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Boutwell, the elder.
We welcome to the Orange Juice Blog our new tax and finance expert who previously commented under the awkward handle TJLocalSA, but will henceforth write under the handle “BOUTWELL,” in memory of [cue Wiki…] “George Sewall Boutwell (January 28, 1818 – February 27, 1905) an American statesman who served as Secretary of the Treasury under President Ulysses S. Grant, the 20th Governor of Massachusetts, a Senator and Representative from Massachusetts and the first Commissioner of Internal Revenue under President Abraham Lincoln. Boutwell, an abolitionist, is primarily known for his leadership in the formation of the Republican Party, and his championship of African American citizenship and suffrage rights during Reconstruction. Boutwell, as U.S. Representative, was instrumental in the passage and construction of the Thirteenth, Fourteenth, and Fifteenth Amendments to the United States Constitution.”
Sticking to his areas of expertise as they intersect with the issues that interest us on this political blog, our BOUTWELL takes a comparative look at the recently released 2010 and 2011 tax returns of the two major Presidential candidates. And … HE’S OFF! – V.
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It would be fitting that after months of long-winded comments mainly about taxation as well as a few exhausting back and forth, that I write an article about the Presidential candidates’ income tax returns.
After months of interest, Mitt Romney released his tax returns in mid-September, approximately five months after President Obama released his returns. It will be up to everyone to come to their own conclusions about what the figures mean to them, but the numbers are the numbers and the best picture we have of both candidates’ income position. By him also only releasing 2010 and 2011, along with a letter from his Big 4 accounting firm, it will still leave many of us wondering “What is it that he does not want to show us?” So, here goes…
The first thing that sticks out about Romney’s return is the sheer size of it. His 2011 return is 379 pages long of which approximately 280 pages are related to foreign disclosures and investments. The foreign investments obviously are what have struck a chord with so many. The second item is that about two thirds of his income is from investments that benefit from lower tax rates (i.e. capital gains and qualified dividends). These two items are probably the biggest differentiators between most of our tax returns and Romney’s besides the sheer size of the figures reported.
A Tale of Two Tax Worlds
Below is a chart showing Romney and Obama’s tax returns broken down into manageable categories:
[click for slightly bigger image]
Romney’s earned income is all from his Schedule C business for speaking/author income as well as Director Fees from Marriott. Obama’s earned income is his salary for being POTUS as well as his book author income. Note that neither Romney nor Obama have any significant business deductions against their Schedule C business income other than commissions (likely to an agent/broker). This would be quite rare in the real world so they may strategically being quite conservative in taking, or not taking, business deductions. Perhaps if everyone’s tax returns were made public, then taxpayers would not be quite so eager to aggressively take deductions.
Romney’s tax rate is significantly lower than Obama’s which illustrates and magnifies the benefits that our current system has for individuals who are investors rather than earners. Virtually all of Romney’s non-qualified investment income is offset by his itemized deductions meaning that even though he has ordinary income which should be taxed at the highest tax rate, because his itemized deductions are about equal to that type of income, he effectively is paying beneficial qualified investment tax rates on all of his income. Contrast that with Obama who has zero lower taxed investment income (he has a sizeable capital loss carry forward) and as such all of his income is taxed as ordinary taxable income. So, despite both of them having income higher than $1MM, one pays a significantly lower rate than the other.
By the way, all of the above is in reference to federal income taxes and not Medicare, Social Security, Self-Employment Tax, State Income Tax, Sales Tax, Household Employee Tax, etc… Yes, I know that other taxes are also important, especially Social Security Taxes and Medicare.
The Value of Deductions and AMT
There has been a lot of talk about limiting deductions for high income earners, but something that I rarely hear as an option is to perhaps first require deductions to be taken against beneficially taxed investment income and then the remainder against ordinary income, or perhaps a pro-rata scenario. If that were the case, Romney would still get his deductions, but they would just not be worth as much since right now they are fully offsetting his otherwise higher taxed ordinary income leaving him solely paying the lower tax rate on his investment income. Maybe it is something that should be considered although writing this entry is the first time it has really come to my attention to this magnitude. The more I think about it, the more I believe that something should be done in this area.
Both Romney and Obama have been impacted by the Alternative Minimum Tax (AMT). Romney is in AMT primarily due to the size of his itemized deductions for state tax and investment expenses. It is relatively rare for someone with this much income to be impacted by AMT although because he loses approximately $2.4MM of deductions, he now actually has some of his income taxed at 28% (the AMT rate). Without AMT, Romney’s tax rates would be even lower: 9% on AGI and 13.7% on taxable. Again, this simply magnifies the benefits of investment income versus earned income. Obama on the other hand is more impacted by pure math of the AMT rather than a certain taxing regime. He also illustrates that as you earn more, you often earn your way out of AMT. In 2010 when he earned $1.7MM he was not in AMT whereas in 2011 when he earned $789K, he is in AMT. This is due to the AMT tax rate being lower than the top marginal rate. AMT hits those who earn less than $1MM much more often than those who earn more than that. It effectively pushes the higher rates to lower incomes.
Foreign Tax Credits
Both Romney and Obama claim the foreign tax credit (FTC). The FTC is meant to avoid double taxation. When a US taxpayer pays tax on income in a foreign land, the US generally offers a tax credit for the tax paid. The US has a worldwide tax system whereas a US citizen pays tax on their worldwide income, regardless of where it is earned. A foreign government generally will tax income earned within their borders, above certain income floors. Romney has over $100K of foreign tax credits in both 2010 and 2011 likely from his investments in entities that have operations in foreign countries. Romney likely has quite a bit of income that has not been repatriated back to the US and as such it is not taxable in the US. Obama also has some foreign tax credits claimed- $5K in 2011 and $22K in 2010. Although I am not entirely sure, it appears that some foreign tax is paid on his author income.
Cancellation of Debt – for Romney?
Another point of interest that I have when reviewing Romney’s tax returns is that he does have cancellation of debt income from one or more of his flow through investments. Not that it is terribly rare to have this type of income, but I am surprised that I have not heard about this at all in the media, although I really don’t listen to much media- I even missed the 60 Minutes special last night. For one party to have cancellation of debt income, another party has to have not collected something they were originally owed. Maybe he does have a little bit in common with the those who have had their houses foreclosed upon…trying to figure out the cancellation of debt rules.
2013 – Increasing Rates Already In Play
Romney will have a significant increase in his 2013 taxes due to the 2010 health care legislation tax increases. In 2013, for those married filers earning more than $250K, they will have a 3.8% tax on their net investment income and another 0.9% on earned income. It is complicated, but I estimate that Romney would see a tax increase of approximately $468K in 2013 if his sources of income and deductions were the same as reported in 2011. This would increase his rates to 17% of AGI and 26% of taxable income.
What does all this mean?
Well, that is for all of us to decide on our own. For me, it confirms that our current system is picking winners and losers. I look forward to comments and will do my best to answer your questions and presume that you will do the same of my question.
General Disclosures
The above is derived tax figures from publicly available documents. The author is not in control of, nor does he have knowledge of, any private information regarding either of the two parties discussed. The sources are believed to be accurate but are not controlled by the author and as such, they may change without notice and without responsibility to update by the author. As always, the author retains the right to get smarter over time. The author is not recommending any tax advice specific or implied. Everyone’s own tax liabilities are their own and the author take no responsibility over them. The above is the author’s sole thoughts and does not represent the thoughts of any other group, organization, or company.
Circular 230 Disclosure
To ensure compliance with requirements imposed by the IRS, we inform you that, unless specifically indicated otherwise, any tax advice, which should be none as previously disclosed, contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any tax-related matter addressed herein.
BOUTWELL signing off.
Welcome to the ranks of columnists, Boutwell! Say goodbye to TJLocalSA for us!
This is a nice piece — but it is chewy (and in parts perhaps even sinewy.)
I have a question or two about Romney’s deliberately not taking all of his deductions so as to keep his tax rate at about 14% rather than, it has been reported, at more like 9%.
(1) How much do those undeclared deductions, to the extent that you can reason out what they would be, affect your analysis? Is there more to the story here than just “I want to look like I’m paying 14%, given that I said that I hadn’t been paying under 13%”?
(2) Is it true that, without penalty, Tomney can simply amend and refile his taxes to take those deductions any time within the next three years (or three years from last April 15, or whatever)? If so, is it appropriate to say that he is “paying a 14% rate” when in fact he not only could, but may yet be, end up having paid anywhere down to a 9% rate for 2011? If he wants to really have paid a 14% rate for 2011, couldn’t he take all of those deductions and then write a check for the amount of his savings to the U.S. Treasury? (Yes, he’s still have the charitable contribution deduction on top of that, so even that trick doesn’t fully work.)
I’ll take my answer off the air.
Glad to contribute Greg…even if it is under a new handle. Income taxes are often complicated and lot to chew on.
1. I don’t believe there is more to the story on the excluded deductions personally other than him being ultra conservative (not D or R conservative, just “safe”) on his lack of business deductions…the same is true for POTUS Obama I believe. On the excluded charity, I do believe it would probably be more in the realm of not wanting to have a low tax rate. I can possibly try to re-run his return with additional deductions tomorrow if I get a chance (still have a number of clients who are trying to tie up their extended tax returns)- the % decrease may not be as much as you may think.
2. Yes, he and anyone else has until the statute of limitations expires to file an amended return. The statute is generally 3 years from the date of filing…so, he has until mid-Sept 2015 or so. Penalties would generally only apply if there was an increase to tax (often avoidable under the right circumstances), which likely would not be applicable as his tax would decrease not increase. He could just right a check but so could everyone else that is calling for increased taxes including some high profile citizens- everyone can always pay more if they feel like doing so. They can also do what Romney apparently has- just not take some deductions. Overall, the best that we know of right now is that he paid about 14% based on his AGI and 21% on his taxable income- that does not seem to be deceptive to me.
I will anticipate your next question; yes, if he loses he definitely would be within his right to file the amended returns and get his money back.
Getting back to you on what his tax rates would look like if he took what has been reported as unclaimed charitable donations ($4MM made vs $2.25MM claimed on his returns)…based on my recalculations, his tax rate based on AGI would go down to approx 10.5% (from 14%) while based on taxable income, it would go down to approx 20% (from 21%). Remember, his donations are not worth as much as POTUS Obama’s due to him being in AMT, so his tax and therefore rate may not have decreased as much as one may expect if they did not understand AMT (taxed at effective 28%). Regardless, it puts him below his 13% claim, but I for one don’t think it is a bad thing to give to charity. Shines a light on the entire system though for sure.
As you notice, I keep indicating a rate based on AGI vs taxable income…in the press, most of the figures you hear is based upon AGI. I personally like looking at the % based upon taxable income for exactly this reason- I don’t think we should vilify someone for making charitable contributions. The charity will reduce both taxable income and tax whereas when you look at it based upon AGI, only the tax changes. I would be saying the same thing if this was the question for Obama also by the way.
Help me understand the deduction issue.
Under “Other Investment Exp” for Romney ’11 the amount of $832,261 effectively wipes out his “Earned Income,” and then the remainder of his income is taxed as investment income, after the rest of his deductions are taken?
Is the OIE management fees for his investments?
I agree with you that investment expenses should only offset investment income.
Demagogue- Unfortunately, I don’t believe we know what the OIE is composed of from his tax returns (I don’t have them in front of me now, so it is from memory). I believe it is from K1’s (i.e. passed through from partnerships mainly) and the K1’s often don’t give detail. It would be my best guess that it is management fees, accounting/professional fees, other investment expenses associated with the generation of investment income.
The amount above is also limited by 2% of his AGI (i.e. the true amount of OIE is actually quite a bit higher- the above amount is after reduction by 2% of AGI, or about $274K). OIE is an add back under AMT (as well as taxes btw), so effectively it is not deducted- essentially his tax would be exactly the same whether he had it or not. His state tax likely was lowered by the OIE which is why you still claim the expense despite not having any federal benefit.
Remember, his non-qualified investment income (interest, non-qual dividends) of about $4MM is also taxed at high ordinary income rates and not just his earned income, so tthe OIE does not on its own wipe out his ordinary income. Obviously, because his other deductions (i.e. charity) are so high, it minimizes any ordinary income tax though (compared to lower qualified rates).
There are limits to the amount of investment expenses one can claim…generally and overly simplified to be up to investment income, but that really is no limitation for someone like Romney. By the way, Romney interest is also investment related whereas Obama’s is mortgage related.
Another issue on his returns is how Bain Capital is paying him his retirement, as carried interest, instead of ordinary income.
This treatment of income as carried interest is reserved for those that “actively” manage investment funds.
Romney’s campaign told Huffington Post that amount is $5.5 million for 2011, saving him about $850,000 in taxes. Is that income listed on the second line as Investment Inc Qualified ?
Sorry for all questions… now you see why I have a CPA.
No probs on the questions…it is quite complicated. Being a CPA is a great profession partly because this is so confusing.
The issue of carried interest is very complex. I don’t believe it would be possible to determine how much is carried interest based on what I have at my disposal (i.e. just his tax returns) or not due to the multiple layers of entities. Generally, carried interest is taxed as capital gains and I would expect that if he had carried interest that the income would pass through as such from partnerships that he and his trusts are invested in. Capital gains I do have grouped in the table as Inv Inc Qualified (along with qualified dividends but not interest income and non-qualified dividends).
Often “retirement” payments are structured in partnership capacities to be the same type of income treatment as they would receive if still in the partnership leadership OR it is actually a payment of what has already happened when he retires yet has not been paid on yet. Retirement in this realm is often not the same as what most workers think of as retirement- it is unfunded and non-guaranteed. Essentially, the retirement is payment over a period of time (lump sum would have too much cash flow impact and you have to let the investments “mature”) for him to leave and let someone else take control and he gets paid for what is already in place of which he was instrumental, presumably, in developing.
I am not familiar with how his retirement is paid out to him, but it would not be uncommon for a payout to be structured as capital gains, if both parties are up for it (often there are competing tax forces in play from each side). Assuming that the $5.5MM figure you provide is correct and we simply want to know what the impact would be if that $5.5MM were taxed as ordinary income instead of LT Cap Gains, I estimate that he would see a federal tax increase of approximately $720K. It is not easy math and thankfully software is available to assist (I have his info input and can make some “what if” calcs). If that was the case, his effective tax rate as a ratio of AGI would go up to approx 19% and as a % of taxable income it would be 29%- relatively similar to Obama.