On July 13, 2012, Henry Blodget on Business Insider reveals how Willard Romney accumulated $21 to $102 million in his Individual Retirement Account.
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.
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.
