In a decision with far-reaching consequences for the private equity industry, the U.S. Court of Appeals for the First Circuit has adopted an expansive view of what constitutes a "trade or business" for purposes of determining whether a private equity fund can be held jointly liable for Employee Retirement Income Security Act (ERISA) multiemployer pension withdrawal liability incurred by the fund's portfolio companies. Although the case specifically deals with ERISA liability, a finding that a private equity fund constitutes a trade or business could also have wider tax implications for the fund, its managers and investors, as discussed below.
Background of Case
The case, Sun Capital Partners III, LP et al. v. New England Teamsters & Trucking Industry Pension Fund et al., No. 12-2312 (1st Cir. 2013) (Doc 2013-18003), involved a fairly typical private equity structure in which Sun Capital Funds III and IV (the "Sun Funds") together acquired 100 percent of a portfolio company, with neither fund owning 80 percent or more on its own. The Sun Funds neither had offices or employees nor did they make or sell goods, and they did not report income other than investment income. The general partner of the funds entered into an agreement with the Sun Funds to provide management services to the portfolio company for a fee, with the services to be provided by a subsidiary of the general partner. When the portfolio company paid fees to the management company, the Sun Funds would receive an offset to the fees the Sun Funds owed to the general partner. At some point after the Sun Funds made their investment, the portfolio company filed for bankruptcy and triggered an ERISA withdrawal liability event.
Trade or Business Analysis
ERISA generally imposes joint and several liability for multiemployer withdrawal liability on all entities that are "trades or businesses" under "common control" (generally 80-percent common ownership). The question of what constitutes a trade or business—versus mere investment activity—is not defined in ERISA or its regulations, and it is also not defined in comparable provisions relating to pension plans in the Internal Revenue Code. As noted by the First Circuit in Sun Capital, although there are various references to the concept of "trade or business" in the Internal Revenue Code, there has never been a definition of general application or any regulations expounding a definition for all purposes.
In holding that Sun Fund IV constituted a "trade or business" for purposes of determining ERISA withdrawal liability, the First Circuit placed great weight on the involvement of the Sun Funds and fund managers in the day-to-day management of the portfolio company and on their contractual rights to be so involved. [It is important to note that in a typical venture capital operating company (VCOC) fund structure, such management rights are necessary to ensure the appropriate VCOC treatment.] The court decided that in considering how to differentiate mere investment activities from a trade or business, it must apply an "investment plus" standard similar to the standard set out in a letter issued by the Pension Benefit Guaranty Corporation (PBGC) in a similar context. Although the First Circuit declined to set forth general guidelines on what constitutes the "plus" activities in this standard, it found that Sun Fund IV in this case satisfied the "plus" test (questions relating to Fund III were remanded for further fact-finding).
The First Circuit analysis of what constitutes investment plus is based heavily on the level of involvement of the funds and their affiliates in the management of the portfolio company. In particular, the court listed the following factors (none necessarily dispositive on its own) as supporting a finding that the Sun Funds' activities constituted more than a mere investment in the portfolio company:
As reflected in the operating agreements and investment disclosure materials, the Sun Funds were actively involved in portfolio companies in which they invest.
The operating agreements gave the general partner of each Sun Fund exclusive and wide-ranging management activity.
The purpose of the Sun Funds was to seek out potential companies in need of extensive intervention with respect to their management and operations.
A management team was built specifically for the purchased company, and restructuring and operating plans were developed for the company before it ever was acquired.
Through a series of service agreements, various affiliates provided personnel to the portfolio company for management and consulting services.
Those services generated fees for the Sun Funds' general partner and its subsidiary.
Significantly, the First Circuit rejected the Sun Funds' reliance on two Supreme Court cases, Whipple v. Commissioner, 373 U.S. 193 (1963), and Higgins v. Commissioner, 312 U.S. 212 (1941), which many private equity funds relied on in the past for the position that their fund structures and activities did not amount to a trade or business. The Supreme Court in Whipple rejected the taxpayer's argument that he was engaged in a trade or business (and therefore entitled to certain tax deductions) because of the time and energy he devoted to the affairs of his corporation. Distinguishing Whipple, the First Circuit emphasized that the Sun Funds did not simply devote time and energy to their portfolio investments, without more, but rather were receiving economic benefits from the management services that the Sun Funds provided. Higgins was similarly distinguished on the basis that the taxpayer there did not participate directly or indirectly in management activities.
The First Circuit rejected the argument made by the Sun Funds that no trade or business was conducted at the fund level because the management activities were conducted through agents and affiliates of the funds. The court, relying on Delaware law, found that a general partner of the Sun Funds acts as the agent of the Sun Funds in providing management services to the portfolio company.
Potential Implications of Decision
With regard to the impact of the trade or business analysis, notably the First Circuit stated: "[w]e reject the proposition that, apart from the provisions covered by [Internal Revenue Code] § 414(c), interpretations of other provisions of the Internal Revenue Code are determinative of the issue of whether an entity is a 'trade or business' [for pension provisions under ERISA]." This limiting language may be helpful to private equity funds in that it shows the court acknowledging that the definition of "trade or business" for tax purposes is not necessarily the same as it is for pension purposes. It may be hoped that other courts would recognize this limitation and not apply the Sun Capital decision for purposes of determining whether a foreign investor has Effectively Connected Income (ECI) under section 864 or whether a tax-exempt investor has Unrelated Business Taxable Income (UBTI) under section 512. The consequences of such an extension of Sun Capital to at least some funds could be quite significant.
Even if Sun Capital were expanded beyond its narrow ERISA holding, the tax implications could vary significantly from one fund to another, and even among investors. For example, a U.S. individual investor in a private equity fund might want the fund to be engaged in a trade or business for income tax purposes, because the investor's management fees would be fully deductible under section 162 instead of limited by section 212, whereas a foreign investor may find such a status untenable.
One question not addressed by the decision is whether the Sun Funds satisfy the second prong of the ERISA test—the 80-percent common ownership test—that must be met to extend the portfolio company's withdrawal liability up to the Sun Funds' level. Investment funds that do not acquire an 80-percent interest should not be held liable even if their activities are held to constitute a trade or business under the first prong of the test. The Sun Funds were related, and it will be necessary for the lower court to analyze whether the intersecting relationships in the group are sufficient to satisfy the common ownership prong.
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