Unlocking the mystery of Romney's 15 percent tax rate. Yes, it's legal.

Mitt Romney can pay a tax rate of 15 percent because his income, from investment firm Bain Capital, is structured as capital gains in the form of 'carried interest.' Here's how it works.

It may sound illegal; it may sound like a tax dodge. But Mitt Romney’s declared tax rate of about 15 percent, well below that of most Americans, is perfectly legal and accepted by the Internal Revenue Service.

How can that be?

Mr. Romney, who lists his wealth at as much as $250 million, still receives much of his income from Bain Capital, a Boston investment firm that he helped found in 1984.

When Romney was working for Bain, he would have received his compensation in two ways: First, a fee charged to clients and taxed as regular income, amounting to 2 percent of the value of the assets under management. Then, Romney also would have received 20 percent or more of any gains in an investment as long as Bain’s profit exceeded a pre-set rate of return.

However, Romney and his Bain partners did not put up 20 percent of the capital – that came from the firm’s clients, other investors such as pensions. From their profits, the client investors pay the Bain partners in what is called “carried interest,” which is taxed at the longterm capital gains rate of 15 percent.

What is carried interest?

It is simply a percentage of the profits of the underlying investment. Although it is unclear where the term comes from, Victor Fleischer, an associate professor of law at the University of Colorado, says one possible origin is from the oil and gas business where someone raising money to drill for oil did not put up much money but received a share of the income if oil was discovered. “Their interest is carried by other investors,” explains Mr. Fleischer.

How does this work?

Bain Capital made a lot of investments in companies. If they bought one company for $100 million and sold it three years later for $200 million, they would have a $100 million capital gain. Out of that gain, Bain could have received as much as $20 million to $25 million, says Fleischer. Bain would then divide its share among the partners who worked on the purchase and sale. Perhaps Romney got $2 million even though he never invested much of his own money. In other words, his interest was carried by the other investors and he is taxed at the longterm capital gains rate for his share of their profits.

Is this widespread?

Fleischer says other well-to-do investors who use this method to get their money are real estate partnerships, oil-and-gas partnerships, and publicly traded investment partnerships. Although hedge-fund managers make large sums of money, much of this money is short-term capital gains, which is taxed at 35 percent.

The Joint Committee on Taxation has estimated that taxing carried interest as regular wage and salary income would generate about $21 billion in additional revenues over ten years.

Has been there any effort by Congress to change the law?

Yes, the House of Representatives has passed legislation sponsored by Rep. Sander Levin (D) of Mich. to tax the money differently. President Obama has indicated he would support a change. But, the US Senate has not done anything, says Roberton Williams, a senior fellow at the Tax Policy Center in Washington.

“The question is how should it be taxed?” asks Mr. Williams. “Since it’s not all regular income, there must be some middle ground that makes logical sense.”

Isn’t it unfair for plumbers and policemen to pay a higher tax rate than investors such as Romney?

Fleischer says the law was originally enacted in 1954 to try to be flexible with small businesses. Now, he says, “it’s used by billionaire investment partners. That’s not what Congress had in mind.”

One of the critics of the law is Warren Buffet, the Omaha-based investor, who has said he pays a lower tax rate than his secretary since he receives carried interest.

However, opponents of making changes say Mr. Buffet should just write a check if he wants to pay higher taxes.

Fleischer says it strikes him as important to change the law, which he says is utilized by sophisticated, knowledgeable people who can afford expensive lawyers. “The rest of us don’t get this kind of treatment,” he says.

However, in testimony before Congress in 2007, Adam Ifshin, then the chairman of the International Council of Shopping Centers Economic Policy Committee, argued that changing the law to increase taxes on carried interest would hurt real estate investment in economically distressed areas.

In addition, he argued that the general partners in real estate partnerships took on heavy risks that their deals would fail. “The general partner is taking risks beyond their investment in any given real estate project, and the carried interest is earned, in part, for taking that entrepreneurial risk,” he said.

Proponents of the current law argue the carried interest is not compensation. “It is a feature of an ownership interest,” said Bruce Rosenblum, managing director of the Carlyle Group, a private equity group, in testimony before Congress in 2007. “Its tax status is well settled and it is anything but a loophole.”