Why am I writing this
I have been trying to keep myself from writing about Romney’s taxes but I can’t help myself.  As person who prides himself on being very astute on tax reduction matters, I have to admire a true star and I am not sure I am worthy to write about this.  If I thought for a minute that Romney would be as good at being a president as he has been in avoiding taxes, I would definitely vote for him.  But then again, my guess is his role in all of this, has been to hire the very best tax advisors and give them the objective of paying as little tax as possible. This demonstrates clear leadership and delegation which is the hallmark of a CEO.   I, on the other hand, have had to figure out a lot of this on my own.   As Steve Rattner said,  “I will tell you that as a private equity guy, I’m familiar with many of the things that he did. And I know many people who have done many of the things that he did. I do not know anyone who did everything that he did.”

This post is not about my political views.  Clearly, I am not going to be voting for Romney for many reasons but how he has handled  his taxes is not one of them.  But how he presents his taxes is definitely one reason because it reflects the character of the man.

First the Latest News
Romney released his 2011 taxes.  I am sure we will learn more as time goes on but there are a few interesting items:

• He ended up paying 14.1% but not taking all his Charitable Deductions.  He must have done this to comply with his statement that he would be paying at least 14%.  This did not really cost him anything since he can do an amended return after the election and get the money back

• His return shows income of 13.7 million dollars down about nine million dollars from the forecast he made as late as Jan.  2012.  I would guess his average income was around 20 million a year in Adjusted Gross Income (IRS income…..not all income).  So what happened to the nine million bucks?

• Price Waterhouse released a letter saying that he paid an average of more than 20% over the last ten years.  But this was not the weighted average.  For instance, he could have had a year where he paid 10% on fifty million dollars and another year where he paid 20% on five million dollars.  The average of the two is 15% the way Price Waterhouse did it but it is really more like 11%.

All that is Legal or might be legal
In my opinion, there is nothing wrong in paying the lowest amount of tax you can legally pay.   After all, you can always write an additional check to the US Government or even better yet, donate to charity (and get that wonderful additional tax deduction).  My issue with Romney and his tax returns is that he not being truly honest to the voters.  He manipulates statements so it appears that he is paying more as a percentage then he really is.  He is not referencing how much money he made, he is referencing his Adjustable Gross Income.  The recent letter that Price Waterhouse release on his behalf is a perfect example.  Romney does not really want us to know much about him.  But one thing is clear, he does not like to pay taxes.  I don’t like to pay taxes either but then again I am not running to be the President of the United States. I probably could not get elected as I have an FBI record which I earned demonstrating against the Vietnam war. A war that Romney supported, but in which he did not serve, choosing rather to spend a few years doing missionary work in the barbaric nation of France.

I should also point out that there is a lot of grey in the Tax Code.  For instance, the difference between a business and a hobby.  Ann Romney has a Dressage Horse – remember the 2012 Olympics?  Romney says that this is a business and wrote off $77,000 in 2010.  Most of this was Passive Loss and he could not take more than $5,000 off his taxes in 2010 but not to worry, you can carry forward passive losses indefinitely and we can rest assured that he will find a way in the future to use this.

A few comments about our Tax Code
IT SUCKS!  It is so incredibly complicated that no one can really understand it.  But it also creates opportunities for those that can afford to get the very best advice. Most tax payers will not be able to pay tens of thousands of dollars for the best tax advice. You have to be able to save a lot of money for that to make sense.  Of course, if you do it correctly, and I am sure Romney does, you can write off the cost of most of that advice from your taxes.  This means the government is in effect subsidizing the advice you get on how not to pay the government.  Something wrong here?

Living off of my Investments
Like Romney, I live off of my investments.  I have had no job since I left Intel in 1999, where I was Vice President of Business Development.  For a number of years, I did serve as a board member to public and private companies.  I also advise a number of companies.  A few of these engagements paid me fees which were subject to ordinary income tax.  But the bulk of my compensation has been in the form of stock grants of various types.

I should also say that, while I am a member of the 1%, I have nothing like the wealth of Romney.  I got the bulk of my wealth by saving money I earned and on which I  paid tax. In most cases I paid the highest marginal rate on this money sometimes more than 45%.  I did of course have a 401k and an IRA but I was not smart enough to know that I could have placed common stock from early stage companies into my retirement accounts.  That is how Romney probably got an IRA with about a hundred million dollars in it.

Trust for Romney’s Children
Romney has way more than the $250 million he says he has.  For instance, he set up a trust for his kids that currently has more than $100 million dollars.  It frankly takes my breath away and shows what a great dad MItt is.   The beauty of the trust is it avoids Estate Tax and Gift Tax. I actually tried this my self but my timing was not good,  it did not work out for my kids. They still have to work. I just hope they don’t become part of the 47% like their dad – I am on medicare and social security.   Here is what you do: You create a Trust with for your children in which you are the trustee. This allows you to do all the complicated tricks you know to avoid taxes for your kids.   Then you either contribute low basis stock to the trust keeping it under the amount that does not require Gift Tax to be paid. For instance for a long time that was $10,000.  He has five sons.  So Romney and his wife can each give $50,000 to the trust every year with out Gift Tax.  It is a bit more these days.  They  can either do that with low basis stock or give cash instead and then have the Trust buy the stock.  I would guess they even used some kind of liquidity discount the get the value on the stock even lower.  They could have also used their life time limit on gifts to put even more assets in the trust for their kids but that was only about a million dollars until recently.   Now if the Romney’s gave their children $100k a year in stock, and they earned 10% after tax on the stock, which would be great long term performance, they would end up with about $3.5 million after twenty years.  So how did the trust get to be about $100 million? You have to get a compounded annual return of about 26% to do that.  It is the magic of Private Equity.

Lets say I want to buy a company.  Well first, I create a company which has almost no value at first. Let call it NewCo.    I issue myself lets say 100% of the outstanding shares of the company valuing the company at $1000.  Now, I bring in other investors to fund the acquisition of another company worth $100,000. But being a great dad, I give my five sons, 10% of my shares which are valued at $100. Then  NewCo sells newly created shares for 90% of the company to to these new investors for the $100 million dollars.   So I am now left with 9% of the company which is worth $9 million dollars.  My very smart kids (smart because they picked me as their dad) have shares now worth a million dollars.  But since no shares were sold, no tax is due. Later the company does real well and we sell it for a billion dollars.  I get $90 million and my smart sons get $10 million.  It is all capital gains so I pay maybe three million dollars in tax and am left with seven million dollars in the children’s trust (assuming we have not figured out a clever way to avoid this tax).  Note, no Estate Tax or Gift Tax was paid.  What a dad!

Charitable Remainder Trust
Romney set up a Charitable Remainder Trust  (CRT) in 1996.  I have one of these too.  He is how it works.  You take appreciated assets like stock in a company you invested in and contribute it to the CRT.  The CRT  then can sell the asset without any tax due at that time.  The money in the Trust eventually goes to charity when you die.  Because of this fact you get an immediate tax donation  which is based on your age.  For instance, for every million dollars, you might get about $150,000 as a deduction.  While that is good news, the really good news is that you have avoided paying capital gains.  So lets say you contribute stock that is now worth a million dollars but you only paid $100 dollars (you cleaver Private Equity guy).  Right now the capital gains rates are pretty low but when Romney was setting this up they were about 28% not to mention the state tax.  So I would guess that Romney saved at least $350,000 net for each million he contributed.  So now for every $650,000 he has a million working for him.  If he set it up like I did, he only has to pay out money if he has a net profit in the CRT. It will be taxed based on the nature of the investment. If he only invests in stocks that have capital gains, he only pays capital gains rates.  There is a lot more too this but you are probably getting the point. Of course, at the end the CRT’s principle will go to charity but if your intention is to do that anyway, that would not be an issue.  And in general, if you live longer than 15 years, your estate will be worth more because you did the CRT then if you did not.  Romney was only 50 years old when he set up his CRT so by now,  I am pretty sure he is beyond the break even point.

A Word about Off Shore Accounts
Now what about those off shore accounts?  I am not sure if Romney includes those in his net-worth.  But one thing we can be sure of is that he is not paying tax on the income of those accounts and they are not included when he says he is paying 14%.  So how did he get these accounts?  It is part of the magic of Private Equity. Lets say you have a private equity firm.  We will call it Bain Capital.  You set up a fund to acquire a company.  The partners in your fund get what is called carried interest. They get 20% of the gains in the investment.  The limited partners, the investors, get the 80%. But you have some foreign  investors that want to invest and not be subject to US taxes.  So you set up a sister fund lets say in the Cayman Islands.  The General Partners of that fund also get 20% carried interest.  The off shore fund also invests in the deal to acquire the company.  The company does well and eventually the stock is sold.  You and your partners now have a profit in Cayman.  If you bring it back to the USA you have to pay taxes so instead leave it there in the Cayman and start to invest it in deals outside the USA.  Not only is your money getting a great sun tan but it is also growing tax free.

The Power of Capital Gains
If you buy a stock and sell it after it has increased in value, the increase is called Capital Gains.  If you sell a stock that has declined in value, the decline is call a Capital Loss.  If the sale happens within one year of the purchase, it is called a Short Term Gain or Short Term Loss. If it is more than a year, it is called a Long Term Gain or Loss.  The rates for Short Term are normally the same as ordinary income. For instance for the highest federal bracket, it is 34%.  If it is long term, the rate drops to 15%. Alternative Minimum Tax plays a role here but forgive me if I do not deal with that complication.

So lets say I am a smart fellow. Maybe I am a former head of the American Olympic Committee or a one term Governor that would not have gotten re-elected,  and I have lots of stocks in lots of different entities.  My objective is of course to grow the value of my stocks but I am smart enough to know that I have to think about that with tax in mind.   So the first thing I know is that I never want to have short term capital gains.  If I have a stock that has done really well after I buy it, but it is not long term, I do not want to sell it unless I have capital losses that I can use to off set it (there are complicated rules about how you apply these losses).  So I am always taking losses to shelter my gains.  Of course, being the great investor I am, I will have on average more gains than losses.  But as long as I believe the stock I own is going to go up, I will want to hold on to it rather than pay 35% in taxes. After all, the stocks I would buy after paying the tax would have to do much better to be equal to the stock I am now holding since I would only have 65% of the value to invest.
How to Keep Ann in Cadillacs and Horses
So how do I get enough money to keep my three houses, horse’s, my wife’s Cadillacs and build my car elevator?  First, I always take my losses so I can sell stocks with the equivalent amount of gain without any tax due.  Then I sell stocks that have little gains. So if I have stocks worth a million dollars but I paid $990,000, I only pay tax on $10,000 but I now have a million in cash.  At the same time, I may have $25 million in unrealized gains.    Now I am worried about the $25 million in Unrealized Gains but I don’t want to realize the gains.  So there are a lot of hedging strategies that I can use like selling Covered Calls and Buy Puts (you will have to buy my newsletter to learn how to do this).   A nice aspect of capital gains is that you can carry forward losses in years where your realized losses are greater than your realized gains.  For instance, most of us that have investments in the stock market had capital losses in 2008 that exceeded any gains we wish to take.  But we got to use them in 2009 or even 2010.  Romney could have not realized capital gains in 2009 because he used losses from 2008. That year his income would have only been a fraction of normal years from the IRS’s point of view, even if he had twenty millions of dollars in gains that year, provided he had more than twenty million dollar loss in 2008.  He could have found himself with lets say $500,000 in income after deductions which was taxed at a 34% tax rate.  He could have made two million dollars in donations that year,  but if it was in the form of appreciated assets. He could have only taken $400,000 as a deduction but could carry the additional $1,600,000 forward to future years (there is a five year limitation).

Charitable Giving
The Romney’s give a lot of money to Charity. Mostly it goes to the Church of the Latter Day Saints, more commonly know as the Mormon Church. My guess is that they do this by giving appreciated stock. This is how I too fund my charitable giving.   So from the value of the gift, they avoid paying federal and state tax on the appreciation and get a deduction for the full value of the gift from their federal and state tax.  While Romney is paying a 14% federal tax rate, please keep in mind that is the average rate.  He may be paying about 35% Marginal Rate (the tax he pays on the last dollar he earns).  The donation will save him tax dollars at his Marginal Rate.  The combination of not paying Capital Gains Tax and then getting the deduction means that it really only costs him 50% of what he donates.   Romney appears to be a very generous man but maybe only half as generous as he presents himself.

The Mormon Church
I can really understand Romney’s commitment to the Church of the Later Day Saints.  It is run like a business  but one that pays no taxes.  It owns about $35 billion in real estate and invests heavily in business.  It has income of about $7 billion dollars a year from members which results from a requirement on Mormons to pay the Church 10% of their earnings.  One of the main activities of the church is to send out missionaries to get additional members of the church who will also have to pay 10% (pre-tax) to the Church. This is a great strategy for growth.  And remember the Church pays no tax.

Blind Trust
Romney’s money is supposedly managed in a blind trust which is administered by his personal attorney.  If you believe that they do not have discussions about investments, then you should definitely not vote for Romney.  He would be too dumb for words.

In Closing
Hope you made it this far.  Please forgive me if I made any math, spelling or grammar mistakes.