News Column

Elite accounting tactics cut Rauner's tax tab

July 1, 2014

By Jeff Coen and Bob Secter, Chicago Tribune

July 02--IRS data show Bruce Rauner to be one of the 11,000 richest tax filers in the nation, but most of the millions he made in recent years was taxed at 15 percent -- less than half the top federal rate for the wealthy, a review of tax documents released by the GOP governor hopeful shows.

One reason behind that sharp discount is that Rauner took advantage of a strategy that yielded big tax savings on his share of investment fees paid to his private equity firm, GTCR. That strategy is allowed under tax rules but has come under IRS scrutiny.

An analysis of the limited records Rauner has released, conducted by the Tribune in consultation with tax experts, gives the fullest picture yet of the steps he took to trim his tax bill. In ways both big and small, the Republican businessman's financial profile is one driven by tax-reducing strategies often out of reach for those of more modest means:

--Rauner's campaign is built around his resounding success at the helm of GTCR, through which he earned millions of dollars a year. But a major portion of that money was reported to the IRS as capital gains taxed at a preferential 15 percent, including money from so-called management fee waivers used by many private equity firms to reduce tax bills for key partners.

--For three years, Rauner reported little regular business income, the tax category that includes partnership earnings and is subject to a top tax rate of 35 percent. Instead he claimed losses of $3.1 million in 2011 and $12.7 million the year before.

--Complicated tax rules related to those business income losses freed Rauner from paying any Social Security or Medicare taxes in 2010 and 2011, despite his reporting healthy earnings in other income categories and listing a combined adjusted gross income for those years of about $55 million.

--In 2012, Rauner claimed an additional $53 million in adjusted gross income, bringing his total for three years to $108 million and easily placing him in the top federal tax bracket of 35 percent then in effect. Tax breaks, however, reduced his effective tax rate for those years to slightly more than 19 percent, about the same rate paid by Democratic Gov. Pat Quinn, whom Rauner is trying to unseat.

Rauner's combined federal tax bill was $20.7 million from 2010 through 2012. Quinn's, according to his tax returns for those years, totaled about $106,600 on income of about $568,000, giving the governor an effective tax rate of 18.8 percent.

Likely the wealthiest office seeker in Illinois history, Rauner has used more than $6 million of a personal fortune he pegs at more than $500 million to substantially bankroll his campaign for governor. Yet Rauner has offered voters only a narrow glimpse into his personal finances, releasing three years of basic tax forms without the kind of detailed, supporting documentation such as schedules that many other candidates often make public.

Experts say the limited nature of his tax disclosure makes it difficult to draw a complete financial picture of Rauner, and the candidate himself has been reluctant to fill in many of the gaps.

In a Tribune interview focused on his taxes, Rauner said his returns "very carefully" adhered to the tax code and that he paid everything owed. At the same time, he said he could not recall some details surrounding losses he claimed and deductions he took.

"My income is based upon a whole lot of things. It's capital gains through carried interest. It's through management fees I get across all the funds," said Rauner, who characterized his earnings as "lumpy" because they fluctuated widely from year to year.

"I've been a very large owner in every GTCR fund over 32 years. I also have other personal investments, some of which generate ordinary income of various types, some of which generate capital gains, some of which generate interest income," Rauner said. "Breaking apart all that detail is hard to do."

Central to Rauner's campaign is his financial success, which he argues is proof of the kind of leadership savvy needed to turn around a financially ailing state. But that approach comes against the backdrop of a broad national argument over the meaning of an ever-widening gap between incomes of the wealthy that keep growing and those of the middle class that have been stagnant for years.

That debate led to political headaches in 2012 for former Massachusetts Gov. Mitt Romney, then the Republican presidential nominee.

And there are significant parallels between Romney and Rauner, both of whom made fortunes at the helm of private equity firms. During his campaign, Romney released two years worth of voluminous tax returns that provided considerable fodder for critics who argued that he took ample advantage of tax code loopholes favoring the wealthy.

While Romney released more than 700 pages of returns and schedules, Rauner's financial disclosures have been much less extensive.

The campaign of the Illinois Republican has released copies of the two-page 1040 tax forms filed jointly by Rauner and his wife, Diana, for 2010, 2011 and 2012without any accompanying documents. The candidate sought an extension on filing his 2013 tax returns and has yet to submit them, a spokesman said.

In 2012, the intense focus on Romney's wealth and taxes spilled over into the business practices of his old firm, Bain Capital, which was found to have engaged in the same sort of fee waivers that have helped Rauner lower his taxes. Since then, the practice has attracted the attention of the IRS, with a top attorney for the tax agency disclosing at a legal conference in Chicago last year that it has begun looking into the broad use of the strategy across the private equity industry.

"We don't like what we see in all cases," the IRS attorney, Clifford Warren, was quoted as saying by several tax industry trade publications.

Experts say most large private equity firms have employed the strategy, some more aggressively than others.

Private equity firms make money for their partners in a variety of ways. Most, including GTCR, take a 20 percent cut of earnings from the large investment pools they oversee -- revenue referred to as "carried interest" but treated as preferentially taxed capital gains. To encourage investment, federal tax law has long conferred special low tax rates on such investment profits.

Another lucrative source of equity firm revenue is management fees, essentially charges for the service of overseeing investments. Most equity firms levy a 2 percent annual charge on the assets they manage for clients, but Rauner has said the GTCR charge is 1.5 percent.

Service fees charged by most professionals, be they money managers or plumbers, are typically considered regular income and subject to taxation at the top of whatever tax bracket the individual qualifies for under the federal progressive tax system, tax experts said. In Rauner's case, that was 35 percent through 2012.

At its core, the fee waiver strategy is an accounting maneuver that blurs the line between management fees charged by equity firms like GTCR to manage funds for investors and profits generated by the firms' investments in the funds they manage.

In short, equity firms technically waive collecting on millions of dollars of management fees they are owed, but that hardly means they forgo the value of those fees. Instead, that gets reflected as a stake in the very investments they manage.

When the investment fund turns a profit, often within months, the equity firm receives the cash value of the waived fees and distributes that among its partners.

All that maneuvering might sound esoteric, but it carries profound tax consequences. Tax rates changed in 2013, but before that it meant the difference between paying a 35 percent rate on fee income or a 15 percent rate on investment income.

Put another way, for every $10 million in management fees an equity firm waived, it could save its partners $2 million in taxes.

"It's a technique that is entirely tax-driven," said Victor Fleischer, a professor who teaches tax law at the University of San Diego and has written extensively about fee waivers. "There's no business motivation behind it."

Brian Krob, a corporate lawyer for the Chicago firm of Ungaretti & Harris, said equity firms began charging management fees years ago to cover administrative costs of overseeing huge pools of money. But as the industry exploded in size a decade ago, he said, the income from fees greatly outpaced the costs of running the funds.

With that, the fees became profit centers in their own right for equity firms, which quickly began devising creative ways to minimize the tax consequences, Krob said.

For years, Rauner said, GTCR had relied on a traditional fee structure as it organized a series of investment funds. Clients paid management fees to GTCR, which then distributed the money among Rauner and his partners, who then were taxed on that income at top rates, he said.

That changed in 2009, he recalled, when the firm was organizing a new investment pool, known by Roman numeral as Fund X, that grew to more than $3.7 billion. At that size, the fund could generate more than $56 million annually in management fees for GTCR.

This time the partners opted to forgo taking fees in cash and instead use fee waivers, Rauner recalled, adding that he was hesitant about the strategy but acquiesced to the wishes of other partners. For one thing, he said, the approach required more paperwork.

Rauner said tax consequences were only one of many considerations weighed. "The tax element is one of the factors," he said. "It's all about trading off less certainty for more upside. If you really, really hit it out of the park you can make more money from carried interest just from raw performance. But there's less certainty to it."

Critics, however, contend the strategy involves little risk because equity firms like GTCR, as managers of the investment pools, can be paid the cash value of fees as soon as there is a profit.

"It's a total tax game. There is no nontax reason for it," said Gregg Polsky, formerly a professor in residence at the IRS who now teaches at the University of North Carolina School of Law. "In reality, everyone knows that. It creates the appearance of risk to try and get a tax result."

Polsky said equity firms are at the controls of the investment funds they manage. He said the only scenario that could prevent them from recouping waived fee revenue is if a fund lost money from start to finish without a single profitable quarter.

"If hell freezes over, they might not get their 2 percent, but that's not going to happen," Polsky said.

Rebecca Wilkins, an expert on fee waivers with the Washington-based Citizens for Tax Justice, said the maneuver gives private equity partners a tax edge over even CEOs of Fortune 500 companies. Those executives, she noted, may be paid millions of dollars in salary, bonuses and stock options, but those are earnings on which they typically are taxed at the highest rates.

"By taking their compensation in this way, they are avoiding ordinary income tax rates, which were 35 percent at the time, plus Social Security and Medicare taxes," she said.

For most wage earners, those so-called payroll taxes are deducted directly from paychecks. But Rauner said he hasn't taken a regular salary since the early 1980s.

For business executives like Rauner, the IRS provides an alternative method for paying Social Security and Medicare taxes called the self-employment tax.

Rauner's tax returns report a payment of $15,777 of self-employment tax in 2012 but no payments in 2010 or 2011. He said he and his wife didn't owe the tax in those two years because it is applied to only certain types of income -- in his case the category that showed multimillion-dollar losses in regular business income.

That is not to say that Rauner did not report making millions of dollars off GTCR and other enterprises, but his tax returns spread it among a variety of income categories and it is impossible to determine why he declared such big losses in one of those without the supporting tax documents Rauner declines to release.

Asked to explain those losses, Rauner said he couldn't recall details but speculated that a portion was likely connected with large ranching operations he owns in Montana and Wyoming. "Some of it's farm and ranch income or losses," he said. "That goes up and down year to year. Some of it's operating losses from other investments that I have made."

Despite owing no payroll taxes for two years, Rauner at the same time did remit what are known as household employment taxes, his returns show. Those are tax withholdings deducted from the pay of two personal assistants to cover their Social Security and Medicare taxes, among other things.

Rauner said he would not be releasing additional tax documents beyond the 1040s he had made public. The experts consulted by the Tribune said such broader disclosure would almost certainly shed light on the business losses he claimed as well as other strategies used to minimize Rauner's tax bill.

"Obviously, in virtually every year the vast bulk of my income is capital gains, because that's where my assets go, to purchase equities, ownership in both business and real estate," Rauner said.

He said his returns show large variations from year to year in interest income, self-employment income and other categories.

"Some of those categories of income are susceptible or part of the Social Security, Medicare taxation system and some of those sources of income are not. But some of those sources of income are positive in some years and losses in some years. That's just the nature of the business."

jcoen@tribune.com

bsecter@tribune.com

___

(c)2014 the Chicago Tribune

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Source: Chicago Tribune (IL)


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