Without special legislation aimed specifically at private equity
companies, such a rationale by the IRS—namely that the activities associated
with private equity companies qualify as an active trade or business—“would have
to apply equally to any man or woman on Main Street who sells a business that he
or she built through personal efforts,” Travis Blais, principal of the
Boston-based Travis Blais & Co., said in e-mailed remarks Sept. 30.
Changing the tax rate on such transactions from capital gains to
ordinary income wouldn't seem to make for good tax policy either, Blais said.
“The fact that an individual expends labor in creating value in an asset is not
a reason to disqualify the sale of that asset from capital gains treatment,” he
Although the court took pains to limit its ruling solely to the
arena of the Employee Retirement Income Security Act (ERISA), practitioners
recently told Bloomberg BNA that even the possibility of that ruling being taken
up by the IRS has shaken the industry for a number of reasons.
One of the categories of investors that may feel the pinch of an
income recategorization would be foreign investors in U.S.-based private equity
funds, Martin Allen, a partner in K&L Gates LLP's Boston office, told
Bloomberg BNA Aug. 21. Non-U.S. investors are generally encouraged to make
passive investments in U.S. businesses through favorable tax treatment.
Typically, such investors are only subject to tax on dividends and interest
paid, and not subject to capital gains tax, Allen said. While the tax rate on
dividends and interest could be as high as 30 percent, it is often reduced by
tax treaties, he said.
If non-U.S. investors were found by the IRS to be investing as
partners in an active trade or business directly, and not through a corporation,
their income could be viewed as effectively connected with a U.S. trade or
business and subject to regular corporate or individual income tax rates, Allen
They would also then be subject to withholding, have to file U.S.
tax returns and pay regular income tax, he said, a possibility that some foreign
investors with an aversion to identifying themselves to U.S. tax authorities may
not be keen on.
However, the IRS may not be able to extend that income
characterization to foreign investors due to a statutory safe harbor for direct
and indirect investments in corporate stock under tax code Section 864(b)(2)(A),
Blais said in a separate Sept. 26 interview.
A similar situation could arise for tax-exempt investors such as
universities, charities, hospitals or pension plans. These entities typically do
not pay tax on dividends, interest and certain other passive income, but do file
returns and pay taxes on unrelated business income, Allen said.
The law requires tax-exempt groups to pay tax on profits if they
invested in what would otherwise be a commercial business out of concern that
tax-exempts would receive a competitive advantage over businesses in the same
industry that are subject to tax, he said.
If a charitable organization investing in a private equity fund
were to be found to be actively engaged in an unrelated trade or business, it
too could be subject to taxes on any gain from the fund's activities, Allen
Some tax-exempt groups may not want to file a return on unrelated
business income and attract the IRS's attention for very similar reasons as some
foreign investors, Allen said. “If the IRS audits for that, who knows what else
it's going to find,” he said.
An additional point of concern could be taxation of carried
interest, specifically that the flowthrough income to a private equity fund's
general partners could lose its favorable tax treatment at the capital gains
rate, Allen said.
If found to be an active trade or business for tax purposes,
private equity fund managers' carried interest—the compensation they receive for
developing the portfolio companies held by the fund—could then be subject to
ordinary income taxes.
The potential impact of Sun Capital
Partners being applied in the income tax context is generally negative;
however, at least one of its outcomes could be favorable, Allen said.
If private equity funds and other financial management businesses
were found to be operating a trade or business, they would be able to deduct
what are currently characterized as investment expenses as ordinary business
expenses, he said.
Private equity funds generally cannot deduct their management fees,
typically 2 percent given to the management company and 20 percent carried
interest given to the general partner, he said.
“The funds would love to deduct those fees as ordinary business
expenses, because they would pass through to the partners,” Allen said. U.S.
taxable partners would be able to deduct their share of those fees above the
line, rather than as a below-the-line itemized deduction, which is subject to
limitations and phased out at higher levels of income.
This outcome, however, “would be the coldest comfort I could
possibly imagine” as a result of Sun Capital, Blais
Traditional Fund Structure
The First Circuit Court's ruling validates the separation of
general partners and management companies found in traditional private equity
fund structures, precisely because the structure of the Sun Capital funds
departed from the norm, Blais said.
Sun Capital departed from the traditional structure in that the
management fees paid by the limited partners in a fund could be offset by the 2
percent annual management fee paid to the general partner.
“That offset isn't always found in private equity deals,” but is a
feature in some funds, in order to eliminate what is seen as double-dipping on
management fees, Allen said.
The First Circuit Court found that the fee offset structure present
in Sun Capital Partners provides a direct economic
benefit to the fund, leading to the conclusion that the fund was a trade or
“While Sun Capital adds to the danger of
using your general partner as the management company, that danger was always
there,” Blais said.
This danger was particular present with respect to the New York
City unincorporated business tax (UBT), Blais said.
One key reason to separate the fund and the general partner has
nothing to do with federal income tax rules; rather, it is due to the UBT in New
York City, where most of the private equity funds are traditionally located,
The UBT applies to the income of all passthrough entities or any
unincorporated businesses in the city. Although private equity firms could
theoretically be taxed at the ordinary rate if Sun
Capital were to apply, “the risk of UBT is not theoretical at all” to a
general partner's carried interest income if the general partner was found to be
actively involved in a trade or business by carrying on the management
activities for the fund, he said.
“Its 20 percent would definitely be taxed by the UBT” in that
situation, Blais said.
The risks posed by a potential application of Sun
Capital Partners to the income tax realm could result in a restructuring
of private equity firms, Allen said.
Funds located outside of the First Circuit's jurisdiction might
particularly be interested in such action, he said. The court's decision,
insofar as it applies in the ERISA context, at least applies in tax courts and
district courts whose decisions are appealable to the First Circuit, he
Hedge funds might also cast a wary eye toward the First Circuit
Court's decision, due to their similar compensation structure with private
equity funds, Allen said. However, “they typically do not buy controlling
interests in portfolio companies and don't get into the day-to-day management of
them,” minimizing the risk that they could also be found to be a trade or
business, he said.
“I would think they'd be treated differently and not open to this
risk, but I don't know if the analysis that will develop out of this case may be
such that it's broad enough to pick up targets that should not be targets of
this conclusion,” Allen said.
The worst-case scenario, in which the IRS recharacterized private
equity passive investment income into ordinary income, could affect a fund's
purchase price, reduce the fund's after-tax yield and have an adverse impact on
the amount of capital the funds are able to raise, Karl Fryzel, a tax partner in
Edwards Wildman Palmer LLP's Boston office, told Bloomberg BNA Aug. 30.
The repercussions of that hypothetical recharacterization could
also affect the purchase price of the companies held within the private equity
portfolios, he said.
Fund managers would also face higher taxes on their carried
interest income, a prospect that has garnered more attention from the Obama
administration and Congress in recent years, Fryzel said.
Democrats have sought since 2007 to tax carried interest as
ordinary income, up to 39.6 percent. The Obama administration's 2014 budget
request proposed such a change, estimating that ordinary income tax on carried
interest could bring in $16 billion over the next decade.
Such a law has never succeeding in making its way through both
chambers, but the Sun Capital Partners case “could shed
more unfavorable light” on that prospect, Allen said.
“If this Sun Capital theory really caught
on and was applied in an income tax context, it's not inconceivable that it
could solve Congress's problem in passing carried interest legislation,” Fryzel
Prospects at IRS
While the worst possible outcomes of the case are reason for
concern, “it's too soon to worry” about them, Fryzel said. One prior Tax Court
case to look to for an example of the IRS's possible unwillingness to get
involved in such issues is Dagres v. Commissioner
he said (60 DTR K-4, 3/29/11
In Dagres, a venture capital fund manager
was allowed to deduct a $3.6 million bad business debt loss in connection with
his venture capital fund and was found to be in a trade or business. The court
did not attribute the activities of the general partner to the limited partners
of the fund, and the government conceded that the fund itself was not engaged in
a trade or business, Fryzel said.
“I personally read into that that when those cases go out into the
fields and get litigated, many times the national office refuses those cases,”
out of wariness for the broad ramifications the trade or business
characterization could have, he said.
The chances are remote that a “rogue” IRS agent will use the Sun Capital case as applied in the ERISA arena to private
equity income and manage to “proceed all the way to litigation without the
national office stepping in,” Fryzel said.
“When you look at the long history in the income tax field of
whether someone is in the trade or business of holding securities or corporate
stock or business entities for sale to customers, they really would have a hard
time making that conclusion in the income tax area,” Fryzel said.
Such a conclusion would demand “serious reflection” within the
national office, he said.
A Treasury Department official recently acknowledged the agency was
aware of the ruling, but spoke of the case in cautious tones (184 DTR G-4, 9/23/13
The case could provide the Treasury with “an opportunity to
reassess what ‘trade or business' means,” Craig Gerson, attorney-adviser in
Treasury's Office of Tax Legislative Counsel, said at a recent American Bar
Association Section of Taxation conference in San Francisco.
Nevertheless, the administration would “not be in any rush to issue
guidance” related to the Sun Capital decision, Gerson
“If they did decide to treat these funds as being in a trade or
business, it's such a dramatic change in the law I think they'd put out new
guidance that would be prospective,” Fryzel said.
To contact the reporter on this story: Lydia Beyoud in Washington
To contact the editor responsible for this story: Cheryl Saenz at