United States

Are private equity funds engaged in business for ERISA or tax purposes?


In a recent U.S. Court of Appeals decision, a private equity fund (PE fund) was held to be engaged in a trade or business for ERISA purposes. The narrow holding of the case in the ERISA area could affect PE funds since it exposes them to potential liability for unfunded pensions of their portfolio companies. That could affect the valuation of the fund, as well as its portfolio companies. In addition, even though the case did not involve any income tax issues, some tax professionals believe the case could have income tax implications for the private equity industry. The main income tax issues that could arise would relate to the treatment of "carried interest," unrelated business taxable income (UBTI) for tax-exempt partners, and "effectively connected income" (ECI) for foreign partners. Such issues could be affected by a determination that a PE fund is engaged in a trade or business for tax purposes.

The trade or business issue

PE funds have evolved over the years and are sometimes referred to as venture capital funds or investment partnerships. Whatever they are called, many investors, for regulatory or economic reasons, have come to prefer them over hedge funds, mutual funds or business development companies (BDCs).

Historically, PE funds and their owners have faced the question of whether they are in a trade or business of buying, holding, managing and selling businesses, or merely investors. PE funds typically take the tax position that they are not engaged in a trade or business. They view themselves as investors rather than engaged in the trade or business of trading securities or managing companies. In contrast, hedge funds will sometimes adopt the position that they are engaged in an active business of trading securities. The trade or business issue is important for many reasons, particularly since trade or business income creates ECI that is taxable to otherwise nontaxable foreign partners and UBTI that is taxable to otherwise tax-exempt partners. Recently, foreign and tax-exempt partners have been among the biggest investors in PE funds, and any negative income tax implications for such investors could curtail the flow of capital.

An additional concern may be the impact of "trade or business" status on the treatment of capital gains from the sale or disposition of portfolio company shares – including the treatment of any share of those gains allocated to certain active partners as a carried interest. PE funds have historically claimed to be mere investors entitled to capital gains treatment. The fund managers or originators of the fund are typically general partners who are compensated for their managerial services through a combination of fixed fees and a share of the fund's profits once they exceed a specified level. This is what is typically referred to as carried interest. Under current tax rules, the capital gain character of the fund's gains applies to the share of such gains enjoyed by the managers through the general partner's share of the PE fund's capital gains, even though these gains are arguably a form of compensation for personal services provided to the partnership.

Numerous proposals have been advanced to change this treatment, mainly because what appears to be personal service income of the managers is being taxed at capital gains rates. The legislation has not advanced, in part because of the persuasiveness of the argument that the funds and their managers are investors and are not engaged in a trade or business. A contrary view on the trade or business issue could add to the arguments of those who want to see these managers taxed at ordinary income rates.

Many tax professionals rely on a number of U.S. Supreme Court decisions to conclude that PE funds are not engaged in a trade or business for tax purposes, and this ERISA decision does not directly contradict those cases. However, it is important to note that even if the courts changed their views on the trade or business issue for tax purposes, capital gains treatment might still be available for the fund and its managers. That is because capital gains treatment is available, even for sales by a business, as long as the sale at issue is not to a "customer" of the business. A business that does not hold itself out as a dealer in securities may have a strong argument that its sales of corporate shares or partnership interests are not sales "to customers."

What the case actually held

Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund (No. 12-2312, 1st Cir., July 24, 2013) involved the issue of whether a PE fund was engaged in a trade or business for ERISA purposes. That issue affected the question of whether the fund was liable under ERISA for certain unfunded pension obligations of one of its portfolio companies. The court ruled that the fund was liable, among other reasons, because it was engaged in a trade or business. In particular, the court of appeals reversed the lower court holding that the fund was not a trade or business under section 1301(b)(1). That holding was based on several factors that are typical for many private equity funds. These included:

  1. Common ownership and control of 80 percent or more of the portfolio company by the main PE fund and a parallel fund, including control of the board of directors.
  2. A goal of making a profit upon sale of the portfolio company and a practice of having a large role in the management and operations of the portfolio company.
  3. Active involvement in the operations and management of the portfolio company (such as decision-making authority concerning hiring, termination and compensation of portfolio company employees).
  4. The fund's departure from the traditional management fee structure, in that management fees paid by the LPs of the fund could be offset by the 2 percent of annual management fees paid to the general partner. This was found to provide a direct economic benefit to the fund from its managerial activities.

Some of the arguments made by the Sun funds in their defense were that they did not have employees or offices, did not sell or make goods, and did not report income on their tax returns other than investment income. The appeals court examined the fund's private placement memorandum and noted its claim to have contractual rights to participate in the management of its portfolio. It noted that the fund's controlling interest also allowed the fund to implement, restructure, build management teams, and otherwise be active in portfolio company operations. The appeals court also observed that the fund's private placement memorandum stated that its economic objective was to see the portfolio company financially turn around and become profitable so the funds could then sell the portfolio company at a substantial profit. The court also noted that these were not mere potentialities, as such powers were actually exercised by the fund. It examined the minutes of individual meetings where employee positions were approved, major computer system upgrades were implemented, and possible acquisitions were discussed. The appeals court found this to be further evidence of managerial control, indicating that the fund was engaged in a trade or business and was not a mere passive investor.


There is no clear definition of trade or business either for ERISA purposes or for income tax purposes. This recent decision must be taken into account by anyone considering that issue. Tax advisors to PE funds should carefully evaluate the potential effects of the decision on their ERISA liabilities and the tax treatment of their investors and managers.

The only apparent positive consequence of trade or business status for tax purposes would be that the expenses of the PE fund would be deemed ordinary deductions under section 162 rather than expenses of generating profit under section 212. The other consequences are generally negative.

The most alarming issue in the court case above is that the characteristics defining an ordinary trade or business for ERISA purposes are exhibited by many PE funds. Though still far away from treating all PE funds as engaged in a trade or business, the court case is cause for concern. Fund professionals and their advisors should reconsider fund structure and operations, including the extent of direct involvement in portfolio investments and the use of the fee offset arrangement.


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