Mitt Romney’s carried interest tax problem

Look into the future and imagine a President Mitt Romney trying to explain how he personally saved millions of dollars thanks to federal income tax rules that don’t make any sense and exist to benefit just a tiny percentage of Americans like him.

Does that strike you as a hard sell?

Private equity executives and people who run other investment partnerships have managed for years to defend the favored tax treatment of a large part of their income, called carried interest. That money - a share of profits those managers earn for investors - amounts to a performance bonus and is taxed at a federal rate of just 15 percent, rather than the 35 percent rate wealthy people would pay on ordinary income.

But Romney’s presidential campaign presents the defenders of the carried interest tax loophole with an entirely new - and much more serious - kind of trouble. Surely they’re cooked if Romney, the man who founded Bain Capital, wins.

In recent years, critics of the carried interest tax treatment twice thought they gathered enough momentum to change the rules, and I piled on in columns hoping to kill the loophole. Both times, that energy fizzled in Washington and amounted to nothing. There’s reason to believe a third shot may do the trick.

Public sentiment is already changing, at least a bit. Consider a poll that Bloomberg News released yesterday that found two-thirds of money managers consider the low tax treatment for carried interest unjustified. Money managers!

Private equity partners charge their customers a flat administrative fee to manage funds. They earn most of their money performance fees as carried interest. Meaning the compensation that can make a private equity manager truly wealthy comes with a huge tax break.

All kinds of people earn performance rewards as part of their overall compensation. Mutual fund managers get bonuses that depend on results. People in sales earn much of their money based on performance. Even union workers at General Motors got $4,000 profit-sharing bonuses last year.

The Internal Revenue Service isn’t offering any of them tax deals on their performance-based income. So why are the Mitt Romneys of the world different?

The carried interest controversy popped back into the headlines this week when Romney released his federal tax returns for 2010 and 2011. A substantial part of Romney’s income in both years came in the form of carried interest.

The numbers, for both years combined: Romney earned $42 million, which included $13 million of carried interest. Romney would have paid $2.6 million more in taxes if that performance money was taxed as ordinary income.

Compared to his overall earnings, that $2.6 million doesn’t look like such a big number. But stack it up against the total federal income tax Romney paid (about $6.2 million for the two years combined) and you see just how valuable the carried interest treatment becomes.

Carried interest is normally earned by investment managers who actively work at a firm. Romney left Bain in 1999, but as part of his departure agreement retained profit sharing rights as a retired partner. He will probably receive some amount of carried interest from Bain for years to come.

Romney faced two big questions about his taxes this week. One was on his low overall tax rate of just under 15 percent, which is not unusual for people who make most of their money from investments. The other was about Romney as a flesh-and-blood example of the carried interest tax break.

On the first, Romney simply said that he paid everything he owed. When it comes to carried interest, it’s hard to say where the candidate stands.

The presidential campaign is creating a big problem for the carried interest tax break and it’s about time. Focused public attention and sentiment will make a difference.

Romney could do himself - and nearly everyone else - a favor by getting out ahead of the issue. Or least he could avoid getting run over by it. He could be the strongest voice to say that private equity managers and other investment partnership executives should play by the same tax rules as everyone else.