United States: First Circuit Finds Private Equity Fund Was Engaged In A "Trade Or Business" For Purposes Of ERISA Rules In "Sun Capital"

In a decision with significant potential tax implications, a three-judge panel for the US Court of Appeals for the First Circuit found that a private equity fund was engaged in a "trade or business" for purposes of the Employee Retirement Income Security Act ("ERISA").¹

Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund involved a dispute regarding whether either of two private equity funds were responsible for the $4.5 million pension liability of a bankrupt company, Scott Brass Inc. ("SBI"), in which the funds were passive investors. The funds, which are under Sun Capital Advisors, Inc., have no offices or employees and report only investment income. Under the ERISA rules, a member of a controlled group is liable for an employer member's withdrawal liability if (1) the member is engaged in a trade or business and (2) the other member is in common control of the employer member.² For this purpose, common control is 80 percent ownership.³

The funds contended that they did not meet either of these requirements because they were not engaged in a trade or business and, individually, neither fund owned 80 percent of SBI. In 2012, a Massachusetts district court found that the funds were not engaged in a trade or business, relying on the fact that they did not have offices or employees, they did not make or sell goods and they reported only investment income on their tax returns.⁴

The First Circuit disagreed with the district court on the "trade or business" issue. The court acknowledged that the term had no uniform definition provided by regulations or the Supreme Court, and applied the Seventh Circuit's "investment plus" standard. The court found that the funds' investment in SBI, combined with the funds' intimate involvement with the management and operation of SBI, constituted a "trade or business." The panel remanded the case to the district court for additional fact finding relating to whether there was common control for purposes of the ERISA rules.⁵ On August 23, the First Circuit entered an order denying a petition for a rehearing en banc filed by private equity firms affiliated with Sun Capital.

The opinion in Sun Capital may have serious implications in the tax world—according to one expert, the case could "devastate the economics of private equity investment."⁶ For tax purposes, private equity funds are generally treated as passive investors that are not engaged in a trade or business. Thus, the ruling in Sun Capital that a private equity firm was engaged in a trade or business creates concern that similar treatment could be applied for tax purposes, potentially leading to significant tax ramifications, including ordinary income for managers, effectively connected income for foreign investors and unrelated business taxable income for tax-exempt investors.⁷

The implications of Sun Capital on tax issues are not clear, as the case related to the meaning of "trade or business" for purposes of the ERISA rules. Some tax practitioners have drawn comfort from the fact that the First Circuit specifically created a holding which related to the ERISA rules and did not attempt to define trade or business for purposes outside this context.⁸ Others have acknowledged that while the language of Sun Capital may be "troubling," they do not believe it should have significant tax effects on private equity funds.⁹ It is unclear what the impact of the First Circuit's decision in Sun Capital will be, but it is certain that the eyes of many in the tax world will be on the rulings that come in the wake of this decision.

Footnotes

1 Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312 (1st Cir. 2013).

2 29 USC. § 1301(b)(1).

3 Id.

4 Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, 903 F. Supp. 2d 107 (D. Mass. 2012).

5 Sun Capital Partners III LP v. New England Teamsters & Trucking Industry Pension Fund, No. 12-2312 (1st Cir. 2013).

6 Amy S. Elliot and Lee A. Sheppard, "Private Equity Fund Is in a Trade or Business, First Circuit Holds," Tax Notes Today (July 26, 2013).

7 Id.

8 Id.

9 Id.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.