Here's One Of The Clever Financial Tricks Mitt Romney Used To Become Dynastically Rich

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While the world waits for Mitt Romney to stop being the only Presidential candidate in several decades to keep his tax returns secret, we’re left to try to solve the Romney money mysteries with the information we have.One of those mysteries is how Romney accumulated $21-$102 million in his Individual Retirement Account.

Yesterday, we speculated that part of the reason might be that Romney remained the “sole shareholder” of Bain Capital more than 15 years after the firm was founded–an ownership stake that would presumably have been worth a boatload of dough.

Importantly, if this stake did contribute to Romney’s wealth explosion, he would have made the money in a way that most people will quickly understand and respect: Specifically, by founding and building a company that ended up being worth a lot.

That’s the American dream, and you would have to be bitter and petty to take issue with it.

But our readers pointed out that the entities Romney was “sole shareholder” of might just have been some of Bain’s individual investment funds, not the firm as a whole, and that there was another tool that Romney used to become rich that has nothing to do with founding and building companies–or, for that matter, just “making great investments.”

This other tool is a financial engineering trick.

And it appears to have been designed and used at least in part to avoid taxes.

Here’s the trick, which was explained in great detail by Mark Maremont in this excellent Wall Street Journal article:

When Bain bought companies, it changed the capital structure to create two classes of stock.

The first class, so-called “L” shares, were a form of preferred stock. These shares had less upside than standard common stock, but they were also safer. They earned interest, and they offered capital protection in the event that the investment did not work well. These preferred shares likely ensured that Romney and Bain would not lose money on investments unless everything went completely to hell.

The second class, so-called “A” shares, were common stock. These shares had a vastly higher risk/reward profile than the preferred shares. If the investment worked, they made much higher returns than the “L” shares. If the investment didn’t work, they got wiped out.

So far so good. And now comes the tax-avoidance part of the trick.

In the days in which Romney was at Bain, capital gains taxes were 28%. If Bain made a killing on an investment, therefore, a big chunk of the partners’ gains would go right to the government. And no one likes writing checks to the government.

So, Romney and other Bain employees, who were allowed to “co-invest” in the firm’s deals (common in the industry, but also a potential conflict of interest), figured out a clever way to get around paying these taxes:

They put the safer preferred shares–the “L” shares–in their regular taxable investment accounts.

And they put the high-risk/high-reward shares–the “A” shares–in their tax-deferred retirement accounts.

Mitt RomneyOn another topic… you can’t be CEO and not be responsible for what the company does. Click for more >

Photo: Alex Wong/Getty Images

Because of the way the risk/return for the “A” shares worked, this was akin to placing stock options in a tax-sheltered account. If things went badly, the entire investment in the risky shares would be lost. (But the partner still might make money overall–through the return and interest on the “L” shares.)But if things went well–bingo–Romney and his partners hit the jackpot. And they didn’t have to pay taxes on their winnings. Rather, they could cash them out, keep them in their IRAs, and then use the proceeds of the bet to make much bigger bets next time.

And as Mark Maremont discovered, Bain’s “A” shares often hit the jackpot.  In one Bain deal that Maremont describes, Bain increased the equity value of a company by an extraordinary 36-fold in 20 months. But the value of the “A” shares over that period–many of which had been placed into Bain employee IRAs–jumped 583-fold.

So, that was the first part of the trick: Dividing a company’s stock into two classes of shares, with the aim of having the high-risk/high-reward class compound tax-free in individual retirement accounts.

The other part of the trick was the value that Bain assigned to the high-risk/high-reward shares during this period.

The lower the value Bain placed on these shares, the more of the shares Romney and other Bain employees could stuff in their retirement accounts without exceeding the annual contribution limit. And, therefore, the more explosive their tax-sheltered gains on these shares might end up being.

So Romney and Bain had a strong incentive to place a low value on the IRA-bound shares. Which they apparently did.

In the days in which Romney was running Bain, Maremont found, Bain valued the IRA-bound shares at about 1/10th of the value of the safer “L” shares.

Tax lawyers Maremont spoke to said that was a very low valuation to place on the risky shares, especially by today’s standards. Most private-equity firms who use this technique these days, he reports, value such shares at 1/3rd or 1/4th of the value of the safer shares.

Now, in Romney’s defence, valuing illiquid equity and options (which is essentially what these shares were) is a subjective craft, not a science, and there’s a wide range of defensible conclusions. But suffice it to say that Romney & Co. appear to have placed very low valuations on the risky shares that went into their retirement accounts and that, if they had placed a higher value on these shares, they would have sheltered less money from taxes.

Such financial engineering and tax-avoidance tricks obviously require a high level of sophistication, both in terms of investing and tax-planning. As a result, for all intents and purposes, they’re only available to a tiny minority of Americans.

Furthermore, these tricks illustrate that Romney’s financial success is not, in fact, just about “making good investments” (although he certainly made many of them), but about taking advantage of loopholes and tricks that a handful of people with considerable financial means can exploit.

Lastly, although such tricks may well be perfectly legal within the letter of the tax code (it depends whether the value that Romney placed on the IRA-shares really was reasonable–a question that’s worth looking into), they’re clearly miles from the spirit of what IRA tax-deferral laws were designed to encourage: Namely, providing a little tax help to help average Americans save modest amounts of money for retirement.

By limiting IRA contributions to a few thousand dollars a year, Congress clearly meant these vehicles merely to be tools with which Americans could save a bit each year on a tax-deferred basis–not to place high-risk/high-reward bets that could allow people to amass vast fortunes beyond the reach of the IRS.

Romney and his colleagues, obviously, never needed the tax help to save for retirement–because they quickly had more money than they would ever need to retire on. So for Romney and Bain, the IRAs were merely tools with which to allow returns to compound without paying taxes.

And it also likely explains, again, why Romney is so adamant about keeping his tax returns secret. Because the “L” shares and “A” shares tax trick was likely only the beginning. And, for obvious reasons, Romney doesn’t want average Americans to discover any more details like this.

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