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Fee Offsets in Private Equity – First Circuit Takes Fact-Specific Approach to 'Trade or Business' Analysis


Fee offset provisions may get a second look by private equity funds after a recent First Circuit U.S. Court of Appeals case (Sun Capital Partners III, LP, et al. v. New England Teamsters & Trucking Industry Pension Fund (July 24, 2013)) held last week that an investment fund was a "trade or business." This case could have wide-ranging federal income tax implications for certain private equity funds with foreign and tax-exempt investors. While the case technically addresses "trade or business" in the context of the multiemployer pension termination liability rules under ERISA, the First Circuit also discussed federal tax precedent. For tax purposes, private equity funds generally take the position that they are not engaged in a "trade or business," which results in beneficial tax treatment for their foreign and tax-exempt investors. If, contrary to that assumption, a private equity fund is deemed to be engaged in a "trade or business," foreign investors would have "effectively connected income," and tax-exempt investors would have "unrelated business taxable income," income these types of investors hope to avoid.

While the court was careful to state that federal tax interpretations of the phrase "trade or business" are not determinative of the ERISA issue, it went on to find that its holding was not inconsistent with those tax interpretations. Specifically, it held that Sun Capital's facts were distinguishable from Higgins v. Commissioner and Whipple v. Commissioner,two U.S. Supreme Court cases holding that the taxpayers at issue were not engaged in a "trade or business." Most concerning is the First Circuit's analysis of fee offset provisions, which are increasingly common in fund structures. Under the court's reasoning, because the funds received an economic benefit in the form of offsets of fees the funds otherwise would have paid to their general partner, the funds received more than mere investment returns. Since the funds did not actually provide management services, the First Circuit's analysis is arguably inconsistent with the assignment of income doctrine. However, the court was willing to attribute the management activities of the general partner to the funds under general agency principles and Delaware partnership law.

In analyzing the ERISA issue, while acknowledging that neither the Internal Revenue Code, the treasury regulations, nor the Pension Benefit Guaranty Corporation (PBGC)'s regulations define "trade or business," the court found the PBGC's "investment plus" standard persuasive and applied it to the Sun Capital funds. In what it called "a very fact-sensitive approach," the court looked at numerous factors, none being dispositive by itself, and held that the Sun Capital funds were a "trade or business" for purposes of determining ERISA withdrawal liability because of the following "plus" activities: (1) active involvement and operation of companies in which they invest (general partners have exclusive and wide-ranging management authority); (2) GPs make decisions about hiring, firing, and compensating agents and employees of the funds and their portfolio companies; (3) extensive intervention with portfolio companies in first three to six months after acquisition including frequent meetings with senior staff to discuss operations, competition, new products and personnel; (4) exercising control by placing employees in a majority of director positions at portfolio companies; (5) providing personnel to portfolio companies for management and consulting services who were immersed in details; (6) offset against management fees funds otherwise would have paid to GP. 

Given the expansive interpretations of federal tax law by the First Circuit in this case, private equity firms should carefully consider the structure of their fee offset provisions and the relationships between the funds and their general partners or management companies. 


IRS Circular 230 Disclosure: To comply with certain U.S. Treasury regulations, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication, including attachments, was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding any penalties that may be imposed on such taxpayer by the Internal Revenue Service. In addition, if any such tax advice is used or referred to by other parties in promoting, marketing, or recommending any partnership or other entity, investment plan, or arrangement, then (i) the advice should be construed as written in connection with the promotion or marketing by others of the transaction(s) or matter(s) addressed in this communication and (ii) the taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor. To the extent that a state taxing authority has adopted rules similar to the relevant provisions of Circular 230, use of any state tax advice contained herein is similarly limited.

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