TAX ALERT 2013-10

Court Holds Private Equity Fund is a Trade or Business OVERVIEW In a case that could have tax implications, a Circuit Court of Appeals held that a private equity fund was a trade or business, and not merely a passive investor, for purposes of a federal pension statute. Although the case only involved pension law, it could potentially have significant implications in other areas, including income tax. This Tax Alert will discuss the case and its possible tax implications for private equity funds. SUN CAPITAL PARTNERS V. NEW ENGLAND TEAMSTERS PENSION FUND Background. The Multiemployer Pension Plan Amendment Act of 1980 (“Pension Act”) requires employers that withdraw from certain pension plans to pay their share of the plan’s unfunded liabilities. Withdrawal liability is also imposed on an organization other than the one obligated if it is under “common control” with the obligated organization and is a “trade or business.” Sun Funds (“Sun”), organized as Delaware limited partnerships, is a private equity fund specializing in leveraged buyouts and investments in underperforming companies. The partnerships are overseen by general partners, who have exclusive authority to manage the partnership and have a subsidiary management company, which contracts with the acquired company to provide management services for a fee. When such fees are paid to the management company, Sun receives an offset to the fees owed to its general partner. In 2006, Sun acquired Scott Brass, Inc. (“Scott”), a manufacturing company. In 2008, Scott was unable to remain in business and stopped making contributions to the New England Teamsters Pension Fund (“Pension Fund). Under the Pension Act, the Pension Fund demanded withdrawal liability from Scott and also from Sun, claiming Sun had entered into a joint venture and was under common control. District Court. In 2010, Sun filed an action in federal district court, claiming it was not subject to withdrawal liability because (1) it was not part of a joint venture and did not meet the “common control” requirement and (2) it was not a “trade or business.” In a 2012 decision, the court did not reach the common control issue, and instead based its decision on the “trade or business” portion of the two-part statutory test. The court discussed a 2007 Pension Benefit Guaranty Corporation appeal letter that found a private equity fund to be a trade or business because its controlling stake in the bankrupt company allowed it to exercise control through its general partner. The court found the letter unpersuasive because it incorrectly attributed activity of the general partner to the private equity fund and also conflicted with Supreme Court precedent. The court found Sun was not a trade or business because it did not make or sell goods or report income other than investment income. In addition, it was not engaged in the general partner’s management activities. Court of Appeals. The pension fund appealed the case and on July 24, 2013, the Court of Appeals for the First Circuit issued its decision. (On August 7, Sun filed a petition for a rehearing, which was denied. On November 21, Sun filed a certiorari petition with the Supreme Court.) The court first noted that while regulations have been adopted pertaining to the meaning of “common control,” there are no such regulations explaining the meaning of

TAX ALERT 2013-10: COURT HOLDS PRIVATE EQUITY FUND IS A TRADE OR BUSINESS

“trades or businesses.” Supreme Court.

Furthermore, the phrase has not been given a definitive, uniform definition by the

Investment plus standard. The court discussed the 2007 appeal letter, which applied a two-prong test to determine if a private equity fund was a trade or business. The first prong was whether the private equity fund was engaged in an activity with the primary purpose of income or profit and the second was whether it conducted that activity with continuity and regularity. This has been referred to as the “investment plus” standard. The court held that some form of an investment plus standard is appropriate under the Pension Act in determining whether there is a trade or business, as opposed to mere passive investment which would preclude liability. The court noted that the investment plus approach was also applied by the Seventh Circuit. In that case, a pension fund was seeking to impose withdrawal liability on a limited liability company that owned rental property, and the court rejected the LLC’s argument that it was a passive investment vehicle. In the present case, the court held that Sun was a trade or business for purposes of the Pension Act, stating: “In a very fact-specific approach, we take account of a number of factors, cautioning that none is dispositive in and of itself.” The sum of all these factors satisfied the “plus” in the investment plus test, and included the following: Sun made investments in portfolio companies with the principal purpose of making a profit. However, a mere profit motive does not itself make an investor a trade or business. Sun is actively involved in the management and operation of the companies in which it invests. The general partners have exclusive and wide-ranging management authority. They are empowered to make decisions about hiring, terminating, and compensating agents and employees of Sun and its portfolio companies. It is the purpose of Sun to find potential portfolio companies that are in need of extensive intervention with respect to management and operations, to provide such management, and then to sell the companies. Restructuring and operating plans are developed for a target portfolio company even before it is acquired. The initial strategic plan is consistently monitored and modified as necessary. Sun’s controlling stake placed it in a position where it was intimately involved in the management and operation of the company. Its active involvement in management provided a direct economic benefit – an offset against management fees it otherwise would have paid its general partner - that an ordinary, passive investor would not derive. This offset was not from an ordinary investment activity which results solely in investment returns. Supreme Court cases. The court then addressed Sun’s argument that it cannot be a trade or business because that would be inconsistent with two often cited Supreme Court decisions, Higgins v. Commissioner (1941) and Whipple v. Commissioner (1963), which dealt with interpretations of trade or business for other tax purposes. The court rejected the proposition that interpretations of other provisions of the Internal Revenue Code are determinative of the issue of whether an entity is a trade or business under the Pension Act. The court cited another Supreme Court case, Commissioner v. Groetzinger (1987), in which the Court warned that when it interprets the phrase, it does not purport to construe it where it appears in other places. The court also stated it did not see any inconsistency with Higgins or Whipple. “Those cases were concerned with different issues and did not purport to provide per se rules, much less rules determinative of withdrawal liability under the [Pension Act].” In Higgins, the issue was whether certain expenses incurred to manage real estate and other investments were deductible as trade or business expenses. In denying the deduction, the Supreme Court reasoned that the taxpayer merely kept records and collected interest and dividends from his securities, through managerial attention for his investments. “Significantly, the…taxpayer did not participate directly or directly in the management of the corporations in which he held stock or bonds.” In distinguishing this case, the court pointed out that Sun participated in the management of the company through affiliated entities.

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TAX ALERT 2013-10: COURT HOLDS PRIVATE EQUITY FUND IS A TRADE OR BUSINESS

Whipple involved a taxpayer who sought to deduct a worthless loan made to a business he controlled, as a bad business debt incurred in the taxpayer’s trade or business. The taxpayer claimed that because he furnished regular services, he was engaged in a trade or business. The Supreme Court rejected the argument, and held that devoting time and energy to the affairs of a corporation is not of itself a trade or business. In contrast, Sun did not simply devote time and energy to the company, but also was involved with management and consulting. Attribution. In a footnote, the court noted that very late in the case, the pension fund argued that a series of Tax Court cases supported the view that Sun was a trade or business because it was “engaged in the development, promotion, and sale of companies.” The cited cases are Deely v. Commissioner (1980), Farrar v. Commissioner (1988), and Dagres v. Commissioner (2011). The court stated that this argument was “presented too late.” In an article which was cited by the court, Taxing Private Equity Funds as Corporate “Developers”, by Steven Rosenthal, the following is stated with regard to Dagres: Recently, the Tax Court examined the trade or business of the general partner of a private equity fund to determine whether an owner of the general partner of the fund had made a loan in connection with that trade or business…The court observed that the activity of promoting, organizing, financing, and/or dealing in corporations…for a fee or commission or with the immediate purpose of selling the corporations at a profit in the ordinary course of that business is a business…as is developing…corporations as going businesses for sale to customers. The court found that the owner had made the loan in connection with the trade or business of the general partner to render management services on behalf of the fund. The Tax Court, however, stopped short: It attributed the general partner’s trade or business activity only upward (to the general partner’s owners, including the taxpayer). By contrast, the court did not attribute the general partner’s activity downward to the private equity fund itself. That was because the IRS and the taxpayer had stipulated that the activity of the private equity fund was investment and not a trade or business - presumably to allow the fund to treat its gains as capital. The court may need to address the downward attribution question later. The court in Sun went on to address attribution in response to an argument “that because none of the relevant activities by agents and different business entities can be attributed to the Sun Funds themselves, withdrawal liability cannot be imposed upon them.” In rejecting this argument, the court looked to the law of agency in Delaware, since Delaware limited partnerships were involved. The court found that a partner is an agent of the partnership for the purpose of its business and activities, and an act of a partner binds the partnership.. “Here, the limited partnership agreements gave the Sun Funds’ general partners the exclusive authority to act on behalf of the limited partnerships to effectuate their purposes.” These purposes included managing and supervising investments in portfolio companies, as well as other activities. The court concluded that under Delaware law, the general partner of Sun, in providing management services, was acting as an agent of the private equity fund. The court reversed the district court and held that the trade or business requirement had been satisfied by Sun. The court stated, “These private equity funds engaged in a particular type of investment approach, to be distinguished from mere stock holding or mutual fund investments.” It also cited an article explaining that “private equity funds differ from mutual funds and hedge funds because they assist and manage the business of the companies they invest in.” It distinguished managing one’s investments in businesses from managing the businesses in which one invests.

POSSIBLE TAX IMPLICATIONS Even though the Sun case deals only with the Pension Act, there could be broader implications in other areas, including taxation. Although the case reiterated that interpretations of “trade or business” in one area of the law should not be extended to other areas, a similar analysis might be utilized. 3

TAX ALERT 2013-10: COURT HOLDS PRIVATE EQUITY FUND IS A TRADE OR BUSINESS

Income taxation. Private equity funds have been a frequent target of possible tax reform. A recent example is contained in the General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals (known as the Greenbook), released by the Treasury Department in April of 2013. One proposal would tax as ordinary income a partner’s share of income on an investment services partnership interest (ISPI) in an investment partnership, regardless of the character of income at the partnership level. Therefore, such income would not be eligible for the reduced rates that apply to long-term capital gains. An ISPI is a carried interest that is held by a person who provides services to the partnership. If the private equity fund was treated as a trade or business for income tax purposes, that might result in taxation of the carried interest as ordinary income. It could also raise the broader question whether gain from the sale of an underlying investment is capital gain, or instead might also be treated as ordinary income. However, Sun was clearly not an income tax case and for now, this does not appear likely. Nevertheless, there has already been much commentary and speculation on the possible income tax implications of the case. One Treasury official downplayed Sun’s significance for purposes of determining what is a trade or business for broader tax purposes, since it wasn’t a tax case. Another commentator was concerned about the argument that the general partner’s trade or business could be attributed to the private equity fund and could taint the limited partners’ distributive shares. Another believed that even if the general partner was in the trade or business of providing management services, it was not likely there would be downward attribution to the fund in the income tax area. In particular, there has been discussion of the management fee offset, which the court cited as a factor in finding a trade or business. In order to avoid the issue, one suggestion is that private equity funds pay their managers’ salaries directly, while others say it shouldn’t matter where the fee is paid from. Medicare surtax. Beginning in 2013, certain net investment income is subject to an additional 3.8% tax, sometimes referred to as the Medicare surtax. Under the statute, net investment income includes income derived from a trade or business (1) which is a passive activity with respect to the taxpayer or (2) which trades in financial instruments or commodities. Net investment income also includes other income and gains, with an exclusion for property held in a trade or business in which the taxpayer materially participates and which does not trade in financial instruments or commodities. For this purpose, a “financial instrument” is defined to include stocks and other equity interests, which appears to include a private equity funds’ typical investments. If a private equity fund is not a trade or business for purposes of the Medicare surtax, then an investor’s income from the fund will likely consist of interest, dividends and capital gain when the fund sells an underlying investment. All of those types of income are net investment income for purposes of the Medicare surtax. If the holding of Sun is extended so that a private equity fund is a trade or business, that would not appear to change the Medicare surtax result. In such case, the income would still be subject to tax if either (1) the fund was engaged in trading financial instruments or (2) it is a passive activity with respect to the taxpayer.

CONCLUSION Although the treatment of a private equity fund as a trade or business by the First Circuit only applies to the Pension Act, it could have broader implications in other areas of taxation as well. Especially since private equity funds have been the subject of tax reform efforts, it will be important to follow future developments in this area.

-National Wealth Planning Strategies Group

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TAX ALERT 2013-10: COURT HOLDS PRIVATE EQUITY FUND IS A TRADE OR BUSINESS

Note: Any examples are hypothetical and are for illustrative purposes only. Note: This is not a solicitation, or an offer to buy or sell any security or investment product, nor does it consider individual investment objectives or financial situations. Information in this material is not intended to constitute legal, tax or investment advice. You should consult your legal, tax and financial advisors before making any financial decisions. If any information is deemed “written advice” within the meaning of IRS Regulations, please note the following: IRS Circular 230 Disclosure: Pursuant to IRS Regulations, neither the information, nor any advice contained in this communication (including any attachments) is intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. While the information contained herein is believed to be reliable, we cannot guarantee its accuracy or completeness. U.S. Trust operates through Bank of America, N.A. and other subsidiaries of Bank of America Corporation. Bank of America, N.A., Member FDIC. © 2013 Bank of America Corporation. All rights reserved. | 1013SLA | 12/2013

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