Are Bain’s Tax Practices Actually Illegal?

More and more people are asking if Bain Capital’s tax avoidance strategies are more than merely aggressive. On August 23, Gawker.com released a staggering 950 pages of documents related to Bain, the private equity firm that Mitt Romney founded, that confirm a lot of what we had previously surmised, including the fact that the Bain private equity funds set up “blocker” corporations to help tax-exempt investors avoid the unrelated business income tax and help foreign investors avoid tax in the U.S. and in their home countries.

CTJ senior counsel Rebecca Wilkins summarized it for Huffington Post: “The Bain documents posted yesterday show that Bain Capital will go to great lengths to help its partners and its investors avoid tax. Beyond simply putting their funds offshore, the Bain private equity funds are using aggressive tax-planning techniques such as blocker corporations, equity swaps, alternative investment vehicles, and management fee conversions.”

The management fee conversions, detailed in several of the fund documents, do what they sound like they do: they convert some of the private equity firms’ annual management fees from clients, which would be taxed as ordinary income, into increased shares of partnership profits known as “carried interest”.  Carried interest is how these firms have structured their performance-based compensation from managing their clients’ investments, and carried interest is taxed at the special low rate at which capital gains are taxed. The management fee conversion is an effort to get yet another form of client compensation taxed at the capital gains rate, which is less than half the rate at which it would be taxed if it were ordinary income. These conversions save private equity firms’ partners millions of dollars in income taxes (the Bain partners alone have saved an estimated $220 million).

Colorado Law Professor Vic Fleischer, an expert on the taxation of private equity, quickly branded the management fee conversions as improper. “Unlike carried interest, which is unseemly but perfectly legal, Bain’s management fee conversions are not legal.”

It looks as though the New York Attorney General agrees. In July, weeks before the Gawker document dump, AG Eric Schneiderman served subpoenas on more than a dozen private equity firms, including Bain Capital.  The AG’s office is seeking documents related to whether the firms improperly converted management fees into additional carried interest, and running the investigation through its Taxpayer Protection Bureau. 

As controversial as private equity firm tax practices have become (thanks to Mitt Romney’s candidacy), we are likely to be hearing more about this investigation soon. Stay tuned.