On March 28, 2016, the US District Court for Massachusetts ruled on remand from a 2013 decision of the Court of Appeals for the First Circuit that two private equity funds had formed a constructive partnership that was under common control with a portfolio company, and were engaged in a trade or business. These rulings resulted in the assets of this constructive partnership being subjected to the withdrawal liability that a jointly owned bankrupt portfolio company owed with respect to a multi-employer pension fund to which it contributed under Title IV of the Employee Retirement Income Security Act (ERISA). (Sun Capital Partners III LP et al. v. New England Teamsters & Trucking Industry Pension Fund) (No. 1:10-cv-10921). (See Tax Alert 2013-1505 for detailed discussion of the First Circuit's decision.) The First Circuit's decision under ERISA formulated a new "investment plus" approach in determining the level of activity that must exist before a partnership is treated as engaged in a trade or business for ERISA purposes. In 2014, the Supreme Court declined to review the First Circuit's ERISA ruling.

Background

Sun Capital involved two private equity funds, Sun Capital Partners III, LP and its co-investment fund Sun Capital III QP, LP (collectively, "Sun Fund III") and Sun Capital Partners IV, LP, (each, a Sun Fund). Each Sun Fund's limited partnership agreement gave its general partner exclusive authority to manage the fund. The general partner of each Sun Fund received an annual Management Fee of 2% of committed capital in exchange for its services to the particular Sun Fund. In addition, the general partner received a carried interest in each of the Sun Funds. Each general partner also had a subsidiary management company that entered into a contract with the holding company of an acquired portfolio company to provide management services to its fund's portfolio companies for a fee (the Portfolio Company Contract). There was a Management Fee Offset in effect under which the management fee owed by the fund's limited partners to the fund's general partners was offset by the fees to be paid to the general partners by the portfolio company. Under the Management Fee Offset, the management fee owed to fund's general partner would be reduced by 100% of any directors' fees and investment banking fees, but by only 50% of any "corporate services fees" and investment banking fees, paid under a Portfolio Company Contract . Additionally, each Sun Fund general partner could elect to waive its Management Fee in exchange for a reduction of such general partner's obligation to contribute to future capital calls (Management Fee Waiver). This Management Fee Waiver election would have the effect of eliminating the Management Fee that could be reduced as a result of the Management Fee Offset. Thus, the parties to these arrangements provided that any Management Fee Offset that could not be applied because the general partner had waived its Management Fee would be carried forward until there was a Management Fee that had not been waived against which the Offset could be applied.

In 2007, Sun Fund III purchased 30%, and Sun Fund IV 70% of the stock of Scott Brass, Inc. (Scott Brass) indirectly through a jointly owned limited liability company (the LLC). A subsidiary management company of the general partner of Sun Fund IV entered into a Portfolio Company Contract with related-party SBHC to provide management services to SBHC and its subsidiaries, including Scott Brass, in exchange for fees, concurrently with the stock purchase. The expense for these fees was allocated to the Sun Funds in a ratio of 30% to Sun Fund III and 70% to Sun Fund IV.

Scott Brass declared bankruptcy in 2008 and stopped making contributions to the Trucking Industry Pension Fund (TPF), a "multiemployer pension plan" sponsored by the Teamsters union, thereby incurring "withdrawal liability" under Title IV of ERISA. Generally, an employer becomes liable to a multiemployer pension plan for withdrawal liability if the employer ceases making contributions to the plan at a time when the plan has unfunded vested benefit obligations referable to that employer. The TPF demanded that the Sun Funds pay this withdrawal liability obligation based on its assertion that the Sun Funds were under "common control" with Scott Brass within the meaning of ERISA Section 4001(b)(1) (29 USC Section 1301(b)(1)). This statute imposes "withdrawal liability" on an organization other than the obligated organization (e.g., Scott Brass) if the "other organization" is engaged in a trade or business that is under "common control" with the obligated organization.

The Sun Funds filed an action in federal District Court seeking a declaration that they were not subject to withdrawal liability under ERISA Section 4001(b)(1) because: (1) they were not part of a joint venture or partnership with Scott Brass and, therefore, did not meet the common control requirement: and (2) neither was engaged in a "trade or business." Concluding that neither Sun Fund was engaged in a "trade or business," the District Court granted the Sun Funds' motion for summary judgment. Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, 903 F. Supp. 2d 107 (D. Mass. 2012). The TPF appealed the District Court's decision, arguing, among other things, that the District Court erred in finding that the Sun Funds were not engaged in "trades or businesses."

The Court of Appeals for the First Circuit reversed the District Court's decision with respect to Sun Fund IV in 2013. The First Circuit ruled that Sun Fund IV was engaged in a trade or business and remanded the case to the District Court to determine: (1) whether Sun Fund III was engaged in a "trade or business"; and (2) whether the Sun Funds and SBI were under "common control," in each case under ERISA .

Current ruling

The District Court on remand was required to find that the Sun Funds satisfied two tests before they could be found liable for the Scott Brass ERISA withdrawal liability: first, whether the funds were engaged in a "trade or business" based on the "investment plus" standard developed by the First Circuit, and second, whether the Sun Funds and Scott Brass were under "common control" within the meaning of the relevant ERISA statutes. The District Court sought guidance in tax principles related to trades or businesses and constructive partnerships to determine whether the Sun Funds and Scott Brass were under common control.

"Common control" and constructive partnership. Section 4001(b) of ERISA provides that the determination whether entities are considered under common control is made "consistent and coextensive" with Code Section 414(c) and the corresponding Treasury regulations. Section 414(c) applies a mechanical 80% ownership test to determine whether entities are in a "parent-subsidiary" common control group.

The District Court did not apply the mechanical Section 414(c) 80% ownership test. Instead, the District Court examined non-tax federal statutes regarding partnerships as well as tax authorities in determining whether a constructive partnership should be treated as having existed between the Sun Funds. The District Court ruled that a constructive partnership existed between the Sun Funds. (The court used the term "partnership-in-fact" to describe this relationship.) In finding that a constructive partnership existed for ERISA purposes "sitting atop the LLC: a site of joining together and forming a community of interest," the District Court relied on the facts that: (i) the Sun Funds co-invested in six portfolio investments, "using the same organizational structure," (ii) the record "show[ed] no meaningful independence in the Sun Funds' relevant co-investments," and (iii) "prior to entity formation and purchase, joint activity took place in order for the two [Sun] Funds to decide to coinvest, and that activity was plainly intended to constitute a partnership-in-fact." The District Court referred to two fundamental cases addressing whether a partnership exists for tax purposes in its discussion of constructive partnerships, Commissioner v. Tower, 327 US 280 (1946) and Luna v. Commissioner, 42 TC 1067 (1964). This constructive partnership was sufficient to establish "common control" within the meaning of the relevant ERISA statutes.

Trade or business Status. The next question before the District Court was whether the constructive partnership established in the first part of its analysis was engaged in a trade or business within the intent of the relevant ERISA statutes. The District Court built its analysis on a theory of "investment plus" that the First Circuit had developed in its earlier opinion.¹ "Investment plus" may generally be viewed as providing that an entity largely engaged in investment activities will nonetheless be found to be engaged in a trade or business if its additional (plus) activities are sufficiently extensive. This "investment plus" status can be found if the investing entity derives a sufficient economic benefit from trade or business activities that exceeds the benefit a passive investor would receive. Both the First Circuit and the District Court focused on the benefit to each Sun Fund of a reduction in its Management Fee obligation that would arise from the Management Fee Offset and whether that benefit arose from the trade or business activities of the manager's management of the businesses of each Sun Fund's portfolio investments.

The general partner of Sun Fund IV waived its Management Fees in 2007-2009 (the period in which the Sun Funds owned their investments in Scott Brass before the bankruptcy of the latter in 2008). The General Partner of Sun Fund IV received its Management Fees in 2010-2012 as adjusted by any Management Fee Offsets that carried over to those years from 2007-2009.

Sun Fund IV argued that these Management Fee Offset "carryforwards" did not constitute a sufficient economic benefit for purposes of this part of the analysis because: (i) they did not offset any Management Fees owed by Sun Fund IV to its general partner during the entire period the Sun Funds owned Scott Brass; and (ii) the carried forward Management Fee Offsets represented only a contingent benefit to Sun Fund IV in the years after 2009 in which the general partner did not waive its Management Fees. The District Court disagreed, stating that Sun Fund IV received a sufficient economic benefit because it had the right to offset future Management Fees.

Further, the District Court found that this economic benefit to both Sun Funds had been rendered to each Sun Fund as a result of the Sun Funds' management activities, a trade or business activity.

The District Court found that this right to offset future Management Fees that arose out of the business activities of the manager's management business was sufficient to satisfy the trade or business test articulated by the First Circuit.

The District Court determined that the assets of the constructive partnership between the Sun Funds and SBI were jointly and severally responsible for the withdrawal liability under ERISA. It found a "partnership-in-fact" between the Sun Funds under which "common control" of these assets existed, and that this constructive partnership was engaged in a trade or business, in each case under ERISA, but looking to federal income tax authorities for guidance.

Implications

Private equity complexes are advised to consider mitigating their ERISA exposures. Based on the holdings in the District Court opinion, funds that were structured to avoid the "common control" test by owning less than 80% of a portfolio company may be considered, depending on the facts, to be part of a common control group with the portfolio company. In addition, funds that have taken the position that they do not operate in a "trade or business" should consider the economic factors presented by the District Court to assess their status.

Tax Alert 2013-1505, which was issued following the decision of the First Circuit in Sun Capital, 724 F.3d 129 (2013) provided as follows:

"Following the First Circuit decision, private equity funds would be advised to consider the possibility that the ERISA joint and several withdrawal liability rules may apply with respect to their portfolio companies. In addition, the decision may have more far-reaching implications for private equity funds, which may need to consider the application of the ERISA and employee benefit tax requirements, such as the qualified retirement plan nondiscrimination and coverage rules and the Affordable Care Act employer mandate excise tax provisions, that apply on a controlled group basis."

"The decision of the First Circuit is an interpretation of the phrase "trade or business" for purposes of an ERISA provision and not an interpretation of the phrase for purposes of a Code provision. Although the court noted that a court's interpretation of a particular provision should not be binding or determinative for purposes of applying any other provision, and the "investment plus" approach applied by the court was very fact-specific, it is possible that the court's description of the Sun Funds' activities and its discussion of cases that interpreted the phrase "trade or business" for federal income tax purposes could have implications for taxpayers generally, and private equity funds in particular, under the federal income tax rules."

There is nothing in the District Court's opinion in Sun Capital on remand that appears to materially change this view regarding the application of this ruling beyond its direct ERISA holding. The District Court's reliance on federal income tax principles, including those espoused in Culbertson and Luna to conclude that a constructive partnership existed between the Sun Funds is troubling. This was not a case of a main fund and its AIVs, but rather two separate funds with presumably different investors to which the managers had separate fiduciary obligations and that did not have a common investment plan. However, Sun Capital is a case under ERISA, and not under the US federal income tax law. Further, the District Court's reliance on the notion that the "Sun Funds are closely affiliated entities and part of the larger ecosystem of Sun Capital entities" founded and managed by two individuals for its ruling regarding constructive partnership is a novel argument under the tax law.

It does not appear that the District Court's decision in Sun Capital should by itself change our conclusions in all but a relatively small number of cases regarding whether a partnership exists, the identity of its partners, or whether it is engaged in a trade or business, in each case for US federal income tax purposes. The decisions of the First Circuit and the District Court in Sun Capital, however, each relied to some extent on tax cases and tax principles in reaching their holdings under ERISA. A tax authority could potentially make these same arguments. We will continue to monitor the implications of this ERISA ruling and whether the constructive partnership approach may apply for income tax purposes. Private equity funds should consider the ERISA and potential income tax implications associated with the Sun Capital decisions.

If you have any questions or concerns regarding the potential application of the court's analysis to your business, please contact the individuals below.

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ENDNOTES

¹ The Section 414(c) regulations that are cross-referenced in the ERISA Title IV withdrawal liability provision do not address what constitutes a "trade or business".