Press Room: Tax Release

July 31, 2013

Private Equity Funds “Trade or Business” Operator or “Investor”

In a Circuit Court decision (Sun Capital Partners III LP et al. v. New England Teamsters and Trucking Industry Pension Fund et al., No. 12-2312 [1st Cir. 2013]), Sun Capital, a private equity fund, was found to be conducting a “trade or business” for purposes of the Multiemployer Pension Plan Amendments Act (MPPAA) (ERISA).  It is possible that this definition of “trade or business” is only relevant for this limited purpose.

If this finding’s analysis of what is a “trade or business” is held to be relevant for determining a “trade or business” for other provisions of the United States Internal Revenue Code (IRC), the income tax consequences to private equity funds, and their investors, would be significant. The results of such a finding could possibly result in:

  1. Unrelated Business Taxable Income for otherwise tax-exempt investors;
  2. Effectively Connected Income for foreign investors; and/or
  3. Ordinary income for investment managers upon sale or exchange of their ownership in private equity funds and/or the funds’ investments.

In this case, the First Circuit Court, in reversing the findings of the U.S. District Court for the District of Massachusetts, found that:

  1. Sun Capital was in the business of managing the acquired company’s (Scott Brass, Inc.) business and that it was not an “investor”; and
  2. Sun Capital was not a passive “investor” but satisfied the “trade or business” part of the controlled group rules for purposes of the relevant provisions of ERISA.

Generally, the concept of what constitutes a “trade or business," for purposes of various IRC sections, has not been defined with bright-line tests. This decision highlights that lack of definition.

The opinion described many of the business, investment and legal relationships between and among the parties in arriving at its conclusions.

We expect a good deal of analysis and disagreement about the impact of the holdings of Sun Capital on the income tax results from the investments of private equity firms in the short- and mid-term future.