David Cay Johnston

Newt Gingrich’s 2010 income tax return inspired a quick response from U.S. congressman Pete Stark.

Twelve days after Gingrich, a Republican presidential hopeful, made his return public, Stark proposed the Narrowing Exceptions for Withholding Taxes (NEWT) Act.

This proposal has an uncertain future in Congress, but it would be a good addition to our tax laws, closing a significant loophole that Gingrich took advantage of.

In their 2010 return, Newt and Callista Gingrich declared that most of the money they earned from their multimedia company, Gingrich Productions, was dividends, rather than compensation for their services.

Because the Medicare tax applies only to labor income, this move allowed them to avoid paying $71,152 in Medicare tax — the amount of the dividend times the 2.9 percent tax rate.

Michelle Selesky, Gingrich’s spokeswoman, did not respond to multiple requests over several days for an interview or comment.

This technique is used by many accountants, lawyers, lobbyists and performers who, like Gingrich, set up S corporations, a type of business organization that passes any tax obligations on to its owners.

The same loophole was used by John Edwards, the 2004 Democratic vice presidential nominee, to avoid about $600,000 of Medicare tax on his earnings as a trial lawyer over a period of four years, information he made public showed back then.

THEIR OWN LABOR

Some investors in S corporations have capital at stake but do little or no work. It is reasonable to classify their profits as dividends. But in the case of Gingrich, and Edwards, their income resulted from their own work and it should be taxed as such.

Stark, a California Democrat, told me he introduced the NEWT Act after learning that Newt and Callista Gingrich reported 80 percent of their nearly $3.2 million in income in 2010 as dividends, mostly from Gingrich Productions, which is set up as an S corporation.

Under Stark’s bill, the income from an S corporation with three or fewer principals would be taxed as compensation, thus incurring Medicare taxes.

Passing Stark’s bill and closing this loophole is a matter of fundamental fairness. The principle that government should tax makers of microchips and potato chips alike should also apply to earnings from work, whether it comes from work on the factory floor, or, as in Gingrich’s case, making videos.

Just as you cannot claim a depletion allowance for your aging body, you should not be able to declare that money you earned by working is a dividend.

The official scorekeepers on tax matters, Congress’s Joint Committee on Taxation, estimated in 2009 that closing the loophole would raise $11.2 billion over 10 years.

IRS ATTACKS LOOPHOLE

The IRS has been attacking this loophole in audits, challenging many tax filings that have used the same strategy that Gingrich used. One of those challenges is now before the 8th U.S. Circuit Court of Appeals in St. Louis in a case watched closely by tax professionals.

It involves David Watson, a certified public accountant in West Des Moines since 1982, who paid himself a salary of $24,000 in 2002. He then reported nine times that much in dividends, which reduced his Social Security and Medicare taxes. He followed a similar pattern in 2003. The IRS said the dividends were really labor income and demanded Medicare taxes.

Watson sued. Robert W. Pratt, the chief federal judge in Iowa’s southern judicial district, wrote in a 23-page decision in 2010 that such a small salary was “unreasonable.” A salary of $91,044 would be reasonable for someone with Watson’s skill and experience, he wrote.

The judge then ruled that Watson owed payroll taxes on $67,044 of the money he had labeled dividends, saying this finding “is amply supported by the evidence.” Watson’s case has been argued on appeal and he now awaits a ruling.

Watson told me that he does not think the IRS has the authority to decide what is salary and what is a dividend. Other court cases show that it does. But Congress should remove any ambiguity by passing Stark’s bill now.

Stark’s proposed NEWT Act contrasts with Gingrich’s own tax plan, which he released in December. Under Gingrich’s plan, dividends would not only be free of Medicare tax, they would also be entirely tax-free.

Had Gingrich’s tax proposal been the law when he filed his 2010 return, my calculations show that his income taxes would have fallen more than 90 percent. His is one of the most outrageously self-serving tax proposals I have seen in years of studying our tax system.

When the Romney campaign disclosed in December that the couple’s five sons had a $100 million trust fund, I suspected that, in setting up the fund, the Romneys used a tax strategy that allows some very rich people to avoid paying gift taxes. But it was impossible to know if this was the case without seeing their tax returns going back years.

So when Mitt Romney released the family’s 2010 tax return last week, I went looking. I found a hint on pages 132 and 134 of the return. It showed that the value of property placed that year into another family trust, the Ann D. Romney Blind Trust, was, for tax purposes, zero. The Ann Romney trust is not the same trust as the one that holds the Romney sons’ $100 million, but I wondered if the Romneys used the same approach in prior years when it came to valuing property placed into the sons’ trust.

Reuters emailed the Romney campaign spokeswoman to ask how much the Romneys paid in gift taxes on assets put into the sons’ trust over the last 17 years. The spokeswoman, citing Brad Malt, the Romney family tax lawyer, answered: none.

The idea that someone could pay zero gift taxes on contributions to a $100 million trust fund may surprise people who have heard arguments that the wealthy are overburdened by gift and estate taxes. But the Romneys’ gift-tax avoidance strategy is perfectly legal.

Under tax rules, wealthy people must pay a gift tax of 35 percent on gifts above a lifetime limit known as the “unified estate tax credit.” That limit was $1.2 million for a married couple in 1995 when the sons’ trust was created and $2 million in 2009, but is now $10 million.

So, if the limit is, at most, $10 million, how did the Romneys create this $100 million fund without paying gift taxes?

The explanation may stem from how the Romneys were able to value the assets put into the trust. If I’m right, it involves a special tax deal that Congress gives to people who manage investment partnerships, as Romney did at Bain Capital from 1984 to 1999.

This deal allows these managers to receive a kind of compensation known as “carried interest.” As the tax law sees it, carried interest does not represent ownership of stock or other securities, only the right to receive future profits. Because there is no ownership, the IRS lets people value their carried interest at zero for gift tax purposes if they meet certain technical rules. We asked the Romney campaign if carried interest was involved several times in emails. The campaign declined to comment about this and other specifics.

VALUING A GIFT AT ZERO

To understand how this works conceptually, imagine your employer gave you a bonus in company stock.

You would owe income taxes immediately on the stock as compensation, and it would be taxed at the same rate as a cash bonus. And if you gave the stock to your children, you would owe, on stock above $10 million, a gift tax of 35 percent of the market price on the day you gave it away.

Now imagine that instead of giving you stock outright, your employer gave you only the right to future increases in the value of company shares – which, like carried interest, is just a right to some potential future income. You could give that right to your children and legally tell the IRS that its value was zero provided they hold onto it for several years.

This would be legally true, even if the company’s stock had been steadily rising for years and was virtually a sure bet to continue going up in value. Of course as a matter of economics it would be a very valuable gift to your children.

The scenario of transferring a right to something of value in the future and valuing it at nothing shows up on the Romneys’ 2010 tax return, which reveals two contributions to the Ann D. Romney Blind Trust. Both contributions were valued at zero.

NO COMMENT

The Romney campaign declined to confirm that this is what happened with the sons’ trust. Malt, the family tax lawyer, and spokeswoman Andrea Saul have declined to go further than Malt’s statement that the contributions fell below the unified credit.

The campaign, which set up an email address for journalists with questions about the tax returns, did not offer any comment nor did it respond to specific questions, including whether any of the personal or trust returns had been audited, whether any adjustments had resulted and whether the gifts to the sons had been completed more than three years ago, which would put them beyond any review by the IRS.

There are other perfectly legal techniques that would also allow many millions of dollars to be passed on while avoiding gift taxes.

The Romneys could attain the same result by putting into the trust any asset whose value was expected to rapidly increase. They could also use a trust that creates an annuity for themselves for a few years provided the trust assets grew much faster than the minimum interest rate payout set by the IRS each month. In each of these cases the parents would pay any income taxes and that is just what the Romneys’ 2010 and preliminary 2011 tax returns show. They report the trust income as their own and pay the taxes on the income the trust earned from its rapidly appreciating assets — but no gift taxes.

How much income will flow from these gifts is known only to the Romney family and to Malt, who works at the Ropes & Gray law firm in Boston.

Mitt and Ann Romney appear to have complied with the law. What’s at fault is the law. Congress treats ordinary taxpayers one way and managers of private equity and hedge funds like Mitt Romney another. It’s also a fiction that there is a lifetime limit on tax-free gifts of $10 million when Congress lets unlimited sums pass untaxed this way.

Will this change? It’s hard to say, given the gridlock in Washington. But President Barack Obama’s State of the Union message could signal a new direction. In a speech that mentioned taxes 34 times, he proposed sweeping changes in the tax code, a message that could resonate in the 2012 campaign and in Congress in 2013. Watch this space.

PHOTO: Republican presidential candidate and former Massachusetts Governor Mitt Romney (L) introduces his sons Tagg (2nd L), Craig (3rd L), Josh (2nd R) and Matt, as his wife Ann (C) looks on, at a campaign rally in Des Moines, Iowa January 3, 2012, the day of the Iowa caucus.   REUTERS/Brian Snyder

What advice do tax lawyers give private equity managers about saving on taxes as they build wealth?

We may get a first glimpse at the answer on Tuesday when, bowing to public pressure, Mitt Romney promises to release his 2010 tax return and a tax estimate for 2011. (See the returns here.)

To get a full picture of Romney’s taxes while he made his multimillion-dollar fortune, we would need to see returns going back to 1984-1999, which is when he ran Bain Capital Management. So far, the Republican presidential candidate has not committed to release those returns.

There’s no suggestion that the former Massachusetts governor did anything illegal. However, Congress allows managers of investment partnerships like the one Romney ran to enjoy tax-saving strategies not available to other taxpayers.

So I asked 10 lawyers in seven states how they might advise a new client who is launching an investment partnership – someone like Romney. While we do not know just what Romney’s lawyers advised, the 10 lawyers laid out nearly identical scenarios.

FIVE PIECES OF ADVICE

(1) DEFER TAX: Congress requires that most workers have income taxes withheld from their pay, but it lets investment partnership managers like Romney earn compensation now and pay taxes later, decades later. It’s called “carried interest.” Paying a tax in the future reduces its cost. Deferring a tax for three decades is the same as not paying it, the lawyers said, because the value from investing the money is far greater than the tax eventually paid. Some of the lawyers said the ability to defer will surprise people who are used to having taxes withheld before they get paid. Mitchell Gans, who teaches tax law at Hofstra Law School in Long Island, N.Y., said it takes only a minute to make clients comfortable with the idea “because it goes with the psychological phenomena that we would all rather pay later than sooner.”

(2) MINIMIZE SALARY: Take only enough salary to live comfortably, the lawyers said, and instead take as much compensation as possible in tax-deferred carried interest. The carried interest will mostly be taxed at the capital gains rate of 15 percent. By contrast, top wage earners pay tax on their highest income of 35 percent and they pay it immediately.

(3) MAXIMIZE THE VALUE OF FAMILY GIFTS: With careful planning many millions of dollars can be given to children while paying little gift tax. Make gifts in years when appraisals show the value of the carried interest is reduced because the investment is not doing well. All 10 lawyers said thorough appraisals are essential to avoid fights with the IRS over valuation, which could result in higher gift taxes and a court fight that would end up in the public record, revealing business details that would make investors shy away from the manager in the future. Romney set up what his campaign said was a trust fund now worth $100 million for his sons, but has not indicated that he will release the gift tax returns, which would show if he discounted the value of assets put into the trust and what gift taxes, if any, he paid.

(4) OBEY THE RULES: Making sure every one of the many technical tax rules is followed at all times reduces the risk that an audit dispute with the IRS or state tax authorities will spill into the public record and cause the loss of tax benefits.

(5) START A SELF-DIRECTED RETIREMENT ACCOUNT: With a self-directed account the fund manager can invest in his own deals. Some of the lawyers noted that retirement funds, including those rolled over into Individual Retirement Accounts after leaving a job, can be shielded from creditors, a valuable strategy if things go awry in the distant future. This makes retirement accounts partial substitutes for asset protection trusts, but without the stigma of asset protection trusts, which some people consider a way to evade obligations to creditors. Large retirement accounts carry no such untoward connotation, the lawyers said. However, they did caution that any asset protection offered by retirement funds comes with an increased tax. That is because any gains are taxed at the same rate as wages, 35 percent for someone like Romney, instead of the 15 percent capital gains rate. Romney’s disclosures show that he holds about a 10th of his fortune – an overall fortune estimated by the campaign at $190 million to $250 million – in retirement accounts with some of the money legally invested in the Cayman Islands and other offshore funds.

THE PUBLIC OFFICE SCENARIO

I asked the lawyers if their advice would differ for clients whose background suggested they might run for public office someday. They split on this.

Some said that their advice would be the same. Others, noting the attacks on Romney by Republican rivals over his offshore accounts or the blistering comments at many websites by individuals, said they might raise the issue of how voters would react to offshore investments, which are legal but not widely understood by Americans who are misled to believe by movies and films that they must be improper.

PHOTO: Republican presidential candidate and former Massachusetts Governor Mitt Romney speaks during a roundtable discussion about housing issues in Tampa, Florida January 23, 2012.   REUTERS/Brian Snyder

A tax return says a lot about a man, especially one aspiring to be president.

If Mitt Romney makes good on his promise during Thursday night’s Republican candidates’ debate to release “multiple years” of his returns, it will likely stir up rather than calm the political storm unless he makes public all of his returns from 1984 through 1999. Those are the years when he built a fortune of more than $200 million while running Bain Capital Management.

There’s no suspicion that Romney has done anything illegal. But what should be secret about the taxpaying relationship between a presidential hopeful and his government?

Romney himself said late on Thursday: “I’m not going to apologize for being successful.”

The former Massachusetts governor disclosed this week that he pays about 15 percent of his income in federal income taxes. That’s the same effective tax rate as a single wage earner making $60,000. Most of Romney’s income consists of dividends and capital gains, which Congress taxes at 15 percent. Were his income in wages, he would have paid a much higher rate.

Congress requires that most workers have income taxes withheld from their pay, but not so investment partnership managers like Romney, who cofounded Bain Capital Management and ran it for 15 years. They can earn compensation now and pay taxes later, decades later if they want. It’s called “carried interest.”

At the debate Romney wouldn’t say just how many years of returns he would make public. He has yet to share any of them. Before Thursday night, he had spoken only of releasing returns come April, the 2011 tax deadline. He came under public pressure to deliver more.

Unless he releases the tax returns from his Bain Capital years he will surely be pressed about how much, if any, of his fortune has yet to be taxed and how long he deferred paying on the portion that has been taxed. He will be asked about Bain accounts in the Cayman Islands, Bermuda and other tax havens. While perfectly legal, these offshore accounts convey an unsavory political whiff to many people, including some of his rivals for the Republican presidential nomination.

And what about taxes on the $100 million that Romney put into a trust for his five sons. How much Massachusetts and federal income tax, as well as gift tax, was paid on that money?

None of these questions can be answered without the returns from his Bain years.

MANY HAPPY RETURNS

Romney’s political problems could multiply once families around kitchen tables grasp the fact that while they pay taxes before getting paid, Romney arranged to delay paying his for years. The disclosures could also lead to popular support for ending such deferrals, which President Barack Obama, a Democrat, proposed in 2008 and again in September. Hedge fund and private equity firms have spent a lot of money on lobbying and campaign donations to avert any such change.

Newt Gingrich, a rival for the Republican nomination, released his own tax returns on Thursday to try to embarrass Romney. Gingrich has warned Republicans that Obama’s campaign in the run-up to November’s elections will hammer these tax issues if Romney is nominated. For sure, the Obama campaign would also hammer Romney over any refusal to disclose the full story of his income and taxes going back to 1984. A no-win situation for Romney? Maybe not.

There are presidential precedents that strongly favor disclosure. In March 2008 Obama released his returns from 2000 forward. In 1999 George W. Bush released his 1998 tax return showing how he made $17 million in carried interest from the Texas Rangers baseball deal he managed.

The practice of releasing returns even predates the revelation during Watergate that President Richard Nixon filed four fraudulent tax returns, resulting in felony indictments of two of his tax advisers.

Back in 1968, another Republican businessman seeking his party’s presidential nomination disclosed 12 years of tax returns. That man was George Romney, Mitt’s father, who said it was the right thing to do.

PHOTO: U.S. Republican presidential candidate and former Massachusetts Governor Mitt Romney and his wife Ann relax while on the campaign bus as they leave a campaign stop in Gilbert, South Carolina, January 20, 2012. REUTERS/Jim Young