Private equity investor? Higher taxes may be looming.

The First Circuit U.S. Court of Appeals ruled Wednesday that private equity funds are engaged in a trade or business under the Employee Retirement Income Security Act (ERISA).  The court said the case, Sun Capital Partners v. New England Teamsters & Trucking, “presented important issues of first impression.”   And the court’s resolution of the trade or business issue now may open the door to much higher taxes for private equity funds and their investors. 

In a unanimous decision, the First Circuit rejected the district court’s finding that private equity funds are merely “passive” investors, which is the position that nearly all private equity funds take for tax purposes.  Under a typical fund’s partnership agreement, the fund must avoid engaging in a trade or business for Federal income tax purposes. 

However, the First Circuit concluded that private equity funds that actively manage the operations of their portfolio companies are engaged in a trade or business.  It does not matter whether a fund has employees or offices, or if its management company has the employees and offices.  The key is whether the fund’s activities (including those of its management company) exceed those of a typical investor.  That extra effort, of course, is the essence of private equity business and is used to justify the huge fees the funds charge their investors.  

While the decision in Sun Capital means that private equity funds may be liable for unfunded pension liabilities of their portfolio companies, it potentially has much broader tax implications that are critical for private equity funds and their investors.  For tax exempt or foreign investors, income from a private equity fund that is engaged in a trade or business is potentially subject to the unrelated business income tax (UBIT) or withholding taxes, respectively.  Moreover the decision buttresses the argument that the income of private equity managers should be taxed at higher ordinary income rates, rather than capital gains rates.  For more detail on this argument take a look at Tax Vox blogs here  and here.

Now may be a good time for private equity funds, their managers, investors, and advisers to reexamine their tax position.