Legal Alert: Not Exactly a Day in the Sun: U.S. Court of Appeals Holds Private Equity Fund Is Engaged in a Trade or Business

In Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312, 2013 WL 3814984 (1st Cir. July 24, 2013), the U.S. Court of Appeals for the First Circuit effectively found that the separate activities of a private equity fund’s managers caused the fund managed by those managers to be engaged in a “trade or business.” While this decision addressed the issue in connection with pension funding liabilities under Title IV of ERISA, the court reached its conclusion in part based upon an analysis of federal tax authorities. If the court’s conclusions were to be applied more broadly, it could drastically alter the landscape for structuring private equity funds, significantly heighten the tax risks for equity fund investors and managers, and potentially “dry up” financing for cash-starved portfolio companies.

Private equity funds (as well as hedge funds and other pooled investment vehicles) provide efficient structures for various types of investors to pool their funds for investment purposes. The traditional structures utilized for these vehicles have intended tax consequences that encourage various classes of investors and fund managers to participate in these vehicles with expectations of achieving certain goals–foreign (non-U.S.) investors prefer not to pay U.S. federal incomes taxes; U.S. tax-exempt investors prefer to avoid unrelated business income taxes (UBIT); U.S. taxable investors find capital gains appealing; and fund managers seek to realize value in the profitability of the fund’s investments through a share of the upside gains. The success of these ventures is well-documented—many portfolio companies have been salvaged or allowed to grow only because of private equity financing and the investors willing to take the risks have been rewarded.

The success of pooled investment vehicles as an efficient means of providing capital to portfolio companies hinges, in no small measure, upon the underlying position that these vehicles are not considered engaged in trades or businesses, but, rather, are treated as mere investors in the underlying portfolio companies. This position is based on long-standing precedent providing that a mere investor is not engaged in a trade or business, no matter how extensive the investor’s activities in managing its investments. See Higgins v. Commissioner, 312 U.S. 212 (1941). However, the decision in Sun Capital Partners calls this position into question and could present a material risk to pooled investment vehicles (primarily private equity funds) that these vehicles may be considered engaged in U.S. trades or businesses.

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