Sun Capital: Trade or Business Armageddon Talk
August 09, 2013Cases
For various reasons, I have not posted on the blog for a while, but the recent Sun Capital decision and the related discussion in certain high profile publications, ABA meetings and such, caught my attention. I am not going to go into detail facts discussion of the Sun Capital 1st Circuit court decision (Sun Capital Partners III LP et al. v. New England Teamsters & Trucking Industry Pension Fund et al., No. 12-2312 (1st Cir. 2013)) but the gist is as follows.
In Sun Capital, the 1st Circuit Court of Appeals reversed and remanded in part a decision of a lower U.S. District Court of Massachusetts and held that a certain private equity fund was engaged in a trade or business for ERISA purposes. The fund recently filed a petition for rehearing to the 1st Circuit.
As readers probably know, most private equity funds are of the view that they are not engaged in a trade or business under the seminal Supreme Court decisions of Higgins and Whipple. Some high profile tax practitioners in the community appear to be of the view that the Sun Capital case spells Armageddon for private equity funds and will devastate the economics of private equity investments. Mainly, the fear appears to be that courts sitting on tax matters can rule that a private equity fund is engaged in a trade or business with the following results (or threats, depending on your point of view). One is based on a “developer” or “promoter” type of theory recently advanced by Steven Rosenthal in an article called Taxing Private Equity Funds as Corporate ‘Developers’ (the article is cited in the Sun Capital case but the theory is not discussed or elaborated on). Under this theory, all of the profits to the manager and the investors will be taxed at ordinary income rates. In other words, this theory would go past what a Levin/carry bill enactment would do and tax all income, both to managers and investors as ordinary income. The second threat appears to be that the fund would trigger UBTI to tax-exempt investors. The third threat appears to be that foreign investors would be hit with ECI.
Before I get to the actual implications of the case, let’s take a look at the threats. Can a fund be viewed as a promoter/developer of portfolio companies, and thus, be taxed under the myriad of developer cases that apply to real estate? If you ask Rosenthal, clearly it can. He has advanced some cogent arguments to this effect in his article which I recommend readers take a look at (published in Tax Notes on January 21, 2013). That said, if you ask most of everybody else in the private equity tax industry, private equity funds don’t fall in this category. I am in this latter camp. The gist of Rosenthal’s theory lies in the “dealer” or “developer” rule of Sec. 1221, which has significant import to real estate investors and developers. The rule provides that a capital asset does not include inventory and property “held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” Whether property is held primarily for sale to customers is a question of fact with an extensive body of law behind it. Courts have crafted numerous factors in resolving the issue including: the nature and purpose of the property acquisition and period of ownership; the length of time the property was held and so on. The key point here is that all of these factors are designed to distinguish something held for investment from something held for sale to customers in an ordinary course of business. In the words of the Tax Court in McManus v. Commissioner, 65 T.C. 197, 212 (1975) the purpose of this rule is to differentiate between gain derived from the everyday operations of a business and gain derived from assets that have appreciated in value over a substantial period of time.
In my private equity tax book, I mused on these trade or business issues quite a bit and pondered that in layman terms, particularly in respect of some large operation funds, it is difficult to argue that they are not engaged in a trade or business. However, in my mind, as a practical matter, it is also difficult to argue that a private equity fund, which is inherently an investment vehicle, should be taxed as a developer or promoter of companies. Are some funds, through their GPs, more actively engaged in the operations of their portfolios than others? Yes, they are. Do some funds “develop” portfolio companies in the pure sense of the word? Yes, they do. However, as a general matter, funds hold property primarily for investment and not for sale to customers. Funds typically are not involved in the day-to-day, create marketing plans, budgets, supervise the workers in the field, and go and sell widgets. In many instances, the funds are actually intent on locking in the founders with rollover equity so that the founders could continue operating and developing the business. While it is difficult to dispute that some funds are closely involved in company operations, the involvement of many funds would not extend further than having several seats on the board of directors and providing some strategic support such as setting strategic priorities, helping with industry relationships and helping with securing financing. Assuming, however, a court finds that a particular private equity fund is engaged in a trade or business, can this convert the carry and the gains into ordinary income? Theoretically, it can, but again, the facts have to be just right, perhaps just as in the Sun Capital case or the Farrar case, which I will discuss in more detail below. Such conversion could occur for example based on some Corn Product theory, or as Rosenthal points out, on some developer/promoter theory. Both the developer/promoter and Corn Products theories are based on the meaning of a capital asset and can be used to conclude that the companies the funds sell are not capital assets. As a result, the funds should not be entitled to the capital gains tax rate. In that regard, in Corn Products the Supreme Court framed a narrow construction of the term “capital asset” and stated: “Congress intended that profits and losses arising from the everyday operation of a business be considered as ordinary income or loss rather than capital gain or loss.”
What about the second threat? If the fund is engaged in a trade or business, would that present a UBTI issue to tax-exempts? It might, but at least to me, it seems that this could be an issue only in limited circumstances. Most tax-exempts already invest in private equity funds through above-the-fund blockers formed for the purpose of avoiding UBTI. The fund could utilize leverage or invest in flow-through portfolio companies which could present UBTI issues in itself aside from any fund trade or business issues. In other words, for tax-exempt investors who participate in funds without a blocker, or the blocker is below the fund, then theoretically, if the fund is treated as engaged in a trade or business, then yes, a tax-exempt investor could have a UBTI issue.
The third threat, seems to me, could only materialize if the “trade or business” is one of promoting and developing property. Again, this is what Rosenthal advocates. To have ECI, the foreign investor obviously has to derive profits from some business. Moreover, that business has to be something other than trading or investing, which is subject to the broad statutory trading exception under Sec. 864(b)(2)(A). The only meaningful challenge that I am aware of to this relatively established rule of law is in the context of a lending trade or business. Private equity funds have long struggled with this ECI issue, but again, that has nothing to do with being a promoter. Therefore, ECI isn’t really a new issue and experienced practitioners should be familiar with planning to avoid it. Most foreign investors already participate in private equity funds through blockers, akin to tax-exempts, but with the purpose of minimizing ECI instead of UBTI.
With this long prelude, what are the tax implications of the Sun Capital case? In my view the implications would be rather narrow and remote, but as I explain below, they could be material if the stars align just right. First, the facts of the case are not representative of most of the private equity fund industry, at least judging in my personal narrow experience. The court here basically focused on the issue that the fund was not really engaged in managing its investments as in Higgins and Whipple, but it was engaged in managing the business in which it invested. The court went into a rather thoughtful analysis of distinguishing Higgins and Whipple and pointed out that in this case, the fund did not merely devote time and energy to the affairs of the portfolio company, but it derived benefits other than as an investor, in this case funneling of managing and consulting fees. This was essential to the decision of the court. Second, the court’s decision is confined to “trade or business” under Sec. 1301(b) of ERISA. Nowhere does the court state that the decision should be read to provide “trade or business” guidance outside ERISA. To the contrary, when the taxpayer attempted to rely on tax cases such as Higgins and Whipple, the court specifically pointed out that trade or business interpretations or definitions for purposes of other sections of the IRC are not relevant for ERISA purposes. In other words, the court expressly said that the “trade or business” definition is not uniform. Third, the court never ruled that Sun Capital was engaged in a promoter or developer business. The court did not address the issue because it was brought too late. Lastly, the most significant consequences to the fund and its investors would arise if a fund is held to be engaged in such a business, as compared for example, to some other business, such as the business of managing a portfolio company.
All of the above said, is this case significant or notable in any way for tax purposes? I think it is. Despite its narrow ERISA implication, the case sets a roadmap, at least in the 1st Circuit, for treating a private equity fund as engaged in a trade or business. Moreover, while the “promoter”-“developer” issue was not reached, it seems to me that the court was persuaded by some of the facts, and if the issue was up for consideration, the court could have ruled “promoter” based on these facts. The issue was very persuasively argued by New England Teamsters (defendants in this case) and the facts specifically stipulate that it was the purpose of the fund to seek out potential portfolio companies that are in need of extensive intervention with respect to their management, to provide such intervention, and then to sell the companies. In other words, the court was impressed by facts showing intent to resell as part of an ordinary business. Considering that intent is one of the key elements of the “developer” analysis of Sec. 1221, it is not a far stretch to say that if this court had to rule on the issue on these facts, it could have ruled that the fund was a “promoter” for Sec. 1221 purposes. Also, this is just about the only case that I know of that has ruled that a private equity fund is engaged in a trade or business by distinguishing Whipple and Higgins, two of the seminal “trade or business” tax cases. There are other tax cases such as Farrar v. Commissioner, T.C. Memo. 1988-385 and Dagres v. Commissioner, 136 T.C. No. 12 (March 28, 2011) that support the view that the fund’s GP may be engaged in a trade or business (and under Farrar, particularly in the business of developing or promotion of business enterprises). But there are no cases, to the best of my knowledge, that support the view that the private equity fund itself is engaged in such a business.
The import of this of course pertains to the ordinary income tax consequences of the investors of the fund as compared to the GP of the fund only. If a tax court were to follow the analysis in this case, and under the right facts, distinguish Whipple and Higgins just as the Sun Capital court did, and if a court also attributes the activities of the GP to the fund, then this could have significant negative consequences to both the GP and the fund’s investors. Those are a lot of “ifs” however. The facts have to be similar to say, those in Farrar where the taxpayer was rehabilitating ailing banks, replaced management with his own trained managers, personally promoted the business, and it was evident that the profits were a result of his personal services. As I said, at least in my personal experience, most funds do not get involved to this great of extent in portfolio company operations. For those who do, however, the Sun Capital case and particularly the Whipple and Higgins analysis therein, is something to keep in mind.
On the bright side, those funds should also keep in mind that the “trade or business” determination is not necessarily all bad. One of the key consequences of this characterization is that management fees and other expenses will be treated as above the line expenses just as with hedge funds instead of separately stated expenses subject to the 2% limitation. Some funds have even made an effort to be viewed as engaged in a trade or business to mitigate this particularly nasty issue for their investors. For example, in Rev. Rul. 2008-39, a fund of funds investing in hedge funds was trying to deduct above-the-line expenses for the UTP fund on the premise of being engaged in a trade or business because it was a partner in the LTP hedge fund trade or business. The IRS did not agree with this for several reasons, one of which was that the business of the LTP was not relevant for purposes of determining whether UTP can deduct expenses as trade or business expenses.
It is difficult to say whether this case would have any real impact on funds but one thing is certain -- the case added some kindling to the “trade or business” debate started by Rosenthal. While I see some meritorious argument for the GP being taxed at ordinary income rates on some “promoter” or “developer” theory under the right facts, I fail to see the persuasiveness of the argument for taxing limited partners under the same theory. Of course, how I see it does not matter that much as long as Tax Court judges start seeing it more like Judge Lynch, who ruled in the Sun Capital case. Again, I think this is not the right result, particularly in respect of the fund’s investors, but only time will tell. It will be interesting to see how Judge Lynch handles the fund’s petition for rehearing, which questioned the court’s use of the “investment-plus” approach and rejection of Whipple, and claimed that the fund never received any management fee offset (a key factor in the court’s ruling).