Attacking Carried Interest Through The Back Door

Last week the United States Court of Appeals for the First Circuit handed down an opinion in favor of the Teamsters Union in relation to certain unfunded pension obligations. Sun Capital Partners III, LP et. al. vs. New England Teamsters & Trucking Industry Pension Fund et. al., No. 12-2312 (1st Cir. 2013) .  The Court found that a private equity fund could be found liable for unfunded pension obligations through the actions of its general partner and related entities.  While that legal breakthrough is likely exciting all the ERISA attorneys across the nation, it’s also causing a bit of a stir among tax attorneys and PE managers alike.

You see the method the Court utilized to find pension liability was to attribute the active trade or business of the PE general partner to the PE fund itself.  While this method is well grounded in agency law and may or may not be right as a pension policy matter, it puts the tax character of income on carried interests into play.

Normally, funds take the position that the grant of a mere profits interest in a partnership (i.e., the carry) is not a taxable event.  The IRS has historically agreed with this view.  Then, as profits are allocated to the carried interest they retain the character such profits would have to any partner.  With respect to private equity type investments this is typically long-term capital gain.  However, if the partnership (i.e., the PE fund) were to be actively engaged in a trade or business and the portfolio companies seen more as inventory, then ordinary income would be the correct characterization rather than capital gain.  Ironically, attacking the issue in this manner would alter the tax treatment for all U.S. taxable PE investors, not just managers.

So, can the outcome of this pension liability case really upend the carried interest battle?  It could, but I doubt that will happen.  Nevertheless, I’m sure there are many people in the IRS and Congress who are looking at this case with a view to shutting down the carried interest saga through the back door.  I personally don’t think this case will carry the day for those opposed to the current tax regime surrounding carried interests for two reasons.  First, the Court found pension liability by attributing the trade or business of the general partner to the fund.  In order to alter the tax character of the income flowing through the carry the IRS would need to RE-attribute such trade or business from the fund to the limited partners.  Traditionally, reattribution has not been permitted.  Second, this method would affect all limited partners in the fund and not just the managers.  Moreover, such a finding would likely leave the carried interest treatment of hedge funds intact.

The Sun Capital case should make all PE funds wary of their pension liabilities, which is real and now current law.  However, the case will also add fuel to an already very hot fire surrounding the carried interest tax debate.

WithumSmith+Brown will monitor the fallout from the Sun Capital case and the carried interest tax debate in general and will keep you apprised of all substantive developments.  Do not hesitate to reach out to your WS+B contact for any questions you might have regarding this update.

-  Tony Tuths

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