.  Note that Oregon PERS shows an overall increase in its capital value of $5.8 million yet took distributions of $10.7 million.

In contrast, Romney’s return has removed this part of the K-1.  This is critical information because what Romney shows as his net gain or loss on the tax return can be vastly different from what he took in total distributions.  Put another way, he might show $1 million of long term income on a fund in which he took distributions of $5 million.  And if he is being allocated significant tax deductions he is not really entitled to, those undisclosed deductions could bring his overall tax rate closer to zero.  (See related blogpost on fractions rule.)

Financial Engineering with Tax Deductions

The reason such big differences can occur between gains recognized and cash distributions from a partnership is due to the allocation of tax deductions.  These private equity firms have made a science out of such allocations in order to eliminate all taxes.

Most of his fellow partners in these funds are tax exempt investors.  These include foundations, endowments and public pensions.  These investors can’t use tax deductions since they are tax exempt and similarly their unusable deductions can not be allocated to taxable investors like Romney.  The big question becomes, are Romney and other private equity partners dipping into this pool of unusable deductions belonging to tax exempt investors via creative accounting and transfer pricing, or in a technical sense, are they claiming what I call “illegitimate carried interest deductions”  designed to reduce their carried interest income.

Back in the 80’s investors were investing $1 to receive $7 of tax deductions yet the loophole was closed via an arcane new rule called the fractions rule.  This rule has given the lawyers and accountants fits ever sense because it was so well written.  Some now call it the Mariana Trench of the IRS code given all the subsequent special rules and accomodations that have been enacted yet also failed to dent its basic purpose, that being preventing taxable partners from using unusable deductions belonging to tax exempt partners.

3)  Part III Section 9a of the K-1 shows the net long term capital gain (loss).  Put another way, these are basically the gains or losses allocated to the partner.  In the Oregon PERS case, these losses shown are unusable since OR PERS is a tax exempt organization.

Now that we have seen what typical K-1’s looks like, that resulting from Oregon PERS investment in a TPG fund, let’s now zero in on what Romney disclosed.  Here is a picture of one in which the only box disclosed is federal tax paid, in this case $52. Other K-1’s are identical with $23 and $7 taxes paid respectively.

Romney Goldman Sachs Hedge Fund Parters K-1’s, Only Box 15 was Disclosed

This K-1 disclosure is preposterous and dramatically illustrates how doctored Romney’s returns may indeed be.   Total taxes paid for three separate Goldman Sachs hedge funds are as follows:

Goldman Sachs Hedge Fund Parters, LLC,    Taxes Paid $52

Goldman Sachs Hedge Fund Partners II, LLC,    Taxes Paid $23

Goldman Sachs Hedge Fund Partners III, LLC,    Taxes Paid $7

It is surprising that Newt Gingrich has not highlighted investment in these funds given Romney’s criticism of his consulting to Fannie Mae.  It was indeed such funds that created the demand for toxic mortgage paper and derivatives, not Fannie Mae and Freddie Mac.

Is Romney Feeding at the Public Trough in Spectacular Fashion?

If the debate is, who is deeper in the public trough,  Romney is clearly the winner since he and his fellow Bain partners have leveraged their wealth mostly off tax exempt investment partners putting up the funds to do “buyouts.”  Buyouts that don’t improve the purchased companies’ long term prospects, but rather may be nothing more than modern day carpet bagging being enabled by noncompliance with key tax code provisions.

Key Rules Must Be Followed For Tax Exempt Partners

Partnerships are very flexible, thus explaining their popularity.  For example, if you are one of 10 investors in a private equity fund, you and your other partners can decide how to divide the benefits of ownership.  If I have significant income from other sources, I might be interested in receiving more than my share of tax deductions simply because they are more valuable to me than to another partner.  Similarly, one partner might be asset rich but cash poor and therefore receiving a cash distribution might be much more attractive to them.  This is all perfectly legitimate and legal, provided none of the partners are tax-exempt entities.

Put another way, the actual income from a partnership is of secondary importance to private equity partners.  What is really important are distributions, whether in cash, the allocation of tax deductions, etc.  You might think, yes, but how can you benefit if a company is not profitable?    The answer again is all about managing cash flow, not profits.

What buyout firms like Bain usually do is take out significant loans in the name of the companies they acquire, rather than in their own name, and then distribute that cash to partners in the form of a distribution rather than reinvest it in the business.   This is but one of many tricks designed to extract cash distributions to partners from the companies they purchase.  Of course a related goal is to make these distributions tax free.

Trafficking in Net Operating Losses

A second significant trick is that these private equity firms traffic in net operating losses that effectively allow them to convert many of the companies they acquire into tax exempt equivalent organizations.

Ask yourself, how can a local day care center compete with a national chain, such as Bain Capital’s Bright Horizons,  if the national chain is paying no federal or state income taxes?  And what is happening to these local communities all around the country is that they are seeing their tax bases decimated by Bain related takeovers of small and mid sized companies who were paying at least some level of taxes.

Of course one of the big tax deductions Bain Capital and other private equity firms take on the road to converting companies purchased to tax exempts is interest on debt involving leveraged buyouts.   This has become a veritable money tree.

Here is how it works.  You issue massive stock options and or partnership like ownership units to portfolio company executives at very low prices and then periodically revalue these companies to show significant gains so that when they are exercised you can capture significant tax deductions on the difference between the original exercise value and the market value at time of exercise.  You are essentially paying the option gains to yourself, the partners, on the backs of other investors and employees.

The beauty of this scheme is that these buyout firms determine the value of the companies themselves and the cost of these deductions is nothing but the ink and paper on which the stock certificates are printed.  They then pool these compensation deductions into massive pools of tax deductions, what are also called net operating losses in tax parlance.

Consistency, an Integral Accounting Concept, Appears Absent with Respect to Fee Recognition. Is Bain Capital Working From Enron’s Playbook?

In a testament to the self destructive nature of greed many private equity firms and their auditors may have gotten sloppy and violated key accounting “consistency” standards.  What they appear to be doing is removing key costs from the valuation of their portfolio companies, thereby inflating values and the resulting tax deductions when options or partnership units are exercised.  Here is a brief video explaining this scheme involving what they call “deal specific” carry fees.

While Enron made an art out of removing expenses and shifting debt to offshore entities in order to bolster its financial statements, thereby inflating income and its stock price, private equity firms appear to be shifting key expenses, including compensation and deal fees, down to portfolio companies they purchase and not reflecting them in valuations of those same companies that ultimately help determine the income they report to the SEC.   This may be an absolute violation of the “consistency” requirement.  Put another way, this is financial engineering gone astray.

This situation reminds me of the time 10 years ago when AOL’s then Chief Operating Officer, Bob Pittman, was noting that if advertising revenues were down, they could simply dedicate more space to affiliated companies.  Bob didn’t seem to realize that intercompany transactions must be dealt with differently and are not sales.  I often wondered where Bob landed after the Time Warner/AOL debacle and it turns out he is now Chief Operating Officer of Clear Channel, one of Bain Capital’s largest portfolio companies.  Could you possibly make this “stuff up?”  One need only google Pittman AOL Clear Channel to confirm this.

Convincing CEOs of Selling Companies to Sell Out Fellow Shareholders and Employees

The next step in this tax scheme is for Bain and other private equity firms to go out and purchase more companies and tell the CEO’s that if they sell to them, they can convert them to tax exempt status, which will allow them to lower prices and dominate the market.   Remember, next to wages, taxes are often the most significant use of cash.  While at Bain and Company, Romney was known, as the firm is still today, for optimizing cash flow planning models.  In layman terms, this means eliminating all taxes through financial engineering.

Often the executives selling their firms to private equity companies stay on after the takeover at the private equity firm.  The problem is that they often do not publicly disclose the accumulated operating losses or tax deductions the firm owns, a valuable bargaining chip, prior to the sale  They also often simply exchange their unvested options for new options/partnership units in the private equity firm.  Meanwhile, the remaining public shareholders lose the capacity to maintain a long term oriented investment.

Clearly, a key dynamic of this whole private equity/Bain Capital buyout phenomenon, which could be nothing more than a tax deduction pyramid scheme, is the involvement of tax exempt investors.  This includes endowments, foundations and public pensions.  Bain is typical in its reliance on these, ranging from State pensions in Massachusetts, Ohio, California and Pennsyvania to prominent foundations and endowments.

Put another way, no one has been more at the public trough than Mr. Romney and his private equity peers.  The reason is that these tax exempt entities pay no federal or state income tax on the gains from such leveraged speculative investments.  Congress tried to prevent this by requiring that tax exempts pay income on such gains to ensure a level playing field for domestic companies.

Romney’s Foundation Appears to be Violating A Key IRS Requirement Regarding Tax Exempt Status. Is It Time For a Flat Tax on All Tax Exempt Investment Income from Sources Other than Treasury Notes?

Perhaps now is a good time to advocate a flat tax of 10 percent on all tax exempt income coming from investments other than US Treasuries.  A related reform should be requiring that all tax exempts, including religious organizations, file an annual 990 disclosure form.  This is required of foundations, endowments and most other tax exempt organizations.  These filings are available at and interestingly it appears that Romney’s foundation is violating key reporting requirements in that, rather than reveal the investments, it instead simply disclosed the accounts are at Goldman Sachs along with the total account balance.

In contrast, the Gates foundation and others meet the requirement by showing a detailed list of investments.

Blocker Corporations Used to Allow Tax Exempt to Skirt Rules

In order to escape this requirement that prohibits tax exempts from investing in leveraged buyouts, private equity firms set up corporations in foreign tax havens, blocker corporations, in which tax exempts such as Pennsylvania PERS invest.   If they did not do this, these tax exempts would have to pay tax on their gains, as they should for such leveraged transactions.  Without that, the market does not work because all tax paying companies would be at a severe competitive disadvantage and be driven from the market.

Being tax exempt is a great advantage in that one does not have to pay tax on investment gains, yet it also means that tax deductions are useless and unable to be bartered for other partnership benefits.  For exampe, CALPERS can not say to Bain, look, you take all our unusable tax deductions because as a tax exempt we can’t use them.  In return, you pay us an extra 10 percent return.  IRS rules strictly forbid this.

Nevertheless, my research indicates that many private equity firms appear to be using transfer pricing and allocation systems to allocate carried interest expenses paid by these tax exempts down to the private equity portfolio companies, often laundered through off shore taxable subsidiaries, in order to capture what should be unusable tax deductions.  Much of this is compensation and deal fee related.

Recap: The Story of Romney’s Return is more about the Deductions Taken, not the Tax Rate on Income

Only by seeing the complete K-1’s can this be revealed.  And if his accounting firm,  which could be at the center of this scheme via its ACS allocation system, is not allocating such deductions to Romney given his political status but rather to other taxable partners, that would be an equally large scandal.

My advice to Mr. Romney would be to fork onto the high road ASAP and openly support more fairness in the tax code by starting with making income by private equity managers taxed at ordinary rates and then talk about lowering rates.  Put another way, fairness before rates.

I would also recommend that he initiate an investigation into his accounting firm’s treatment of carried interest related expense allocations to determine if he indeed was being allocated such deductions. That could be resolved in a 5 minute phone call.

What Romney and the other candidates also need to realize is that there are two sides to a job.  The first is income and benefits to the employee and the second side is tax revenues to support the local communities in which they operate.  Would it not be interesting if Bain disclosed its total federal and state income taxes paid by Bright Horizons day care across all 50 states, and this were compared to local day care centers?   My guess is that it is close to zero.

If the Bain capitalism model is to use these and other creative maneuvers to drive competitors from the market and then raise prices resulting in an abusive monopoly, that is the very definition of crony capitalism.  Later in a separate blog post we’ll look at Bain Capital’s involvement with Clear Channel and Ticketmaster as a thought provoking example.

Bain and its partners were so anxious to complete the takeover of Clear Channel that they sued Citigroup and other leading banks at the height of the financial crisis in mid 2008 to force them to make good on commitments to finance the $22 billion takeover.

This is indeed a big untold story of the finanical crisis that led to mass layoffs as smaller and mid sized firms got locked out of the credit markets.  Rather than consumers not repaying their mortgages, the much bigger issue was firms like Bain sucking up all the banks’ available liquidity in order to do leveraged buyouts.

What resulted was an environment in which firms like Bain could prey on liquidity starved smaller and mid-sized firms.  The notion that Romney is a jobs creator or Bain’s form of creative destruction is healthy is laughable to any competent investment professional.

As Romney’s opponent Gingrich notes, private equity is an important component for job creation, yet clearly these firms must be distinguished from the “buyout crowd” led by Bain.   The buyout crowd is nothing but a self-destructive greed mill.  Those are strong words, yet Romney’s Bain is known within the industry for charging 50 percent higher fees than most, that is 30 percent carry rather than 20.