Did Bain Capital Execs Break The Law Using A Common Tax Avoidance Strategy?

New York’s Attorney General Eric Schneiderman is investigating a number of financial companies — including Mitt Romney’s old private equity firm Bain Capital — that in the past decade avoided paying millions of dollars to both federal and state governments by executing a dubious tax avoidance strategy available only to very wealthy executives.

The investigation, first reported by the New York Times, brings a long-standing controversy over federal tax treatment of what’s known as “carried interest” back into the spot light. But it also raises state-level questions about why the New York attorney general is stomping on what is traditionally IRS or state-tax authority turf.

“[W]hat the hell is the Attorney General doing here?” asked Ed Kleinbard, a tax expert at USC’s Gould School of Law who has explained Romney’s controversial tax strategies to reporters on behalf of the Obama campaign. “I’m glad he’s shining light on this tax practice. But it’s not clear what his role is. These are tax issues. These are tax issues that should have been aggressively audited and litigated by the IRS.”

A source familiar with the New York probe explains that the Attorney General’s authority in this case stems jointly from the state’s False Claims Act and a more recent enhancement to that law called the Fraud Enforcement and Recovery Act, which together empower the attorney general to bring actions against anyone who defrauds the government, and force them to pay triple damages and civil penalties back to the treasury.

Early in his term, Schneiderman stood up a Taxpayer Protection Bureau within his office and dedicated prosecutors to cracking down on companies that illegally skirt state tax laws — which many private equity firms may have.

At issue is a practice — common in the private equity world — of converting compensation designated as earned income into “carried interest,” which, at the federal level, is often taxed as a long-term capital gain at a much lower rate of only 15 percent, but also enjoys different advantageous treatment in New York State.

Because financial lawyers have, for years, rested their guidance on lenient interpretations of the tax code, and because the IRS has done a poor job of policing practices like these, the question of whether private equity fund execs can legally convert their management fees into carried interest has never really been settled, according to Kleinbard. But a simple analogy suggests the practice should be forbidden in certain cases.

Imagine you receive a cash bonus at the end of every year. If late in December you ask your employer to alter the arrangement and provide the bonus in stock rather than cash, the IRS could cry foul. Since the bonus had already been earned (if not actualized) tax authorities might view the new arrangement as equivalent to cash compensation that was then used to purchase stock. That compensation would be taxed as ordinary income before it could be plied into an investment.

So timing matters.

“They took what was their compensation income and rolled it into carried interest, after that compensation had already been earned, very late in the year,” Kleinbard said. “I think the critical question is how late in the day — was the income already earned? I think the answer is yes. And I would’ve advised against that kind of structure. … Other firms either didn’t do it at all, or they did it the right way, by waiving their management fees in advance. You say in 2012 that you will waive your management fees in 2013.”

Victor Fleischer, a law professor at the University of Colorado — raised a similar objection after Gawker.com posted years worth of Bain financial documents that revealed Bain’s practice of rolling its management fees into carried interest. Schneiderman’s investigation began before the Gawker document dump, according to the Times.

The New York probe cuts right to this issue. It’s premised on the notion that when firms convert management fees into either carried or capital interest, they’re illegally evading state taxes. In the case of a capital interest conversion, the fees are simply not taxed at all. In the case of a carried interest transition, execs can defer taxation, and thus potentially reduce their tax burden.

Though the probe hinges on the question of whether private equity firm executives evaded state taxes, it indirectly discredits arguments in favor of the carried-interest loophole, which has been a controversial bug in federal tax policy for years.

“What it does demonstrate is that carried interest is just a way of paying compensation,” Kleinbard says.

For this and other reasons, it’s unusual territory for a state AG.

“I think we’ve just been let down by the IRS. They just haven’t done a good job at policing these practices, for a decade now,” Kleinbard said. “I can’t figure out what the AG is doing here. He’s not doing any tax audits. And I certainly don’t think they rise to a criminal level.”

But Schneiderman probe is not entirely unprecedented. Earlier this year, Schneiderman filed a $300 million tax fraud lawsuit against Sprint for evading state sales taxes the company is required to pay when customers pay their monthly service charges.

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