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.