How much do private equity players really pay in income taxes? Mitt Romney — the nation’s best-known PE man — says he pays about 15%. While Romney’s 2010 (final) and 2011 (“in process”) tax returns seem to confirm his view, the reality (explained below) is more complicated. John Berlau and Trey Kovacs suggest in their Tuesday WSJ op-ed that Romney pays 44.75%, a long way from 15%. The real number is probably somewhere in between. Let’s look at Romney’s 2011 (in process) tax return:

If we take “effective tax rate” to mean total tax paid divided by total income, Romney’s 2011 effective federal tax rate (at least on the surface) equals 15.4% calculated as Line 61 ($3,226,623, below) divided by Line 22 ($20,908,880, above). The comparable percentage from Romney’s 2010 tax return is 13.9%. So how do Berlau and Kovacs — joined since by Paul Caron at Tax Prof Blog — get 44.75%?

The Berlau-Kovacs-Caron calculation assumes that Romney’s direct 15% rate is imposed *on top of* taxes of 35% (the top corporate marginal tax rate) presumably already paid on the same income before it gets to Romney.

Let’s say that through a private equity partnership Romney buys Toys R Us (“TRU”) (Wait. He did!) which thereafter earns taxable income of $100. If the $100 were taxed at 35%, TRU would pay $35, leaving $65 for distribution as (taxable) dividends to Romney. Since dividends* are taxed to individuals at 15%, Romney himself would pay an additional $65 x 15% = $9.75. The total federal tax burden on the original $100 of TRU income would therefore be $35 + $9.75 = $44.75. (The math would be the same if TRU pay no dividends but Romney later sells his TRU stock. This is because the share price should reflect the $35 corporate-tax “bite”.)

That’s the Berlau-Kovacs-Caron number. But is it right? Not necessarily. It depends on at least three key assumptions: (a) TRU is tax-structured as a C corporation, not as a flow-through partnership; and (b) TRU has taxable income and pays the maximum 35% rate during Romney’s period of ownership; (c) related to (b), TRU does not use net operating loss or tax credit carry-forwards to reduce or eliminate its tax paid. While (a) may be a relatively safe assumption, (b) and (c) are not. Private equity players typically invest in companies that are under-performing or in outright financial trouble. This suggests that most PE investees are acquired with carry-forwards of one kind or another that effectively reduce their corporate tax rates to well under 35%.

Therefore, while the average individual investor should expect an effective federal tax rate of about 45% on income from corporate investments, private equity players are not average. No individual’s tax return (not even the Romney’s 547 pages of 2010 and 2011 tax returns) provides all the details, but it’s fair to say that Romney’s tax posture differs from the average principally because so much of Romney’s taxable income flows through from private equity partnerships. Because of how private equity partnerships work — essentially healing companies unhealthy and selling them once they are healthy again — it is likely that much of Romney’s PE income arrives in his tax return not previously taxed or at rates lower than 35%. Result: Romney probably pays significantly less than 44.75% on his private-equity income. This is not to say that what he pays is too little. What tax rate is fair or appropriate is a more complicated question for another day.

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* We assume here that the dividends are “qualified dividends” subject to a preferential 15% rate. Otherwise, the dividends would be taxed at the taxpayer’s ordinary income marginal rate.