First Circuit - Are private equity funds engaged in a “trade or business”? 

August 6:  A decision of the U.S. Court of Appeals for the First Circuit, in a case of first impression, may impact well-settled expectations on a fundamental question for the private equity industry—whether private equity funds engage in a “trade or business.” Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Industry Pension Fund, No. 12-2312 (1st Cir. July 24, 2013).

The conventional view is that a private equity fund is an investment vehicle, not a trade or business. The First Circuit in Sun Capital rejected that conventional view in an ERISA case.

Read the First Circuit’s decision

KPMG observation

Sun Capital is not an income tax case, but is a case addressing application of Title IV of ERISA (the Pension Benefit Guarantee Corporation’s rights to protect underfunded plans). However, practitioners and those in the private equity industry need to study the case and consider its broader implications outside of ERISA, in tax and beyond, due to the First Circuit’s discussion of certain income tax provisions.


This case pitted the New England Teamsters & Trucking Industry Pension Fund (the Pension Fund) against two Sun Capital Partners private equity funds (the Funds) in the wake of the bankruptcy of one of the funds’ portfolio companies (SBI).

The Pension Fund claimed that the Funds were responsible for SBI’s share of underfunded qualified pension benefits, for the “withdrawal liability” (applied when a company stops contributing to the multiemployer pension plan).

The court’s holding focuses on rules relating to the Pension Benefit Guarantee Corporation (PBGC), but potentially could be used in other areas.

In order to establish withdrawal liability under ERISA, the Pension Fund had to establish that the portfolio company and the private equity fund were under “common control” and that the Private Equity Fund was a “trade or business.”

There is no uniform definition of “trade or business” in ERISA, the Code, or in regulations. In a declaratory judgment action, the federal district court entered judgment in favor of the Funds, holding that they were not a trade or business. The district court did not reach the “common control” element of the withdrawal liability claim.

First Circuit

The First Circuit Court of Appeals reversed, holding that on the facts of the case, one of the Funds operated a trade or business.

In the absence of any PBGC regulations—an absence the court lamented—the First Circuit analyzed the issue by reference to an analogous case from the Seventh Circuit and a 2007 PBGC appeal letter, which the court afforded a degree of deference.

In a fact-specific approach, the First Circuit took into account a number of factors, none dispositive, to reach its conclusion that one of the Funds was a trade or business:

  • The Funds make investments in portfolio companies with the principal purpose of making a profit.
  • The limited partnership agreements and private placement memos explain that the Funds are actively involved in the management and operation of the companies in which they invest.
  • The agreements also give the general partner of each Fund exclusive and wide-ranging management authority.
  • The general partners are empowered through their own partnership agreements to make decisions about hiring, terminating, and compensating agents and employees of the portfolio companies.
  • The general partners receive a percentage of profits as compensation.
  • It is the purpose of the Funds to seek out potential portfolio companies that are in need of extensive intervention with respect to their management and operations, to provide such intervention, and then to sell the companies.
  • The Funds’ controlling stake in SBI placed them and their affiliated entities in a position where they were intimately involved in the management and operation of the company.
  • The Funds’ active involvement in management provided a direct economic benefit to one of the Funds that an ordinary, passive investor would not derive: an offset against the management fees it otherwise would have paid its general partner for managing the investment in SBI.

This list should be familiar to those who work in and with the private equity industry.

The court did not decide whether the other Fund was a trade or business because the record did not show whether the management fee offset provided an economic benefit to the other Fund, thus implying that this factor was integral to its determination of a trade or business.

The court tested its conclusion against a broad survey of cases—including the Supreme Court decisions in Higgins v. Commissioner, 312 U.S. 212 (1941), and Whipple v. Commissioner, 373 U.S. 193 (1963). Although the court noted that the definition of “trade or business” in Higgins and Whipple is not determinative for purposes of determining withdrawal liability under ERISA and is not uniformly applied for all purposes of the Internal Revenue Code, the court went on to state that it saw “no inconsistency” between its decision and the decisions in the leading federal income tax cases addressing this issue, Higgins and Whipple.

What’s next?

The First Circuit remanded the case to the district court to consider the “common control” element, and the trade or business issue as it applies to the other fund under consideration, so the decision is not yet final. Further, the Funds may move for a rehearing or petition the U.S. Supreme Court to take the case. Nevertheless, the case raises immediate implications for other private equity funds.

The PBGC statute provides that PBGC should use the principles of section 414(c) of the Internal Revenue Code in determining whether there is common control. Section 414 (c) treats employees of “trades or businesses” under “common control” as employees of a “single employer.” The general rule provides that the entities are under common control if an entity owns at least 80% of the voting power or value of a corporation or 80% of the capital or profits interests of a partnership. Section 414(c) is designed to pull related companies together so pension and health benefits for the employees of the entities are “nondiscriminatory”—that is, the benefits provided to employees of the controlled group do not favor the highly compensated employees of the controlled group by putting employees in different but related companies.

KPMG observation

This decision applies directly only to a PBGC rule and does not directly implicate the Internal Revenue Code. The major tax question that hangs in the balance is what—if anything—the IRS will do with this case. The implications are potentially enormous for the private equity industry if the IRS decides to borrow the First Circuit’s view of a “trade or business” for various tax provisions.

Section 414(c) is generally used under Title I of ERISA, the part of ERISA embedded in the Internal Revenue Code. These are generally sections dealing with benefit plan provisions (including pension, 401(k) plans, and some health plans). The IRS could potentially borrow the holding of the case for rules directly tied to section 414(c). As an example, if the IRS used the First Circuit’s definition of “trade or business” for section 414(c), private equity funds might have to watch for possible discrimination issues for pension and 401(k) plans, fringe benefits, and health benefits provided by different companies owned at least 80% by a private equity fund (or possibly by related funds).

Further, if the IRS decided to use the “trade or business” definition for other parts of the Internal Revenue Code, the effects could be much more widely spread. Here are just some of the items whose treatment could change if the settled tax conclusion—that private equity funds are investment vehicles—was disturbed:

  • Income attributable to foreign (including sovereign) investors may be subject to ECI withholding,
  • The branch profits tax may apply on the deemed repatriation of effectively connected earnings and profits to foreign investors,
  • Heightened risk of capital gain/ordinary income conversion with implications if portfolio companies are considered held for sale in the ordinary course of a trade or business, which could also implicate unrelated business income tax for tax exempt organizations,
  • Potential excess business holding issues for private foundations,
  • Possible implications on the issue of whether management fee offset amounts are income to the private equity fund, and
  • Fund-level expenses may be fully deductible rather than limited as investment expense deductions.

At a minimum, taxpayers will likely consider Sun Capital when evaluating risks presented with respect to potential pension obligations of a portfolio company, especially in connection with due diligence.

However, although the holding in Sun Capital is currently limited in its reach, and does not consider the authorities issued subsequent to Higgins and Whipple that analyze investment versus trade or business, it does raise the possibility that for federal or state tax purposes, similar arrangements could result in a fund having a trade or business. Although the outcome and reach of Sun Capital is still unclear, taxpayers may want to:

  • Review their current PE structure and agreements to identify structures that are similar to Sun Capital,
  • Consider whether modifications to their current and new private equity structures and agreements are warranted in order to manage the various business and tax risks presented in Sun Capital, and
  • Review the manner in which business is conducted (and revise as needed) to support the separateness of the taxpayer’s investment activity through the fund from the trade or business activity of the management company.

For more information, contact a tax professional in KPMG’s Washington National Tax.

Karen Field (on ERISA tax issues)


Seth Green


Tom Greenaway


Rick Speizman (on exempt organization issues)


Sarah Staudenraus


Jim Tod


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