Financial Services Insights – December 2013 - The Latest on the Trade or Business Issue for Investment Funds

Whether a taxpayer is engaged in a “trade or business” continues to be in the forefront of recent court decisions effecting private equity funds and hedge funds.

Vallone_FranIn Sun Capital Partners III, LP et al. v New England Teamsters & Trucking Industry Pension Fund et al.  (Sun Capital case) the United States Court of Appeals for the First Circuit has reversed a Federal District Court decision by holding that a Delaware private equity fund was engaged in a trade or business for purposes of ERISA, in a case involving a bankrupt portfolio company’s multiemployer pension withdrawal liability.

Under ERISA, as amended by the Multiemployer Pension Plan Amendment Act of 1980, (MPPA), an employer that withdraws from a multiemployer plan is required to pay a pension’s vested but unfunded benefits.  In addition, the withdrawal liability is also imposed on a member of a controlled group, if the other member is both in common control (owns 80% or more) of the employer member and is also engaged in a trade or business. 1 

In the Sun Capital case, the private equity funds Sun Capital Partners III LP, Sun Capital Partners III QP (Sun Fund III) and Sun Capital IV LP (Sun Fund IV) owned 30% and 70% of the closely-held failed portfolio company, Scott Brass Inc., (SBI) a manufacturer of brass and copper coil, through fund-related entities Sun Scott Brass, LLC that owned Scott Brass Holding Corp. (SBHC). Sun Fund III and Sun Fund IV (Sun Funds) had neither employees nor offices, and only held investments. The Sun Funds were venture capital operating companies (VCOCs) for ERISA purposes. As per the private placement memorandum to investors, the Sun Funds “were required to substantially participate in or substantially influence the management of the operating companies of at least 50% of its portfolio….”2 In 2008 SBI stopped contributing to the New England Teamsters & Trucking Industry Pension Fund (TPF) and TPF sent a demand for payment of withdrawal liability under ERISA to both SBI and to the Sun Funds.  TPF and Sun Funds moved for summary judgments in the Federal District Court in Massachusetts.  The District Court did not address the issue of common control under ERISA. The issue at hand was whether the Sun Funds were engaged in a trade or business for purposes of pension fund withdrawal liability.

Among other arguments presented to establish that the Sun Funds were engaged in a trade or business under ERISA’s withdrawal liability provisions, the TPF relied on an earlier informal opinion letter by the appeals board of the Pension Benefit Guaranty Corporation (PBGC) with respect to the court case, Sheet Metal Workers Nat’l Pension Fund v. Palladium Equity Partners, LLC (Palladium Equity.)3  In Palladium Equity, the PBGC’s informal letter highlighted the two prong test in Commissioner v. Groetzinger to determine whether the private equity fund was in a trade or business under ERISA.

With respect to Palladium Equity, the PBGC held that the private equity fund was engaged in a trade or business under ERISA by establishing that the primary purpose of the private equity fund was to make a profit, and that the size of the fund and its profits were sufficient evidence to establish continuity and regularity of the private equity fund’s activity. 4 The PBGC’s opinion letter also explained that the fund’s general partner (the fund’s agent) received more than investment income, as it received compensation for providing management and advisory services. 5 The PBGC established an “investment plus” test to ultimately be used with pension termination liabilities under ERISA.

The District Court dismissed the 2007 Appeals Board opinion letter and opined that its interpretation of the rule of agency and Commissioner v. Groetzinger were incorrect.  The District Court ruled in favor of the Sun Funds and held that the Sun Funds were investors. Among other arguments, the District Court referenced the Supreme Court tax cases of Higgins v. Commissioner and Whipple v. Commissioner, where an investor that manages its own investments and only earns investment income is not engaged in a trade or business.

In its decision, the First Circuit remanded the issue of ERISA common control to the District Court and directed the issue of whether Sun Fund III was engaged in a trade or business for ERISA purposes for further proceedings.  The First Circuit also reversed the District Court decision, and held that Sun Fund IV was not a passive investor and was engaged in a trade or business for ERISA purposes, under an “investment-plus principle.”

The First Circuit held that the Sun Funds and its affiliates were actively involved “with sufficient continuity and regularity” in the management and operations of SBI, the “plus.” 6 

The First Circuit presented the following factors that satisfied the “plus” element. These factors are common in private equity funds.

  • Per the Sun Funds’ Private Placement Memorandum, the purpose of the Fund was “to seek out portfolio companies that are in need of extensive intervention with respect to their management and operations, to provide such intervention and to then sell the companies.” 7 The First Circuit also added that the Sun Funds had earned significant profits from the sales of the portfolio companies.
  • The general partners’ limited partnership agreements called for “limited partner committees,” that would have the authority in “hiring, terminating and establishing the compensation of employees and agents of the Fund or portfolio company.”8 
  • The general partner for each Sun Fund had exclusive authority to oversee and manage its respective Sun Fund’s investment activities in return for an annual management fee and a carried interest of its respective investment profits.
    • Each general partner’s wholly owned management company provided SBHC and SBI with employees, consultants, and managerial and advisory services for a fee. The fees that SBI paid to the general partner would be an offset against the management fee that Sun Fund IV was required to pay to its general partner.  The First Circuit held that Sun Fund IV received an economic benefit, i.e., compensation other than the normal investor’s return.

In the end, the First Circuit established that its decision was consistent with the Supreme Court tax cases of Higgins, Whipple and Groetzinger. Unlike Higgins, the Sun Fund did participate in the management of SBI through its affiliates.

In response to Sun Funds’ investment income argument, the Court held that the Sun Fund IV “funneled” management and consulting fees to its general partner and management company, and that Sun Fund IV received direct economic benefit in the form of the management fee offset.  The Court further held that under Delaware partnership law and under the partnership agreement, the general partner of Sun Fund IV could be held as the Fund’s agent.9 

The First Circuit has made it clear that the investment-plus trade or business model was to be applied to ERISA’s withdrawal liability provisions. However, if the Sun Capital trade or business interpretation was to be extended to the general income tax rules, some possible results would be: to subject non-U.S. investors in a PE Fund to effectively connected income (ECI), to create unrelated business taxable income (UBTI) for the PE Funds’ tax-exempt investors, and to subject non-resident partners in a PE fund to state and local taxing authorities.

As the tax code and regulations do not define when an activity constitutes a trade or business, we have been left with a myriad of court cases to determine when an individual taxpayer’s trading activity gives rise to “trader” status.  As a trader, the individual taxpayer is able to fully deduct trader expenses for federal and state tax purposes. To the extent a taxpayer is not considered to be a trader they will be an “investor.” Investors will have limitations on the deductibility of expenses both at the federal and state levels.

Based on earlier tax cases, a taxpayer is held out as a trader when the taxpayer’s trading is substantial and continuous, and the taxpayer’s profits are short-term gains captured by the swing in the daily market movements. 10 

In Endicott v. Commissioner, the taxpayer wrote call options on the stocks he purchased at 100% margin. His strategy was to make a profit from the premiums he received on the expired options. The taxpayer would hold some of his stock for an extended period of time, as he received dividend income on the stock that he held on several occasions. The taxpayer testified that he didn’t trade options on a daily basis as the commission fees were high.  However, he also testified to monitoring his portfolio regularly to maintain a profitable strategy.

The Tax Court held that the taxpayer was not a trader, as the number of trades was not substantial for two of the three years in question. The taxpayer executed 204 trades during 2006, 303 trades in 2007, and 1,543 in 2008.  In addition, the Tax Court held that the number of days of trade execution did not meet the frequency, continuity and regularity test.  The taxpayer traded on 75 days in 2006, 99 days in 2007 and 112 days in 2008. It was also determined that the taxpayer held his stock for an average of 35 days with some stock being held for over 4 years.   From this 35-day average holding period, the Tax Court concluded that the taxpayer was not looking to profit from the swings in the market. In its argument against trader status, the court added the fact that over the three years, the taxpayer reported long term capital losses on Schedule D, and in 2008, the long term capital losses exceeded the short term losses.  Finally, even though the dollar amount of the taxpayer’s trades was large, the Tax Court held that trading large amounts of money would not suffice to establish trader status.

As can be seen in Endicott v. Commissioner, the Tax Court has outlined long established case law to determine a taxpayer‘s status of “trader or investor.” Although the case law has focused on individual taxpayers, hedge funds should consider these cases to assess their own “trader or investor” determination.

1. Amy S. Elliot and Lee A. Sheppard, “Private Equity Fund is in a Trade or Business, First Circuit Holds,” Doc 2013-18068, 2013 TNT 144-1.

2. Sun Capital Partners III LP et al.  v.  New England Teamsters & Trucking Industry Pension Fund et al.: No. 12-2312, “First Circuit Reverses, Vacates Summary Judgment to Private Equity Funds in Withdrawal Liability Case,” Doc 2013-18003, n.4,  2013 TNT 144-9.

3. Ibid.

4. Ibid.

5. Ibid.

6 Steven M Rosenthal, “Private Equity Is a Business: Sun Capital and Beyond,” Doc 2013-21957, TNT 184-19.

7. First Circuit Holds That a Private Equity Fund May be Liable for Portfolio Company Pension Obligations, Skadden, Arps Slate, Meagher & Flom LLP & Affiliates, July 29, 2013.
8. Ibid at 2

9. Ibid.

10.  William G. Holsinger, et ux. v. Commissioner, T.C. Memo, 2008-191.  


Financial Services Insights – December 2013 

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