Tax Analysts Blog

Sun Capital Might Be Bigger Than You Think

Posted on Sep 23, 2013
Practitioners, commentators, and taxpayers have spent weeks trying to figure out the importance of the First Circuit’s decision in Sun Capital. When the court held that a private equity fund was in a trade or business for the purposes of ERISA, it caused many to wonder whether tax law would be affected. Perhaps the only people that were conspicuously silent were government officials, who declined to speculate on the case. That changed at the American Bar Association meeting in San Francisco when a Treasury official confirmed that the case did give the government an opportunity to reassess its position on trade or business.

Before any private equity fund lawyers panic, the government isn’t necessarily going to change what it thinks trade or business means. Craig Gerson, attorney-adviser in the Treasury Office of Tax Legislative council said, "I think there's a recognition that the court's decision in the First Circuit may give us an opportunity to reassess what trade or business means. We are approaching it with caution. We understand that the law here has worked fairly well as it has stood for a long period of time.” Gerson added that no one was in a rush to issue guidance and that any change would be “policy-driven” (whatever that means) and would come after the results of the case’s remand.

Any new Treasury position is likely to be unfavorable to private equity taxpayers. The permissive interpretation of trade or business status has allowed funds to achieve favorable tax treatment for their income and kept foreign investors from having what is called effectively connected income, which would subject them to U.S. tax. Treasury has always been lenient on foreign investors in terms of tax and information reporting as a means of encouraging investment in the United States (notice how often the United States is referred to as a tax haven by foreign countries and the uproar over the possible reporting of Florida bank accounts to foreign tax administrators). If the government were to reassess its view on trade or business, private equity funds could be subject to ordinary income rates or UBIT rules, and foreign investors could have to pay U.S. tax. Any or all of those would be devastating to an industry already struggling to meet expectations.

Gerson’s statement that “the law here has worked fairly well” shows where Treasury’s bias lies and should give some comfort to fund managers, investors, and advisers. The fact is that the law is only really working well for private equity funds. It’s not exactly clear how it benefits regular taxpayers, the fisc, or the economy at large. The government is forfeiting revenue it could be collecting from private equity funds, both in the form of taxing foreign investors and preferential rates given to fund income (particularly regarding carried interest compensation). Is this permissive tax policy encouraging more productive investment? The workers at Scott Brass probably aren’t so sympathetic after Sun Capital’s funds tried to avoid paying pension liabilities.

Sun Capital is a unique case, with particularly bad facts for the funds. The funds’ attempts to avoid $4.5 million in pension liabilities after being intimately involved in the failed restructure of Scott Brass were not viewed sympathetically. And the First Circuit went out of its way to stress how limited its holding was (although it did reference both the tax law definition of trade or business and a paper by Steven Rosenthal on why private equity funds are in a trade or business for tax purposes). The court could easily have reached a different conclusion on ERISA liability with even slightly different facts.

But bad facts make bad case law, as the old saying goes. In this case, bad for private equity funds, might be good for the tax system in general. There is no valid tax policy reason why funds that engage in the business of buying and developing companies or those that take an active management role in restructuring should be considered mere investors by the tax law. Treasury might not want to reassess its position, but if funds keep up unsympathetic conduct perhaps outside parties like the Teamsters in Sun Capital might force it to. And that would probably be good for everyone.

For those interested in a lively discussion of what Sun Capital might mean for the law, Tax Analysts will host a panel discussion of the case on Friday, September 27, at the National Press Club in Washington. There will be a live videostream of this event that you can access on Friday afternoon.

Read Comments (2)

richard g. jacobusSep 24, 2013

I respectfully disagree with the suggestion that Sun Capital signals a
potential shift in the definition of a trade or business for federal income tax
purposes.

The First Circuit got off to a great start by correctly noting (slip opinion
pp. 17-18) that the imposition of withdrawal liability under 29 U.S.C. §
1301(b)(1) is a statutory form of corporate veil piercing. But the wheels came
off the opinion when, for reasons inadequately explained, the First Circuit
made the analytical leap (pp. 18, 35) from the corporate veil piercing issue to
case law addressing the definition of a “trade or business” for federal income
tax purposes. Whether a taxpayer may claim a loss deduction, or characterize
the deduction as an ordinary loss rather than a capital loss, for federal
income tax purposes has nothing to do with corporate veil piercing, a remedy
available to creditors in some circumstances.

True, the 2007 PBGC appeals letter made the same analytical leap (pp. 19-20).
It is unclear, however, how the PBGC transmuted the Groetzinger definition of a
"trade or business," applicable for income tax purposes, into the "investment
plus" standard for imposing pension liability under section 1301(b)(1). This
is the weakest link in the entire analysis, all the more so because the First
Circuit’s discussion of Chevron, Auer, and Skidmore deference (pp. 20-23) to
the PBGC’s "investment plus" interpretation of the term "trade or business" is
superfluous to the holding.

That said, arguably the Sun Funds got what they deserved by arguing incorrectly
(p. 30) that Higgins and Whipple established the ironclad test for the presence
of a “trade or business” at all times and places. In all likelihood the Sun
Funds argued for a uniform legal definition of "trade or business" because
their argument against veil piercing was factually less persuasive and unlikely
to prevail at the summary judgment stage.

The First Circuit correctly rejected absolute consistency with Higgins and
Whipple as the correct manner of interpreting the term "trade or business" for
purposes of withdrawal liability under section 1301(b)(1), noting the Supreme
Court's statement in Groetzinger that it has expressed no uniform definition of
that term for federal tax purposes (pp. 18-19, 31-32). Remarkably, the First
Circuit then came full circle and declared (p. 35) that its "investment plus"
test is consistent with Higgins, Whipple, and Groetzinger. Again, why should
that kind of consistency matter? Congress has not said that withdrawal
liability under section 1301(b)(1) hinges on the same facts that drive a “trade
or business” analysis for federal income tax purposes, nor that the underlying
policy aims are alike or even similar. Courts have no valid reason – at least
none identified by the First Circuit – to presume such an equivalence.

Lastly, as others have noted, the First Circuit's reliance on agency law
principles and the management fee offset (pp. 36-39) is flimsy at best.
Entirely too much weight was given the management fee offset received by Sun
Fund IV. And, more to the point, these sorts of facts may be probative in the
veil-piercing context, but are inapposite to a “trade or business” inquiry
under Groetzinger, Whipple, and Higgins.

Steve RosenthalSep 28, 2013

Mr. Scott's observations are spot on. Treasury is taking the "trade or
business" issue seriously, which is a positive development. I also am somewhat
concerned that institutional inertia might prejudice the outcome, but we must
wait and see.

Mr. Jacobus offers valuable insights. However, I believe Sun Capital merely
observed the obvious: private equity funds engage in a trade or business.
And now there is an appellate decision that applies the leading tax authorities
for trade or business--Groetzinger/Higgins/Whipple--to private equity (and,
largely, applies these authorities correctly).

I agree with Mr. Jacobus that withdrawal liability is a form of piercing the
corporate veil. But the 1st Circuit did not use this extra authority for its
decision. Rather, the 1st Circuit applied normal agency principles “[w]ithout
resolving the issue of the extent to which Congress intended in this area to
honor corporate formalities.”

By analogy, hedge funds and mutual funds engage in a trade or business, with
any of their own offices or employees. They act through their general partners
and investment advisors, respectively, yet both are in a trade or business for
tax. Likewise, private equity funds engage in a trade or business with the
help of others.

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