Tax Analysts Blog

First Circuit Deals Equity Funds a Blow in Sun Capital

Posted on Aug 12, 2013
The furor over the First Circuit’s decision in Sun Capital Partners v. New England Teamsters hasn’t abated. The court’s holding that a private equity fund was engaged in an active trade or business and therefore was liable for pension liabilities under ERISA could have a profound impact on treaties, the structure of equity funds, and the acquisition of struggling companies. But is the controversy overblown? Will Sun Capital be extended into the tax area to find that more funds are engaged in an active trade or business?

Scott Brass made copper and brass products. It was purchased by the private equity funds Sun Capital Partners III and Sun Capital Partners IV in 2006. The price of copper fell sharply, and the company went bankrupt. Shortly afterward, the Teamsters union pressured the funds to pay $4.5 million in pension benefits. The funds objected, and the matter was taken to the First Circuit.

The court sided with the Teamsters, holding that the funds were not passive investment vehicles. Importantly, it also said that the funds were in a business whose purpose was “to seek out potential portfolio companies that are in need of extensive intervention with respect to their management and operations, to provide such intervention, and then to sell the companies.” That holding scares private equity funds because being in an active trade or business has important consequences in many areas of the law.

Reuters argued that the court decision will deter private equity funds from buying struggling companies. The Reuters article focused on how the decision could reduce the incentives for rescuing struggling firms that have pension liabilities. The article quotes Choate Hall & Stewart, which wrote that the ERISA complications of the holding could mean that each portfolio company in a fund could be held liable for the pension liabilities of other companies in the fund, “if portfolio companies can be connected via a chain of ownership passing through the fund.” The article concludes by pointing out that this is only a pension fund case and that any implications for the tax law are pure speculation.

But the speculation was rampant and probably warranted, given that the court cited an article by Steven Rosenthal of the Urban-Brookings Tax Policy Center in which he argued that private equity funds should be taxed as having ordinary income (“Taxing Private Equity Funds as Corporate ‘Developers,’” Tax Notes, Jan. 21, 2013, p. 361). After the decision, Rosenthal said that Sun Capital should be a wake-up call to private equity firms, which he called willfully ignorant of the tax consequences of what they were doing.

Monte Jackel disagrees with Rosenthal. In a post on his blog, he wrote that the tax law can’t have it both ways, saying, “In order to treat the income earned by the partnership as ordinary, it would be necessary to attribute the trade or business of the partnership, that was at first instance attributed to the partnership from the general partner, to the limited partners. This would be really stretching it, as the expression goes, because the only reason the partnership is treated as engaged in a trade or business in this case is because the partnership was treated as an entity for federal tax purposes in the first instance.” He concludes that “that approach would be applying both aggregate and entity principles to the same parties in the same transaction, and has never been done before by either the IRS or the courts, and would be just plain wrong.”

Private equity funds are on shaky ground in arguing that they are passive investors and should continue to receive capital gains treatment. Funds could well be right in their technical arguments that under partnership law, they are eligible for capital gains treatment. But the popularity of carried interest reform in some parts of Congress, the perpetual quest for revenue raisers, and the general feeling that hedge funds should be more heavily regulated (and, by extension, more heavily taxed) might trump technical legal correctness, particularly if funds begin to lose more cases on their status. If the courts turn against funds, it is unlikely that the IRS, Treasury, or Congress will jump to their defense.

Read Comments (2)

Monte JackelAug 12, 2013

I doubt that the IRS will take action against the funds on this issue. I have
never seen the IRS go against intense public pressure and lobbying groups, and
that is what will happen if it tries to write guidance on the issue. It could
happen that the IRS could actually accidentally take the issue to court and
win, as happened in the Campbell case years ago. But I think that would only be
an accident. I got a very thoughtful comment the other day on my postings by
someone who said that the tax law should treat part of the private equity fund
as capital gain (the funded capital part) and part as ordinary (the part where
services are added to improve the product for sale) but that person pointed out
that the tax law does not favor bifurcation. I suppose Congress could write a
new exception into section 1221 but you still need to split the capital from
the ordinary component. I do not think that this bifurcation issue is any
different than the bifurcation issues faced in the proposed limited partner
self-employment tax regulations of over a decade ago which have gone nowhere.
The article by Steve Rosenthal is an all or nothing approach and has both its
virtues and its problems. It will be interesting to see if either the tax
administrator or the tax writers have the courage and political will to do
anything meaningful on this subject. Past history tells me the answer to that
question is no.

Ronique Breaux JordanAug 12, 2013

Thank you.

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