New York Times DealBook:   A Tax Shelter Mitt Romney Could Love, by Victor Fleischer (Colorado):

Gov. Mitt Romney’s 2011 tax return highlights the use of a questionable tax planning technique that may have avoided Medicare tax liability on up to $2 million of services income derived from his past employment at Bain Capital. …

Mr. Romney continues to receive cash payments from the companies that
manage Bain Capital’s funds. A couple of weeks ago in this column, I described how private equity firms like Bain Capital convert management fees, which would normally
generate ordinary income, into investments that yield capital gain.

R.
Bradford Malt, the trustee who manages Mr. Romney’s Bain holdings, has
stated that Mr. Romney did not participate in the fee conversion
program. One might have logically inferred, then, that Mr. Romney’s
share of the management fee income would be reported as wage income on
Mr. Romney’s tax return.

Not so. Instead, the payments are
reported on Schedule E of the return as distributions from S
corporations — the largest being $1,961,325 from Bain Capital Inc. The
distinction between wage income and an S corporation distribution is
meaningless from a business standpoint, but it’s important for tax
purposes.

Current law imposes a 2.9% Medicare tax on all wages and
self-employment income. To avoid this tax, taxpayers have an incentive
to characterize as much labor income as they can as investment income
(like carried interest) or as a distribution from an S corporation. …

This strategy, more or less, was made famous by the trial lawyer and former presidential candidate John Edwards, giving rise to what is sometimes known in tax policy circles as the Edwards Loophole. (It has been employed more recently by Newt Gingrich, who has provided speaking and consulting services through an S corporation.)
The IRS has challenged this abuse of S corporations, finding some success in the courts. …

The problem is that the line between return on human capital and
return on investment capital is difficult to draw. By paying themselves a
(modest) salary, the owners of S corporations put the IRS in the
difficult position of having to estimate what a reasonable wage is.

In a recent article,
the law professor Richard Winchester noted that under current law, the
government can rightfully attack these distributions “as being nothing
more than disguised compensation.” But because the government is ill
equipped to perform the kind of audits that would help detect all
potential instances of disguised compensation, Mr. Winchester notes that
“the vast majority of these cases probably go unchallenged.”

The
use of the S corporation as a tax shelter is widespread. A 2002
Treasury inspector general report stated that of 84 S corporation
returns under audit, the average shareholder wage was only $5,300, while
the average shareholder distribution was nearly $350,000. Obviously, in
many of these cases the wage portion is being deliberately understated.

In the case of Mr. Romney, the issue of his Medicare tax liability is
complicated because he no longer provides services to Bain Capital.
Some portion of the payment represents payment for past services
rendered, but perhaps some amount could be attributed to nonwage income.

Existing
case law gives the IRS ample authority to challenge at least some
amount of the “true up” payments as remuneration for services rendered.
If the entire amount were attributed to past services, then Mr. Romney’s
use of the S Corporation avoided $58,000 in Medicare taxes. Without
knowing the terms of the severance agreement, however, determining Mr.
Romney’s proper tax liability is difficult.