Sun Capital: Are private equity and real estate funds a trade or business?

In a decision that could have sweeping implications for private equity and real estate funds, the United States Court of Appeals for the First Circuit held that a private equity fund was engaged in a trade or business for purposes of the multiemployer pension termination liability rules, which reference the tax law concept of trade or business. In Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund et al., No. 12-2312 (1st Cir. 2013), the court held that the private equity fund was in the business of managing the acquired company’s business and that it was not an investor.

Specifically, the management services provided by a general partner to a bankrupt portfolio company can be attributed through affiliated entities up to a private equity fund, which the court held wasn’t a passive investor but satisfied the trade or business prong of the control group test in the ERISA rules.

The court’s finding of a trade or business for ERISA purposes may affect the tax world. Private equity managers have long relied on Whipple v. Commissioner, 373 U.S. 193 (1963), and Higgins v. Commissioner, 312 U.S. 212 (1941), for the proposition that the involvement of a professional manager doesn’t turn what would otherwise be mere investing into a trade or business.

If private equity funds are generally found to be in a trade or business for tax purposes, the ramifications could include ordinary income for managers, effectively connected income for foreign investors, and unrelated business taxable income for tax-exempt investors.

Key concepts from the Sun Capital case:

  • This is an ERISA case involving pension liabilities and not an income tax case, but the trade or business concept transcends both ERISA and the Internal Revenue Code.
  • A private equity firm purchased a brass and copper fabrication company and, basically, used two funds to own it 70/30. The funds had no offices or employees.
  • The court viewed the funds’ managers as agents of the ultimate owners, so it could attribute the agents’ activities to the funds, and that normal agency law establishes a trade or business.
  • The court noted in its decision that its conclusion was limited to section 1301 of ERISA.
  • The phrase “trade or business” is not defined in either ERISA or Treasury regulations and has not been given a definitive, uniform definition by the Supreme Court. The only guidance from the Pension Benefit Guaranty Corporation (PBGC) is a 2007 appeals letter. In the letter, the PBGC adopted a two-prong test it purported to derive from Commissioner v. Groetzinger, 480 U.S. 23, to determine if the private equity fund at issue was a trade or business. The PBGC asked (1) whether the private equity fund was engaged in an activity that has the primary purpose of income or profit and (2) whether it conducted that activity with continuity and regularity. The PBGC found that the private equity fund involved in the matter met the profit motive requirement. It determined that the size of the fund, the size of its profits, and the management fees paid to the general partner established the requisite continuity and regularity. The PBGC observed that the fund’s agent provided management and advisory services and received fees for those services. The PBGC’s approach has been dubbed the “investment plus” standard.
  • The First Circuit used this investment plus standard in reaching its decision.
  • It should be noted that the Groetzinger standard is considered a relatively low bar to reaching a trade or business conclusion by many commentators. The Supreme Court in Groetzinger has held that if one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and isn’t a mere hobby, it’s a trade or business for purposes of the trade or business expense deduction under § 162(a)(1).
  • The decision does not reference the Dagres v. Commissioner case (136 TC 12), where a venture capitalist made a loan to a business associate and claimed a business bad debt deduction. The IRS disallowed the deduction, claiming it was a personal loan unrelated to his trade or business. In Dagres, the court ultimately said the taxpayer was in a trade or business as the taxpayer had multiple roles with respect to the venture capital business: owner/employee of management company and member-manager of general partner LLC (nominal capital in each deal).
  • The Dagres case also left unresolved the question of capital gains vs. ordinary income for a carried interest:
    • “It may be anomalous that, with the IRS’s concurrence, a venture capitalist may treat its receipt of “carry” as a nontaxable event … and may then report its eventual income as capital gain, see Rev. Proc. 2001-43 … section 4.01, but that treatment is not challenged here. Accordingly, even though this profit interest is compensation for personal services, it is deemed to remain pass-through income with the same character in the hands of the recipient (the General Partner LLC) as in the hands of the partnership (the Venture Fund LP), i.e., primarily capital gains from investment.” (emphasis added)

While the court didn’t mention Dagres in its decision, the case is important as the IRS may use a combination of Sun Capital and Dagres to start asserting funds, or more likely fund managers, are in a trade or business.

Key concerns:

Does that decision provide the IRS ammunition to attack the manner in which private equity partners are taxed on carried interest? To the extent the question turns on whether the private equity fund is managing the trade or business, the case may well be dispositive. On one hand, fund managers may argue that the case resolves only what defines a trade or business for the narrow purpose of assessing withdrawal liability under the Multiemployer Pension Plan Amendments Act (MPPAA). However, the court’s statement that “the Whipple ‘without more’ formulation is perfectly consistent with an investment plus test” suggests that the court’s views regarding the trade or business status of the typical private equity fund may have relevance in determining whether, for tax purposes, a private equity fund is engaged in a trade or business. Coupled with Dagres, the IRS could assert ordinary income treatment on carried interests amongst other potential outcomes.

Action items:

  • You should be aware that a significant fact the court used to find that the fund was engaged in a trade or business is that the 2 percent management fee paid by the fund to the general partner was partially reduced by fees paid to the general partner by the portfolio company. Offsetting fees should be avoided for this reason.
  • As you structure any new deals, consider this case (as well as Dagres) in planning discussions with your attorneys.
  • Sun Capital is significant to investors who are considering purchasing a business with substantial withdrawal liability exposure or substantially underfunded single employer plans. If you are considering such a purchase, carefully consider the ERISA impacts of this ruling.
  • We expect many private equity funds and  investors to continue to take the position, based on Whipple, Higgins, and similar authority, that they are not engaged in a “trade or business” for federal income tax purposes. Given that Sun Capital is in the ERISA setting, at this time we feel that it is premature to restructure any existing deals based on the outcome of this one case.

For more information or any questions you might have on this topic, please contact your Baker Tilly advisor or send an e-mail to tax@bakertilly.com.