When the Romney campaign announced it was releasing Mitt & Ann Romney’s 2010 U.S. Individual Income Tax return (the Romney return), I must admit that I was anxious to review it. Guess I am a bit of a tax voyeur! Even after looking at thousands of tax returns, it is still interesting to review a return and to try and understand the components of the return. The Romney return is especially interesting as it is one of high net worth, high profile individuals and you usually don’t find that type of return posted to the internet! Here is a link to the return from the BostonGlobe.com website. The return has also been posted on various other websites, but I am linking to the BostonGlobe.com website, as the return is posted showing PDF page numbers that I will refer to later. (If you are interested in seeing the tax returns of other Presidential candidates, past & current Presidents, Tax Analysts’ Tax History Project has a database of those returns.)
Although the Romney return is 203 PDF pages long, I will summarize and explain it in hopefully an understandable manner. While tax law may be complex, once the income and deductions have been determined, the actual tax computation, is not as difficult as some believe. I’ll be going over the regular tax, alternative minimum tax and foreign tax credit computations. Whew, it is like tax 101 in a single return! 🙂 After the computations, I’ll share a few observations and comments.
First, I’ll re-summarize pages 1 & 2 of their Form 1040:
Romney 2010 Tax Computation – Summary (right-click on the link to open)
Now that the return has been summarized, the next step is to compute the regular tax liability. To do this, income is segregated by how it is taxed. The Romney’s have two categories of income. Qualified Dividends and Long-Term Capital Gains from investments, that in the Romney’s case, are taxed at a flat 15% and ordinary income taxed based upon the graduated tax rate schedule for married individuals filing a joint return (10% – 35%). Deductions from total income, itemized deductions and the personal exemption are netted against the ordinary income category. Finally, the applicable tax rates are applied against the computed income. Here is the computation:
Romney 2010 Regular Tax Computation (right-click on the link to open)
Alternative Minimum Tax (AMT) is the next computation. The Romney’s Qualified Dividend income and Long-term Capital Gain is taxed at the same 15% rate for AMT as it was for their regular tax. Their ordinary income is adjusted for differences between regular tax and AMT, and then subjected to tax at AMT tax rates. Their personal exemptions and itemized deductions for taxes and job/miscellaneous expenses are not allowed for AMT, so these amounts are added back. Refunds of previously deducted taxes, which were subject to regular tax, are not taxable in AMT since there was no prior tax benefit in AMT, are subtracted out. They also have a small amount of AMT adjustments that originated from some of their partnership investments. Due to the amount of their AMT income, they do not have any benefit of a base exemption from AMT. (The AMT exemption for married taxpayers filing jointly was $70, 950 in 2010 and was reduced [but not below zero] by 25% of AMT income in excess of $150,000.) The AMT tax rate for ordinary income is 26% on the first $175,000 and then 28% on the excess. AMT is the amount that the computed tax under the AMT rules exceeds the taxpayer’s regular tax. The last step in the AMT computation is to adjust the computed AMT for the difference between regular tax and AMT Foreign Tax Credit. AMT is computed on Form 6251 – Alternative Minimum Tax – Individuals and is shown on pdf pages 36 & 37 of the Romney’s return. Here is the Romney’s AMT computation:
Romney 2010 AMT Computation (right-click on the link to open)
The next piece in the computation of the Romney’s 2010 tax is tax credits allowed. The Romney’s received a Foreign Tax Credit of $129,697 and an Other Credit of $1 (from a partnership investment).
U.S. citizens and residents are taxed on their global income from all sources, even if that income is earned in another country and is subject to tax in that country. To mitigate the impact of this potential double taxation, U.S citizens and residents are eligible for the Foreign Tax Credit (FTC). Basically, the FTC allowed is the lessor of the foreign tax paid on the income and the amount of U.S. tax on the income. To the extent that the foreign tax paid on the income is greater than the calculated amount of U.S. tax on the income, this excess may be carried back or over and be used in the computation of a prior year’s or future year’s FTC. For purposes of calculating the FTC, income is allocated among categories of income. For the Romney’s income is allocated between “passive” and “general” categories and the FTC computation is done separately in each category, and it is done for both regular tax and for AMT. The Romney’s paid $67,863 in foreign taxes in 2010 and their FTC was $129,967. Their U.S. FTC exceeded the amount of actual foreign tax they paid in 2010, due to the carryover of foreign taxes they paid in a prior year, but were not able to utilize in that prior year. The FTC is calculated on Form 1116 – Foreign Tax Credit and the four Forms 1116 needed for the Romney’s return are on pdf pages 21-28 of their return.
The Romney’s return reflects $29,151 of Self-employment tax. The Self-employment tax is on Mitt Romney’s income from author/speaking fees and from director’s fees totaling $593,996. I’ll discuss this computation in a future article.
The Romney’s return also shows employment taxes on/withheld from household employees of $$4,270.
The Romney’s total tax reflected on line 60 of their 2010 Form 1040 is $3,009,766. I want to calculate the Romney’s effective tax rate on income. To do that, I’ll subtract the $29,151 of Self-employment tax, subtract the $4,270 of employment taxes relating to their household help and add back the actual foreign income tax they paid of $67,863. The result is $3,044,218. Dividing this total tax amount by the amount of total income (as reflect on their Form 1040, line 22) of $21,661,344 equals an effective tax rate of 14.05%. Here are the computations:
Romney 2010 Summary of Tax & Effective Tax Rate (right-click on the link to open)
So, now that I’ve walked through the mechanics of the return, I’d like to take a look at why the Romney’s enjoy such a very low & perfectly legal 14.05% effective federal tax rate for 2010.
The biggest reason for their low effective tax rate is that they have a significant amount of their income that is taxed at much lower capital gain rates. They have $3,327,678 of qualified dividend income and $12,118,710 of long-term capital gains taxed at preferential capital gain rates out of total income of $21,661,344. ($3,327,678 + $12,118,710) / $21,661,344 = 71.3% of their income being taxed at preferential capital gain rates. Capital gains had historically been taxed in a preferential manner until the The Tax Reform Act of 1986 (PL 99-514) lowered the top marginal rate on ordinary income from 50% to 28% and also set a maximum rate of 28% on capital gains. In 1990, PL 101-508 increased the top marginal rate on ordinary income, but held the maximum capital gain rate at 28%. Subsequent laws changed the computation and lowered tax rates for capital gains. In 2003, PL 108-27 reduced the then maximum capital gain rate on investment type capital gains of 20% to 15%. PL 108-27 also for the first time ever, subjected “qualified dividends” to tax at capital gain rates with the new maximum capital gain (investment type gain) rate of 15%. Formerly all dividends were subject to the ordinary income tax rates (maximum rate of 35%).
If all the Romney’s 2010 taxable income were taxed at ordinary tax rates (no benefit of capital gain rates), their regular tax would increase to $5,813,916. They would have no AMT, because now their regular tax would exceed their AMT. Also because of the higher regular tax, they would now fully utilize their prior unused carryover of foreign taxes paid and their FTC would increase to $148,634. Their net tax on income would increase by $2,837,351 to $5,881,569. Approximately $611,000 of this increase would be attributable to the their qualified dividends being taxed at ordinary income rates. Their effective income tax rate would increase to 27.15%. Here is a comparison of the computation of their effective tax rate based upon 2010 law and the result if there were no preferential capital gain tax rates:
Romney 2010 Summary of Tax & Effective Tax Rate -Comparison (right-click on the link to open)
The Romeny’s have over $4.5 million of itemized deductions (including almost $3 million of charitable deductions) and even though many of these itemized deductions may have been derived from or related to the production of capital gain income, the itemized deductions are all deducted from ordinary income in the computation of their tax.
One alternative approach might be to try and directly allocate itemized deductions for their investment expense, investment interest and gift of appreciated securities (deducted at fair market value and no recognition gain on the difference between the fair market value and cost basis) between ordinary income and capital gain income. However, this would probably be quite complicated as you would have to get into the detail of the expense. For example, how much of the investment fees related to the production of interest and non-qualified dividend income as opposed to qualified dividend and long term capital gain income?
Another approach might be to allocate the itemized deductions in the ratio of long term capital gain and ordinary income bear to total income. As indicated above, 71.3% of their income is taxed under favorable long term capital gain rates. Adjusted for deductions from total income, this becomes 71.4%. Under this approach, 71.4% of their itemized deductions would be allocated to long term capital gain income and 28.6% would be allocated to ordinary income. Here is an example of how their tax might be computed under this approach:
Romney 2010 Tax Computation – Proforma – Apportioned Deductions (right-click on the link to open)
As can be seen in the computation, their regular tax would increase by $645,990 to $3,519,044. (The increase of $645,990 can actually be reconciled by taking the amount of itemized deductions of $3,224,742 and personal exemption of $5,209 now allocated to long term capital gain income and multiplying the total of $3,229,951 by the difference betweeen the marginal tax rates of 35% on ordinary income and the 15% on long term capital gain income: $3,229,951 x 20% = $645,990.) Also in this case, because of the increase in regular tax, AMT goes away (even with computing AMT with the same allocation of deductions). Their allowed FTC also increase as before. After the impact of the elimination of AMT and the increased FTC, their net tax increase under this scenario would be $394,064 and their effective income tax rate would increase to 15.87%. Here is a comparison of the computation of their effective tax rate based upon 2010 law and the result if itemized and personal deductions were proportionally allocated between income taxed at ordinary income tax rates and income taxed at preferential long term capital gain rates:
Romney 2010 Summary of Tax & Effective Tax – Comparison 2 (right-click on the link to open)
So, that is the end of my look at the Romney’s 2010 Form 1040. Hopefully, this has helped you better understand the federal taxation of higher income individuals and, perhaps, caused some thought about the implications of the significant preferential tax treatment of qualified dividends and long term capital gains and the manner in which itemized deductions are utilized. 🙂