Private equity funds need not fear tax consequences of Sun Capital, but should they be concerned about where the IRS might take it?

Transcription

1 Private Equity Tax Alert Nixon Peabody LLP November 18, 2013 Private equity funds need not fear tax consequences of Sun Capital, but should they be concerned about where the IRS might take it? By Christian M. McBurney Potential impact of Sun Capital The question has been swirling in private equity circles whether the recent Sun Capital 1 case will result in a drastic alteration in the income tax treatment of investors and fund managers of private equity funds. This author believes that the fears are unlikely to come to fruition, for the reasons stated below. However, it is possible that someday the Internal Revenue Service ( IRS ) will revisit this area and issue guidance that changes the way fund profits are taxed. If it does, U.S. tax-exempt investors, U.S. taxable investors and possibly even non-u.s. investors could have a major disincentive to invest in actively managed private equity funds. This author argues that such a development, if it came to pass, would have a substantial adverse impact on innovation in the U.S. economy. In Sun Capital, the First Circuit Court of Appeals attributed the fund manager s trade or business to the private equity fund in order to impose pension liability on the fund. It is unlikely that Sun Capital, on its own, will have a substantial impact on the taxation of funds. First of all, Sun Capital involved the definition of the term trade or business for ERISA purposes only. ERISA is not part of the Internal Revenue Code. Thus, the case is not authority for federal income tax purposes. The court in Sun Capital made that point several times as well. The narrow issue in the case involved whether a private equity fund could be exposed to potential liability for unfunded pensions of a portfolio company in which the fund held a controlling interest. It is more than conceivable that a court as a matter of policy would want to interpret the trade or business definition broadly in that context. The court seemed most interested in how much control the fund asserted over the portfolio company. By contrast, the definition of the term trade or business used for various income tax purposes is a very different matter. The importance of Sun Capital for income tax purposes can be measured by whether or not tax attorneys revise their standard tax disclosure in private equity offering memoranda. Typically, in such memoranda, the tax disclosure provides that the fund is not expected to be treated as engaged in a trade or business. This treatment has several implications, including that individual investors cannot generally deduct management fees, and losses on sale of stock are capital in character and 1 Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, No (1st Cir. July 24, 2013).

2 therefore are subject to capital loss limitations. To date, the author has not seen any revisions to the applicable tax disclosures. The Sun Capital decision will be important only if the Internal Revenue Service (IRS) uses its reasoning as a springboard for going farther than the case s narrow holding and issues new regulations or other guidance changing the taxation of private equity funds. While a recent IRS official conceded that such an approach is possible sometime in the future, it may not happen at all, and even if it did, it would likely take at least several years before the new rule took effect, and it is by no means clear how broad or narrow such rules would be or whether they would be valid under current statutory authorizations. As will be seen below, the Sun Capital decision itself is rather narrow. It is always possible that some rogue IRS auditor will bring up the issue in an audit of a private equity fund investor or fund manager. If that occurs, it is hoped that the IRS National Office would want to quash the effort so that it could take time to have a comprehensive consideration of the matter before acting, if at all. The narrow ruling of Sun Capital The reasoning of the Sun Capital decision seems questionable, at least in terms of the definition of trade or business used for income tax purposes. Private equity funds, as well as some other types of investment funds, have typically treated themselves as an investor and not as engaged in a trade or business, relying in part on two U.S. Supreme Court cases. In Whipple, for example, the Supreme Court stated the following: Devoting one s time and energies to the affairs of a corporation is not of itself, and without more, a trade or business of the person so engaged. Though such activities may produce income, profit or gain in the form of dividends or enhancement in the value of an investment, this return is distinctive to the process of investing and is generated by successful operation of the corporation s business as distinguished from the trade or business of the taxpayer himself. When the only return is that of an investor, the taxpayer has not satisfied his burden of demonstrating that he is engaged in a trade or business since investing is not a trade or business and the return to the taxpayer, though substantially the product of his services, legally arises not from his own trade or business but from that of the corporation. 2 Similarly, in Higgins the Supreme Court stated that no matter how large the estate or how continuous or extended the work required may be, managerial attention to your own investments does not constitute a trade or business. 3 The Sun Capital decision itself is narrowly drawn, based on a number of factors, none of which on its own was dispositive. The court of appeals adopted an investment plus test to determine whether the fund was in a trade or business, derived from a standard adopted by the Pension Benefit Guarantee Corporation ( PBGC ) and pension case law (and not income tax authorities). The PBGC s factors included the size of the fund, the size of its profits, and the substantial 2 Whipple v. Commissioner, 373 U.S. 193 (1963). 3 Higgins v. Commissioner, 312 U.S. 212 (1941). The IRS has not ruled very often in this fund context. In Revenue Ruling , the IRS ruled that a fund of funds that solely acquired, held and disposed of interests in hedge funds was not engaged in a trade or business under section 162 and therefore that the management fee paid by the fund was not deductible under section 162 but instead was subject to section 212 limitations.

3 management fees paid to the general partner. In addition to relying on these factors, the court of appeals two main factors were the following: The active role of the general partner in the management and operation of the portfolio companies in which they invest. The court noted that the fund s offering memorandum stated that the fund s purpose was to seek out portfolio companies in need of extensive intervention in respect of management and operations, provide such intervention and sell the companies at a profit. The court further noted that applicable agreements gave the general partner wide-ranging management rights in the portfolio companies and, in fact, the general partner made decisions regarding the hiring, firing and compensation of employees of the portfolio companies. The fund had a controlling stake in the portfolio company at issue. The fund was able to reduce its fees to the general partner by offsetting against the management fees it otherwise would have paid its general partner for managing its investments. As with most private equity funds, the general partner was entitled to an annual fee of 2% of the aggregate capital commitments to the fund, with such fees being reduced to the extent the general partner or its affiliates received fees from other sources. Here, according to the court, the portfolio company made payments of more than $186, to the fund s general partner, which amount was used to offset the fees the fund had to pay its general partner. If the IRS were ever to attempt to apply the same rationale for income tax purposes, reliance on the active role of the general partner in the management and operation of the general partner would appear to be inconsistent with the Supreme Court s Whipple holding, particularly where the only return on investment is sale on gain from appreciation and dividends. Thus, it seems that the existence of the management fee offset structure was particularly important to the court of appeals decision. However, as applied for income tax purposes, it seems odd that such a minor aspect of the fund could have such a major implication as to treat the fund as engaged in a trade or business. It would appear to be a stretch to use the management fee offset structure to change the traditional treatment of a gain on sale of stocks and securities by funds which is to treat such gain as capital gain and not unrelated business taxable income or U.S. effectively connected income. In addition, it is not clear why the management fee offset structure should be treated any differently than if the fund managers were employees of the fund. If the fund managers were employees of the fund, no management fee would be paid to a separate entity. It would thus be clear that the only income of the fund would be based on the return of an investor through dividends, interest and gains on the sales of stocks and securities. It is also controversial that the activities of the fund s general partner entity would be attributed to the fund. The two entities are separate. Even if the general partner is engaged in a trade or business of managing funds, it is not necessarily the case that the fund would also be treated as engaged in a trade or business. It is well established that a partnership s activities can be attributed to its investors. Thus, for example, if a limited liability company that is taxed as a partnership is treated as generating income effectively connected with a U.S. trade or business, such income would be attributed to the non-u.s. direct or indirect investors of such company. But here there is a double attribution: the trade or business of the general partner is attributed to the fund, and then is attributed to the fund s investors. 4 It is true that the activities of an agent can be attributed to its principal for income tax purposes, but the author is not aware of any prior authority arriving at that conclusion for income tax purposes in the fund context. Therefore, it is hoped that, in the unlikely 4 See, e.g., IRC Section 875(1).

4 event that the IRS comes out with a rule that mirrors the Sun Capital holding, it will be prospective and subject to grandfather rules. The developing portfolio companies for resale theory If a private equity fund is treated as engaged in a trade or business for income tax purposes, a key question would be what kind of trade or business. Is it merely earning fees from portfolio companies? If that is the case, the fund s equity interests in its portfolio companies should still be treated as capital assets and gains on the sales of such stocks and securities should still be capital gain, although under section 1231(a). The greatest danger to private equity funds is if the IRS issues guidance to the effect that actively managed private equity funds are in the business of developing, promoting and selling portfolio companies, and that the equity interests held by a fund should be treated as property... included in the inventory of a taxpayer or property held by the taxpayer primarily for sale to customers in the ordinary course of the fund s trade or business. Under that approach, as discussed in more detail in the next section, suddenly all of the fund s previous capital gains would be treated as ordinary income and unrelated business taxable income, and possibly income effectively connected with a U.S. trade or business. It certainly seems a stretch to use the management fee offset hook used in Sun Capital to suddenly treat a fund as holding portfolio stock that is inventory or primarily for sale to customers. The IRS would have to go well beyond Sun Capital to take such an approach. Indeed, the court in Sun Capital explicitly refused to consider the argument that the Sun Funds should be treated as engaged in the development, promotion, and sales of companies on the ground that such argument was presented too late. To treat funds as holding inventory or property held primarily for sale to customers, the IRS would have to adopt a theory propounded in certain circles that fund general partners are in the business of developing, promoting and selling portfolio companies; that such business should be attributed to the fund; and that the fund s stocks and securities are inventory or are held primarily for sale to customers. This could be called the developing portfolio companies for resale theory. It is by no means clear that the IRS would have the authority to issue guidance to that effect. It is well established that a taxpayer that purchases and sells stocks for its own account with the principal purpose of realizing investment income in the form of dividends and gains from appreciation in value over a relatively long period of time is treated as an investor, and not as a seller of inventory or property held primarily for sale to customers. It would not appear that private equity funds have inventory, which is periodically sold to customers, or that is has any customers at all. Potential impact of the Sun Capital approach on types of investors As discussed above, it is by no means clear if the IRS will feel inclined to release any guidance based on the Sun Capital approach, and if it did, how much of an impact it would have. The bigger impact would occur if the IRS decides to go beyond Sun Capital and press for the developing portfolio companies for resale approach. This section of the tax alert considers the potential impact if it did. Unlike the recent carried interest legislative proposals that failed to pass Congress the last several years, which was an attempt to convert some of the capital gain flowing through funds to fund managers to ordinary income, such an approach could adversely affect a wide range of investors and other taxpayers. U.S. tax exempt investors. Many U.S. tax exempt entities invest in private equity funds, relying on the tax rule that gains on sale of stock, securities and most other types of assets are not treated as

5 unrelated business taxable income ( UBTI ) and therefore are excluded from taxation. Today, many U.S. tax exempts are comfortable not only investing in stocks and securities, but also indirectly in limited liability companies that conduct operating businesses. The annual income flowing to the U.S. tax exempts constitute UBTI, and U.S. tax exempts must pay tax on it, but such tax liability is generally no more burdensome than if they invested through a corporate blocker. On a sale transaction, absent the application of the debt-financing rules, in general the only gain from the sale of inventory or property held primarily for sale to customers would be UBTI. Thus, under current law, such a sale would typically generate little or no UBTI. If the IRS were to adopt an aggressive stance, the worst case scenario is that the fund s investments in stocks and securities, as well as in limited liability companies, would be treated as inventory or property held primarily for sale to customers. In that case, a sale of such equity and debt interests at a gain would generate UBTI. 5 As a matter of economic policy, the author believes that it would be a major detriment to the U.S. economy for the IRS to take the position that private equity funds whose portfolio companies are actively managed by the fund s general partner are in a trade or business resulting in the fund holding stocks and securities primarily for sale to customers. If that were to occur, U.S. tax exempts would have little incentive to invest in such funds. Instead, they would invest in funds that are not actively managed. Such a result could result in the diversion of billions of dollars from private equity funds and therefore have a substantial adverse impact on innovation in the U.S. economy. An interesting question is whether U.S. tax exempt investors, out of concern of Sun Capital, will seek to end the practice of management fee offsets. However, it seems unlikely that management fee offsets alone could result in a fund being treated as holding stocks and securities as inventory or primarily for sale to customers. In addition, if the fees are paid by the portfolio companies to the fund rather than to the general partner, such fees would likely be UBTI and would still, of course, provide a benefit to the fund under Sun Capital. The other alternative is to permit the fund managers to keep such fees, with no management fee offset; perhaps the 2% fee payable to the fund manager could be slightly reduced, say to 1.8%, for anticipated fees to be received by the general partner. In that case, the fees paid by the portfolio companies should not be treated as providing a benefit under Sun Capital. Non-U.S. investors. Non-U.S. investors, including sovereign fund investors, are currently willing to invest in the stock of U.S. corporations directly because the corporate tax treatment blocks the attribution of the corporation s operating business to the stockholders. For the same reasons, they are willing to invest in funds that invest in the stock of U.S. corporations. Currently, a fund typically is not treated as engaged in a trade or business, so that gain on sale will not be treated as income effectively connected to a U.S. trade or business ( ECI ) and be attributed to the non-u.s. investors. If the developing portfolio companies for resale approach is adopted for income tax purposes by the IRS, then the fund would be treated as engaged in a trade or business and ECI could flow through to non-u.s. investors. If it did, this would mean that they would have the obligation to file U.S. income tax returns and pay U.S. income taxes at regular rates, and non-u.s. corporate investors would also be liable for the branch profits tax. In addition, the fund would be obligated to withhold U.S. tax at a 35% rate on allocations of ECI. What amount would be treated as ECI, however, is unclear. Code section 864(b)(2) excludes from ECI income earned from trading in stocks and securities for the non-u.s. investor s own account. This provision thus protects non-u.s. investors. Indeed, it was 5 Query how gain from a limited liability company selling its assets could be treated as UBTI.

6 enacted to promote investment in U.S. stocks and securities by non-u.s. investors. Arguably, the IRS would not have the statutory authority to adopt the developing portfolio companies for resale approach and treat stocks and securities of funds as inventory or held primarily for sale to customers. If the IRS succeeded in court in this effort (in spite of section 864(b)(2)), an affected fund s income generally would all be ECI. Again, such treatment would create a huge disincentive for non-u.s. investors to invest in private equity funds that actively manage their portfolio companies. As argued above, this could have a substantial adverse impact on innovation in the U.S. economy. Taxable U.S. investors. U.S. taxable investors, when possible, seek to benefit from favorable capital gains rates. Currently, the maximum federal capital gains rate is 20%, while the maximum federal ordinary income tax rate stands at 39.6%. If the IRS attempted to treat stocks and securities of funds as inventory or held primarily for sale to customers, and succeeded, an affected fund s gain on the sale of stocks and securities held more than one year would all be subject to ordinary income tax rates and not capital gain rates. Such trade or business treatment would have some benefits for U.S. taxable investors: they would be able to deduct their fund management fees without limitation and would be permitted to offset ordinary losses on sale against ordinary income on sale. However, on balance, the loss of capital gain treatment on sale would discourage their investment in private equity funds that actively manage their portfolio companies. U.S. taxable investors would likely prefer investing in private equity funds that do not actively manage portfolio companies, mutual funds, or directly in the stock market. The author doubts that such a tax policy would be designed to improve the U.S. economy. Fund managers. If the Obama Administration had its way, it would probably prefer to apply Sun Capital in a limited fashion so that capital gain flowing through to general partner-owed entities, and eventually to fund managers, is converted to ordinary income, thus accomplishing what the failed effort to enact carried interest legislation could not. It is not clear, however, how the IRS could administratively accomplish that limited goal in the absence of new authorizing legislation. Real estate and other funds. If the IRS attempted to go farther than Sun Capital, and treat funds whose portfolio companies are actively managed as having stock and other equity interests as inventory or held primarily for sale to customers, it could have implications far beyond the private equity industry. Recall that the proposed carried interest legislation was intended to apply to all investment funds, including real estate funds and partnerships, and family partnerships. For example, consider a small partnership of local investors seeking to purchase and refurbish a building, where the partnership s general partner takes an active role in the project. If the IRS adopts the approach that active management of portfolio companies should cause a fund to be treated as holding stock that is primarily for sale to customers, that approach could also turn gain on the sale of the real estate project in this example from what should otherwise be capital gain into ordinary income. Such an approach would generate a firestorm in the real estate industry. Conclusion The author argues that the Sun Capital decision is narrow and unlikely to result in the IRS issuing guidance that will have a substantial impact on private equity funds. However, while it appears unlikely, the case could spur the IRS eventually to adopt a developing portfolio companies for resale theory, which would result in a drastic change in how private equity investors and their managers are taxed on fund profits. It is not clear whether adopting such an approach would, if challenged, be upheld in court. In any event, the IRS (and the Department of Treasury) should carefully consider the potential substantial adverse impact on the U.S. economy such an approach would likely have.

7 For more information on the content of this alert, please contact your Nixon Peabody attorney or: Christian M. McBurney at or This newsletter is intended as an information source for the clients and friends of Nixon Peabody LLP. The content should not be construed as legal advice, and readers should not act upon information in the publication without professional counsel. This material may be considered advertising under certain rules of professional conduct. Copyright 2013 Nixon Peabody LLP. All rights reserved.