Carried Interests: Current Developments

, New York Law Journal


Joseph E. Bachelder III
Joseph E. Bachelder III

The tax status of so-called "carried interests," held by private equity fund sponsors (and benefitting, in particular, the individual managers of those sponsors) is the subject of today's column. A decision by the U.S. Court of Appeals for the First Circuit holding that a private equity fund was engaged in a trade or business for purposes of the withdrawal liability provisions of ERISA (Employee Retirement Income Security Act) has caused considerable comment on the issue of whether a private equity fund might also be held to be in a trade or business (and not just a passive investor) for purposes of capital gains tax treatment on the sale of its portfolio companies. Proposed federal income tax legislation, beginning in 2007 and continuing into 2013, also has raised concern as to the status of capital gains tax treatment for holders of carried interests. The following discussion addresses both of these developments.

The Sun Capital Case

In a multiemployer pension plan withdrawal liability case, Sun Capital Partners III v. New Eng. Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. 2013), the First Circuit held that a private equity fund could be found liable for the liability of one of its portfolio companies.1 In doing so it reversed the district court, remanding as to the issue of "common control" for the equity fund involved in its decision. The First Circuit's decision is the subject of a petition for a writ of certiorari filed by Sun Capital with the U.S. Supreme Court Nov. 21, 2013.

The portfolio company's liability was incurred under ERISA2 for its pro rata share of a multiemployer pension fund's unfunded benefit liabilities upon the portfolio company's ceasing to make contributions to the pension fund due to its bankruptcy.3 Under ERISA, an employer's affiliates can be liable for the unfunded pension benefit liabilities of the employer under a "two-pronged test." 29 U.S.C. §1301(b)(1) (ERISA §4001(b)(1)) provides that "all employees of trades or businesses…which are under common control shall be treated as employed by a single employer and all such trades or businesses as a single employer…."4 The "common control" part of the test was not before the First Circuit and is subject to further proceedings before the district court.

Thus, the issue decided by the First Circuit was limited to whether the private equity fund was engaged in a trade or business within the meaning of §1301(b)(1) and applicable Pension Benefit Guaranty Corporation (PBGC) regulations thereunder. It is not a requirement under section 1301(b)(1) or PBGC rules that an affiliate be in the same trade or business as the employer with the primary obligation. It is sufficient that the affiliate (in this case, the private equity fund) be in a trade or business whether or not the same as that of the employer.5

In reaching its holding, the First Circuit imputed to the private equity fund certain activities of the fund's sponsor, Sun Capital Advisors Inc., the fund's general partner and the fund's investment manager (including employees, as well as agents, of these affiliates). The First Circuit looked initially at a wide range of activities, including acquisitions, management operations and the sale of portfolio companies.

In reaching its conclusion that the fund was in a trade or business, it focused on the activities involved in the management and operations of the fund's portfolio company, Scott Brass Inc., whose withdrawal from the union pension fund gave rise to the unfunded benefit liability.6 Taken together, these different activities involved in the management and operation of Scott Brass Inc. added up, in the opinion of the First Circuit, to the private equity fund being in a trade or business for purposes of §1301(b)(1).

The court, alternatively, might have found that the private equity fund was engaged in the trade or business of acquiring, developing, and promoting portfolio companies for later sale. It made explicit it was not so deciding because that issue had not been raised in a timely manner by the plaintiff labor union.7

The First Circuit's opinion raises the question whether that court would have concluded that the private equity fund was engaged in a trade or business if the Sun Capital case had been a tax case (instead of an ERISA case) and had involved the issue whether the holder of a carried interest in the fund was entitled to capital gains treatment for its share of the gain realized by the fund on the sale. (This assumes that Scott Brass Inc. was profitable, not in bankruptcy, and was being sold for a gain).

It would seem possible, if not probable, that the same court with the same facts would find a trade or business for purposes of Internal Revenue Code §1221(a)(1). In order to qualify a sale for capital gains tax treatment the property sold must be a capital asset. Section 1221(a)(1) excludes from capital asset treatment "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business."

If a court finds that a private equity fund was in the trade or business of acquiring portfolio companies for development and sale it would seem likely that it would also find the fund was holding the portfolio company in question primarily for sale to customers in that trade or business within the meaning of Code section 1221(a)(1) above. There is case law to support this view.8 Notwithstanding this, it is noted again that Sun Capital is not a tax case and, further, the First Circuit explicitly did not address the issue of whether the private equity fund was in the trade or business of developing, promoting or selling portfolio companies for sale to customers. At the time this column was written, the Supreme Court had not decided whether to grant a writ of certiorari in the Sun Capital case.9

Carried Interest Legislation

On Feb. 11, 2013, Senator Carl Levin introduced S.268, titled, "Cut Unjustified Tax Loopholes Act," which includes a proposal to require treatment of certain carried interests as ordinary income rather than capital gains.10 Legislation to similar effect has been introduced in the Senate and House of Representatives for a period that began in 2007.11

A carried interest, for this purpose, means an interest in profits and gains from an investment to the extent such interest is given in consideration for services rendered in connection with the management of the investment rather than in exchange for a capital contribution toward the funding of such investment.

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