One of the benefits of being a fashionista is the ability to understand when other phenomena that people believe herald some brave new world are just fads.
Investing is subject to fads and fashion. Monetary policy is subject to fads and fashion. Economics, especially, is subject to fads and fashion -- and bad ideas don't go out of style once they're shown to be bad.
What's going on in men's fashion? We're still looking at relatively tight suits with natural shoulders and ankle-length cuffed pants. But men's clothes are being made from interesting technical fabrics.
The tight Tom Ford suits worn by Daniel Craig in the most recent James Bond film, Skyfall, are emblematic. The suit is so retro '60s that it goes well with the classic Aston Martin DB5 that the movie hauled out of mothballs.
Craig's suit was fairly conservative, very tight, and made of stretch fabric. The jacket's shoulders are natural, the lapels are narrow, the V is deep, and the sleeves are cut to show shirt cuffs. The trousers are tapered and just hit the shoe tops. Craig wore a narrow tie and tabbed-collar shirt.
It is well known that Craig worked out 16 hours a day to get himself in shape for the film. Craig's jacket gaped at the neck during one of the initial fight scenes, which a jacket should never, ever do. Otherwise the suits hold their own, even while the jacket is buttoned, during a lot of physical scenes.
Is this a revolution in menswear? It's actually a revolution in fabric technology. It was always possible to blend wool with stretchy synthetics, but it wouldn't look like Savile Row fabrics. The newest fabrics have enough stretch to do fight scenes while maintaining a dressy look.
High-fee investing is going out of style. The mystique is gone when hedge funds can't outperform the indexes. Some sovereign wealth funds have cut out private equity managers by buying companies themselves and hiring people to run them.
Private equity is an investing style, not a separate industry, that is a revival of the old leveraged buyout but with the partnership form of organization. Like fashion, private equity may have run its course. We may be in the late stages.
Fees paid by private equity targets for the privilege of being managed are going out of style because investors noticed that private equity managers were leeching cash out of portfolio companies that way.
Fortune recently described monitoring fees as a skim from portfolio companies. Private equity managers used to argue that portfolio companies should pay them to be managed and monitored, otherwise they'd have to pay McKinsey for the same privilege. But the fees have nothing to do with the portfolio company's actual needs -- they are set at the time of acquisition (Fortune, Sept. 5, 2013).
In more recent deals, there are no monitoring fees, or investors have been promised a 100 percent rebate of them. Some fund managers are offering rebates on older deals. But as Fortune noted, funds are still charging transaction fees, in which a portfolio company pays a fee for the privilege of being acquired.
It's a good thing, too, because an appellate court held that these fees were a factor that put the managers and their fund in a trade or business for purposes of termination liability upon a portfolio company's withdrawal from a multiemployer pension plan.
The First Circuit decision in Sun Capital Partners III LP et al. v. New England Teamsters & Trucking Industry Pension Fund et al., No. 12-2312 (1st Cir. 2013), stands to seriously disrupt the "rip, strip, and flip" equation of private equity investing. The private equity funds' petition for a rehearing was denied. (Prior coverage: Tax Notes, Sept. 2, 2013, p. 975.)
Private equity uses a lot of tax gimmicks, but profit from this investing style depends critically on other financial factors. And the pejorative "rip, strip, and flip" describes these factors rather well.
Rip: The target must be acquired cheaply and the borrowed money to buy it must be cheap. There is no problem with borrowing money under the Fed's zero interest rate policy, but acquirers have overpaid for targets in the late stages of this fashion.
Strip: As in the old leveraged buyouts, private equity acquirers use the target's own cash to help finance the acquisition and feather the managers' nests. Sun Capital stands to impede access to terminated pension plans, and indeed to constrain the ability of a fund to terminate a plan at all.
Flip: Upon sale of the target, private equity managers and investors hope to enjoy capital gains treatment and no effectively connected income or unrelated business taxable income. For those treatments, the funds would have to be mere investors and would have to be able to sell at a gain.
What's this got to do with taxation? Not as much as some commentators and readers think. Sun Capital primarily affects private equity at the "strip" level -- expense reduction and access to target funds -- and not at the "flip" level -- capital gain treatment.
In Sun Capital, a couple of private equity funds unsuccessfully argued that the trader/investor tax standard should be invoked to relieve them from pension termination withdrawal liability. Did the court rely on the tax law to get to its pension result? No. Is the investment plus standard the court used new? No. It has been the law in the Seventh Circuit for a decade.
Can we re-import what the First Circuit did back to the tax law? The decision is result-oriented, but this result didn't need the tax law. Unions are in court all the time with business owners resisting pension termination liability, and courts have been aggressive in imposing liability. Other circuits have addressed similar questions, including in the context of a private equity fund.
The bottom line is that Sun Capital does not put private equity investors in a trade or business for tax purposes. It does put them in a trade or business for purposes of withdrawal liability from terminated pension plans. That may be a bigger blow to private equity math than ordinary income treatment for investor returns would be.
What's a judge to do when a $10 billion private equity fund walks away from a dying company like a discarded toy, leaving the Teamsters pension plan to pick up the mess?
Sun Capital Advisers LLC specialized in turnarounds of undervalued companies (it was not a party to the case). The investment advisory firm, which employed 123 managers, structured the deals for its private equity funds and provided management services to the portfolio companies.
Two Sun funds, Sun Capital Partners III and IV, owned 30 percent and 70 percent, respectively, of a limited liability company that owned a holding company that acquired Scott Brass, a Rhode Island brass and copper industrial coil fabricator, for $8 million in early 2007. Sun Fund IV, the majority owner, had $1.5 billion of committed capital.
The general partner of each Sun fund was a limited partnership of which the two individual founders of Sun Capital Advisers were the managers, entitled to two-thirds of the profits of each general partner.
Each general partner owned a subsidiary management LLC for the fund, which was hired to manage the portfolio companies. The general partners' ownership of the management LLCs is unusual. In most private equity funds, there is overlap in ownership and personnel, but not ownership of the management company by the general partner. The Sun funds paid fees to the general partner; most funds pay the fees to the management company.
The general partner LLCs were entitled to a management fee of 2 percent of committed capital and 20 percent of the profits of the funds they managed. When a portfolio company paid a management fee to the management LLC, fund investors received a credit for the management fee they owed the general partner. In short, the investors' management fee was being paid by the portfolio companies.
The two founders were heavily involved in managing the Scott Brass business. The funds' general partners made hiring decisions and threw a lot of bodies at the project. Managers who worked for the fund management company sat on the Scott Brass board.
In late 2008, after the copper price bubble burst, Scott Brass technically violated its loan covenants because its inventory lost value. It stopped contributing to the local Teamsters pension plan. A month after that, its creditors put it in involuntary chapter 11 bankruptcy.
Another month later, the Teamsters sent the funds a bill for $4.5 million for pension fund withdrawal liability of a ratable share of vested unfunded benefits (29 U.S.C. section 1381). That is roughly the amount of cash the Sun funds borrowed to buy Scott Brass, and more than their equity investment, which they told the court they lost.
If the Teamsters multiemployer fund were to become insolvent, the Pension Benefit Guaranty Corp. would pick up responsibility for pension benefits, which would be reduced from what was promised in the union contract. So the Teamsters had an interest in the continuing solvency of their fund.
ERISA, which is contained in the tax code and labor laws, has a special rule designed to pierce the corporate veil to prevent employers from avoiding pension liability by putting operations in separate entities.
ERISA technically considers the Sun funds to be venture capital funds because they have contractual rights to participate in the management of operating companies and exercise those rights in the ordinary course of their business (29 C.F.R. section 2510.3-101(d)). In footnote 4, the First Circuit declined to adopt the Teamsters' argument that all venture capital funds are in a trade or business.
The Multiemployer Pension Plan Amendments Act (MPPAA) was intended to bolster ERISA by preventing contributing employers from fleeing underfunded union plans by imposing withdrawal liability on them regardless of the plan's financial condition at the time. Often when a union plan becomes shaky, it is because the entire industry is in crisis.
Under the MPPAA, withdrawal liability can be imposed on a related company if it is under common control with the obligor and is itself engaged in a trade or business. So a commonly controlled group counts as a single employer. All trades or businesses within that group are jointly and severally liable for the withdrawal liability of any other member. The policy is to prevent the avoidance of withdrawal liability obligations by fractionalizing assets.
The relevant statute states: "For purposes of this subchapter, under regulations prescribed by the [PBGC], all employees of trades or businesses (whether or not incorporated) which are under common control shall be treated as employed by a single employer and all such trades and businesses as a single employer." (See 29 U.S.C. section 1301(b)(1).)
A parallel rule in the tax code, section 414(c), treats all employees of trades or businesses under common control as employees of a single employer. Section 414 regulations define common control as 80 percent of vote or value, or a brother-sister relationship in a controlled group (reg. section 1.414(c)-2). A partnership can be a trade or business for this purpose (reg. section 1.414(c)-2(a)). Sun Capital did not decide the common control question.
The PBGC's ability to interpret section 1301(b) is constrained by the statement in section 1301(b) that "regulations prescribed under the preceding sentence [aggregating commonly controlled trades or businesses as a single employer] shall be consistent and coextensive with regulations prescribed for similar purposes by the Secretary of the Treasury under section 414(c) of title 26."
There is a similar statement in section 1301(a)(14)(B) that "the determination of whether two or more persons are under 'common control' shall be made under regulations of the corporation which are consistent and coextensive with regulations prescribed for similar purposes by the Secretary of the Treasury under 414(c) of title 26."
Neither the IRS nor the PBGC has regulations defining trade or business. So the statutory reference to section 414(c) doesn't have to bring in any tax precedent. It merely requires that the two agencies interpret trade or business and common control consistently for purposes of imposing withdrawal liability and other ERISA rules that go with common control.
All the PBGC had before the court was its own Appeals Board letter (an administrative opinion) opining that a private equity fund was in a trade or business in a single-employer pension plan termination liability situation. Relying on tax precedent, the Appeals Board figured that a fund had to be in some sort of business (Commissioner v. Groetzinger, 480 U.S. 23 (1987)).
The Appeals Board's two-part test asked whether the private equity fund was engaged in an activity for the primary purpose of profit, and whether it conducted that business with continuity and regularity. Readers will recognize the Groetzinger test. The PBGC found the profit motive in the partnership agreements, and continuity and regularity in the size of the private equity fund and its fee earnings.
The PBGC also thought about agency. It observed that the private equity fund management company got 20 percent of the profits. It attributed the acts of the management company, as the fund's agent, to the fund. The fund in question had a controlling interest in the portfolio company whose termination liability was at issue. One does have to put termination liability where the money resides.
The PBGC dubbed its test "investment plus." It appeared in Sun Capital as amicus curiae on the side of the Teamsters. The PBGC asked both courts for deference to its opinion and didn't get it.
But at least one important court has endorsed the Groetzinger test. That would be the Seventh Circuit, home of the largest Teamsters' pension fund and the venue for a lot of withdrawal liability cases (Central States, Southeast and Southwest Areas Pension Fund v. Fulkerson, 238 F.3d 891 (7th Cir. 2001)). No economic nexus between the obligor and commonly controlled trades or businesses need exist (Central States, Southeast and Southwest Areas Pension Fund v. Personnel, Inc., 974 F.2d 789, 792 (7th Cir. 1992)).
The Seventh Circuit reaffirmed this view recently, in a case in which the individual owners of a contributing employer rented real property to it and its employees maintained the property as their agents. Some family entities had no employees, but the court held statements of purpose against them. The court held that the owners and their other company were in related trades or businesses, making them liable for withdrawal liability (Central States, Southeast and Southwest Areas Pension Fund v. Messina Products, LLC, 706 F.3d 874 (7th Cir. 2013)).
It was only a matter of time before a private equity fund wound up in court with multiemployer plan termination liability, and the Sun funds were not the first. A similarly structured deal, in which three private equity funds owned a group of companies, went to district court in Michigan (Board of Trustees Sheet Metal Workers' Nat'l Pension Fund v. Palladium Equity Partners, 722 F. Supp. 854 (E.D. Mich. 2010)).
In Palladium, fund managers sat on the boards of the portfolio companies. They had hands-on involvement in reorganizing the companies. They ran the finances and met with customers. The district court found the PBGC opinion persuasive, but refused cross-motions for summary judgment on the view that the facts could be interpreted either way on the trade or business question. The court noted that the private equity funds had stated purposes and actions that went beyond mere investment. The parties settled.
Sun Funds III and IV won a summary judgment in district court that they were not liable for withdrawal liability on the ground that they were not engaged in a trade or business (Sun Capital Partners v. New England Teamsters & Trucking Industry Pension Fund, 903 F. Supp.2d 107 (D. Mass. 2012)). That court noted that the PBGC's deficit is more than $5 billion.
While lawyers have been structuring private equity deals to avoid the 80 percent threshold for some time, no one asked for opinions about termination liability. That's quite a roll of the dice considering the potential amount, the Seventh Circuit precedent, and the antiavoidance rule in the MPPAA scheme (29 U.S.C. section 1392(c)).
Lawyers advising private equity funds warn that they could stop acquiring more than 80 percent interests in portfolio companies, or just stop buying companies with big pension liabilities. Private equity funds could offer lower prices for such companies. It's not as though sellers of companies will start offering guarantees for unfunded liabilities. Or private equity funds could buy business assets instead of entire companies, as in the recent Hostess deal.
Trade or Business
"The income tax law, almost from the beginning, has distinguished between a business or trade, on the one hand, and 'transactions entered into for profit but not connected with . . . business or trade,' on the other," Justice Harold Blackmun wrote in Groetzinger, citing Whipple v. Commissioner, 373 U.S. 193 (1963).
The phrase "trade or business" appears hundreds of times in the code. The tax law has many variations of a trade or business test, with the test used depending on the question being asked. Blackmun recognized this problem in Groetzinger, explaining why there was no one trade or business test:
The difficulty rests in the Code's wide utilization in various contexts of the term "trade or business," in the absence of an all-purpose definition by statute or regulation, and in our concern that an attempt judicially to formulate and impose a test for all situations would be counterproductive, unhelpful, and even somewhat precarious for the overall integrity of the Code.
In Groetzinger, the Court stated that an interpretation of the phrase for one purpose does not control others. Footnote 8 states: "We caution that in this opinion our interpretation of the phrase 'trade or business' is confined to the specific sections of the Code at issue here. We do not purport to construe the phrase where it appears in other places."
Groetzinger was a full-time gambler, and the Supreme Court wanted to make sure he wasn't a dilettante. Dissenting Justice Byron White accused the majority of making a result-oriented decision to spare him a harsh minimum tax, flouting the will of Congress, which did not intend for gambling to be a trade or business.
Trade or business is a factual question, so no single test would cover all situations. For investment funds, the tax law focuses on the dichotomy between traders and investors, which determines whether losses will be ordinary, whether expenses are fully deductible, and whether gains will be capital.
The tax law makes it difficult for investors to have a trade or business, and the IRS to this day resists section 475(f) elections. It's all about preventing ordinary losses from being taken too permissively.
Turns out there are lots of really busy investors, who somehow never get good enough at their purported business to avoid losing money. Under Higgins v. Commissioner, 312 U.S. 212 (1941), continuity and regularity of conduct are not enough to make investors into traders. The test for investor status revolves around what kind of returns the investor is getting.
In Higgins, the taxpayer, a Paris resident, had an extensive portfolio of commercial real estate and securities that he devoted much of his time to managing, with the assistance of his New York and Paris offices and staffs. He deducted his expenses as the ordinary expenses of a trade or business under the predecessor of section 162. The IRS allowed the expenses for the real estate, but disallowed them for the securities.
"The petitioner merely kept records and collected interest and dividends from his securities, through managerial attention for his investments," the Court said, belittling the taxpayer's participation. Higgins "did not participate directly or indirectly in the management of the corporations in which he held stock or bonds." The facts, the Court concluded, did not permit reversal of the tax administrator's judgment, which the courts had sustained.
Mostly, the Supreme Court deferred to the tax administrator's discretion to interpret the phrase "trade or business." The Court stated that "no matter how large the estate or how continuous or extended the work required may be, managerial attention to your own investments does not constitute a trade or business."
Whipple was a business bad debt case. The taxpayer wanted to deduct a loss for a worthless loan that he had made to a business he controlled. The Supreme Court concluded that he was an investor. Whipple is often cited to prevent bad debt deductions by business owners and executives. The Court stated:
When the only return is that of an investor, the taxpayer has not satisfied his burden of demonstrating that he is engaged in a trade or business since investing is not a trade or business and the return to the taxpayer, though substantially the product of his services, legally arises not from his own trade or business but from that of the corporation.
But what if the service provider takes on outside investors as partners and uses their money to buy lots of companies, some of which are successfully reorganized and others bankrupted? The tax law doesn't have a good answer to a hyperactive investor/service provider.
The Tax Court bucked Whipple on a business bad debt deduction in Dagres v. Commissioner, 136 T.C. 263 (2011), imputing a partnership's business to a partner. The taxpayer loaned money to his mentor and forgave the loan when the latter's company went bust, as so often happens in Silicon Valley.
The taxpayer was an individual member/manager of the general partner LLCs of several venture capital fund limited partnerships sponsored by his firm. At stake was a bad debt deduction for a loan the manager made to a source of investment leads. The taxpayer was one of the faces of the firm, and often joined the boards of portfolio companies.
The Tax Court found that the general partner was in the trade or business of fund management even though all it did was hold profits interests in the funds. Then the court attributed the general partner's business to its members without explanation. The IRS did not dispute that the individual taxpayer was in the trade or business of the general partner.
The IRS argued that the venture capital fund itself was an investor. The Tax Court did not go so far as to put the manager in the business of the fund's portfolio companies.
For private equity, the question riding on investor status is entitlement to capital gain. It's clear that private equity investors and managers are not traders. So again, the question is whether the trade/investor differentiation is asking the right trade or business questions for them. It was clear to the district court in Sun Capital, whose decision the First Circuit reversed, that Groetzinger was not the right test.
The district court relied on Higgins and Whipple to hold that the fund was an investor. The court also rejected a PBGC argument that the funds were in constructive partnership with Scott Brass.
District Judge Douglas P. Woodlock found the PBGC's informal opinion unpersuasive on the ground that it misinterpreted the tax precedent and wrongly attributed the general partner's activity to the funds, which were passive pools of capital with no employees.
"The trade or business of an agent does not transfer to the principal," Woodlock stated. It did not trouble the court that the same manager signed both lines on the management agreements.
"That the general partner of each fund was receiving non-investment income does not mean that the Sun Fund itself was engaged in the full range of the general partner's activities," Woodlock stated, noting that the funds' tax returns listed only dividends and capital gains.
Whether any kind of fund manager is in a trade or business is a factual question that makes the government nervous. The IRS won't make blanket statements whether any investment fund or manager is engaged in a trade or business (Rev. Rul. 2008-39, 2008-2 C.B. 252). At a recent meeting, a government official would not take a position on the Sun Capital decision. (Prior coverage: Tax Notes, Sept. 9, 2013, p. 1066.)
First Circuit Decision
The Groetzinger test asks whether the taxpayer got out of bed every morning and went to the dog track -- yes, the dog track. This might not be the right inquiry for private equity managers, but it has become the accepted test for pension termination liability.
The First Circuit described its approach to what the Sun managers were doing at Scott Brass as "investment plus" while denying that it was deferring to the PBGC letter. The court concluded that Sun Fund IV, which owned 70 percent of the LLC that owned the holding company that owned Scott Brass, was in a trade or business.
Both Sun Funds III and IV were in court. There was an argument in the lower court about how the pair divided ownership of Scott Brass to avoid a control relationship under ERISA. Sun Fund IV, the majority owner, had admitted at trial that it had sufficient capital to buy 100 percent of Scott Brass. The funds admitted that this ownership structure was intended to minimize withdrawal liability.
The First Circuit affirmed the district court's holding that the funds' ownership arrangement was not a transaction to avoid or evade withdrawal liability (29 U.S.C. section 1392(c)). So the court held that Sun Fund IV, at least, was in a trade or business. The two courts appear to have ignored the separate identity of Sun Fund III.
The First Circuit was not moved by the funds' plans to resell the company. It focused on what the managers were doing while they were reorganizing Scott Brass. The court noted that the fund management company stated reorganization of troubled companies as a purpose. Chief Judge Sandra Lynch threw the management company's promotional materials right back at them.
For the court, the question was whether the private equity funds, acting through their agents the managers, were active or passive. They would have to be really passive to avoid withdrawal liability.
The court focused on the considerable management and consulting fees that Scott Brass paid to the general partner. The court concluded that Sun Fund IV received advantages from Scott Brass before the latter was put into bankruptcy. An ordinary passive investor would not have a portfolio company paying its fund management fees, Lynch noted.
Sun Fund IV received a direct economic benefit by means of Scott Brass effectively paying the fees that investors contractually owed the general partner. The company paid $186,000 to Sun Fund IV's general partner, which was offset against the fees charged to investors.
These fees also served to distinguish Whipple, in which the taxpayer only got an investor's return. The First Circuit said that the very common arrangement in which the whole management fee is rebated to investors by means of a portfolio company paying a monitoring fee takes the investors out of the protection of Whipple.
Lawyers used to worry about fee sharing and plan for smaller rebates. But investors don't want to pay hefty fees, so 100 percent rebates have become common. If a court in a tax case were to look through a fee arrangement and conclude that investors were effectively sharing in monitoring fees, those investors would have to hope that their ordinary income would be limited to the fees. That is, they would argue for capital gain on the sale of the portfolio company.
The First Circuit distinguished Higgins on the ground that the definition of trade or business does not have to be consistent for pension and income tax purposes. Tax law criteria do not dictate pension law consequences when the purposes of the pension rules would be unfulfilled (United Steelworkers of Am., AFL-CIO & Its Local 4805 v. Harris & Sons Steel Co., 706 F.2d 1289 (3d Cir. 1983)).
Lynch noted that the tax law does not have a single definition. And Higgins did not participate in the management of his portfolio companies. The Sun Funds argued that Groetzinger cannot be interpreted inconsistently with Higgins, which Blackmun tried to distinguish while he was picking a rationale.
The funds argued, correctly under the tax law, that the trade or business of a partnership cannot be attributed to the investors. The First Circuit rebuffed this argument, using agency theory, Delaware state law, and the funds' partnership agreements. Under state partnership law, all partners are agents of a partnership. The general partner of the funds was acting as the investors' agent in relation to Scott Brass.
Here's what should scare private equity fund managers: While applying "investment plus," the First Circuit declined to delineate "plus." It held that if the controlling parties, acting through their agents, were doing something more than passive investment, they were on the hook for termination liability.
So investment plus may be described as an active/passive test. The Sun Funds derided the First Circuit test as "we know it when we see it" in their unsuccessful petition for rehearing. That may be, but investment plus appears to be the law in most of the unionized, industrial Northeast and Midwest.
The First Circuit remanded on the common control question, which the district court did not reach. The case is not over because there is still a question whether Sun Funds III and IV satisfy the common control test.
The Teamsters argued that the two funds form a joint venture. This question was raised in Palladium, when three sister private equity funds faced a union with a multiemployer plan termination liability claim. The structure of the funds' ownership of the contributing employers was similar to Sun Capital, as was the private equity managers' heavy involvement in the portfolio companies.
Three funds from the same sponsor shared ownership -- 62 percent, 27 percent, and 11 percent -- of a group of bankrupt automotive supply companies with collective bargaining agreements. The general partner appears to have treated the trio as a single fund.
The court refused cross-motions for summary judgment on the question whether the private equity funds had a joint venture constituting common control for purposes of the MPPAA. The court relied on the tax law to determine whether a joint venture existed, and concluded that it needed more factual development. The case was settled.
Common control could affect other pension questions, like the aggregation of entities for application of nondiscrimination rules. Another scary prospect for private equity funds is that if a fund trade or business is the deemed parent of a controlled group that includes all its portfolio companies, all members could be jointly and severally liable for the termination liability of any portfolio company.
It's not clear what trade or business the First Circuit would have the managers in. Are they in the money management business, the restructuring business, or the copper fabrication business? It didn't matter to the court, and it doesn't matter to the MPPAA scheme.
Given footnote 4, it does not look like the court put the funds in the money management business. Given the effort some private equity managers put in, a court is hard-pressed to differentiate them from the owners of a closely held Midwestern trucking company.
The most that can be said for the First Circuit decision is that it suggests that tax lawyers might want to look for a different standard than the Higgins trader/investor inquiry to describe what private equity managers do.
The private equity fund gripe about the Groetzinger test is that it is a very low threshold of trade or business. But private equity managers do a lot; raising the threshold using some other test might still put them in a trade or business. Most private equity funds attempt to reorganize their portfolio companies, either a little or a lot. That's the mystique -- the managers will work some magical transformation of the portfolio company.
Certainly running someone else's money can be a trade or business. Whipple and Dagres tell us that. Even hired guns who go in and reorganize might be viewed as essentially working for the investors. So they could be money managers, while the investors would still be investors.
The tax law has no good explanation of what should be the treatment of active investors who get their hands dirty running their portfolio companies and accept fees for services, but do not become employees of those companies. They wear a lot of hats, which make their investors vulnerable to agency arguments.
Private equity funds usually take the position that they are investors, entitled to capital gain treatment on the sale of shares of portfolio companies, and entitled to the benefits of nonresident investor status. They don't flip portfolio companies with enough volume or frequency to be considered traders.
And these funds do not seem to be dealers because they do not have customers. A dealer would clearly be engaged in a U.S. trade or business, so that foreign investors would have effectively connected income.
The difference between a dealer and a promoter or developer is that a promoter or developer works some transformation on the asset to be resold. A dealer does not transform its holdings, which are inventory that it merely resells. The developer/promoter line of cases offers an explanation for what private equity managers do to portfolio companies. (Prior analysis: Tax Notes, Jan. 21, 2013, p. 361; and Tax Notes, Feb. 11, 2013, p. 651.)
The Sun Capital court explicitly refrained from addressing the promoter question. In footnote 26, Lynch said that the promoter argument was raised too late.
Could Sun Funds be described as promoters? They admitted in their promotional materials that companies were to be reorganized for the purpose of being sold within five years of acquisition.
Private equity managers do get separate compensation for managing portfolio companies -- they are not limited to an investor's return under Whipple. And the managers who are working in the portfolio company's business typically don't take salaries from the company. Their investors might be less vulnerable to agency arguments if the managers made themselves portfolio company employees and took salaries.
Ironically, the less scrupulous practices of some private equity funds would do better to prevent them from having a trade or business of being a promoter. If a private equity fund, acting through its managers, merely extracts cash from a portfolio company before reselling it, the argument could be made that the fund was an investor.