In today’s private equity environment, two common transactions between fund-owned portfolio corporations present challenging tax considerations: (1) asset sales between fund-owned portfolio corporations and (2) the acquisition by a fund-owned portfolio corporation of another portfolio corporation’s debt. (These were reviewed in Keller, “Transactions Between Private-Equity-Fund-Owned Portfolio Corporations,” Tax Clinic, 37 The Tax Adviser 518 (September 2006); the current item contains excerpts from that 2006 item.)
In September 2007, there was an interesting Pension Benefit Guaranty Corporation (PBGC) Appeals Board decision that, aside from its obvious potential ERISA implications, might alter the federal income tax consequences of the second item and, for that matter, any other private equity transactions where concluding whether the fund itself conducts a “trade or business” is critical to some income tax result.
The following example was discussed in the September 2006 Tax Clinic:
X Corp. and Y Corp. are both C corporation portfolio investments wholly owned by F, a private equity fund. F is a large, diversely held limited partnership (i.e., five or fewer persons own more than 50%) engaged primarily in long-term investing that generates a preponderance of income from long-term capital gains and dividends. F’s general partner manages its assets full time. Although the investment purpose of any particular underlying portfolio corporation might vary, F is a typical leveraged buyout fund, primarily dedicated to the capital appreciation of its underlying investments. X and Y each operate a separate trade or business, with separate and distinct management. They have no commonalities other than being owned by F. Y has acquired certain debt of X from an unrelated third-party creditor at a substantial discount. If X settled its debt for a discount, cancellation of debt (COD) income would result (assume none of the Sec. 108(a)(1) exclusions apply). However, because Y acquired the debt, and assuming X services the debt’s full face amount, does X recognize the discount as COD income, or does Y recognize it as gain (over the appropriate timing)?
According to Sec. 108(e)(4)(A), the acquisition of debt by a person bearing a relationship to the debtor, as specified in Secs. 267(b) or 707(b)(1), from a person who does not bear such a relationship to the debtor is treated as the acquisition of such debt by the debtor. In addition, Sec. 108(e)(4)(C) provides that two entities, treated as a single employer under Sec. 414(b) or (c), are treated as bearing a relationship to each other as described in Sec. 267(b). Thus, Y’s acquisition of X’s debt will result in COD income to X, if X and Y are “related” under Sec. 108(e)(4). But are they related?
The September 2006 Tax Clinic discussion concluded that X and Y were not related taxpayers under Sec. 267 and that Sec. 707(b)(1) did not apply to them. It also concluded that X and Y were not members of a controlled group under Sec. 414(b). Thus, they were clearly not related under Secs. 267, 707, or 414(b). However, the relationship of X and Y under Sec. 414(c) is less clear. A recent PBGC Appeals Board decision adds context to the analysis as a result of its specificity to a private equity fund and its underlying portfolio corporations (PBGC Appeals Board Decision, “[Company ‘A’] Pension Plan” (9/26/07), www.pbgc.gov/apbletters/Decision--(Liability within a group of companies) 2007-09-26.pdf).
Trades or Businesses Under Common ControlAccording to Sec. 414(c), all employees of trades or businesses (whether or not incorporated) that are under common control are treated as employed by a single employer. Regs. Sec. 1.414(c)-2(a) defines two or more trades or businesses under common control to include a brother-sister group of trades or businesses under common control, a combined group of trades or businesses under common control, and a parent-subsidiary group of trades or businesses under common control. The first two of these three definitions can be dealt with easily.
Brother-sister group: Under Regs. Sec. 1.414(c)-2(c)(1), a brother-sister group of trades or businesses under common control refers to two organizations conducting trades or businesses, if the same five or fewer persons who are individuals, estates, or trusts own a controlling interest in each organization and, when such person’s ownership of each organization is identical, such person is in effective control of each organization. Under the Regs. Sec. 1.414(c)-2(c)(2)(iii) definition of effective control, if the brother-sister group is owned by a partnership, such five or fewer persons must own more than 50% of that partnership. Thus, X and Y are not members of a brother-sister controlled group because the five-or-fewer/50% test is not met.
Combined group: Regs. Sec. 1.414(c)-2(d) provides that a “combined group of trades or businesses under common control” means any group of three or more organizations, if (1) each such organization is a member of either a parent-subsidiary group of trades or businesses under common control or a brother-sister group of trades or businesses under common control, and (2) at least one such organization is the common parent organization of a parent-subsidiary group of trades or businesses under common control and is also a member of a brother-sister group of trades or businesses under common control. F, X, and Y are not a combined group because although F is the common parent of X and Y, it is not also a member of a brother-sister group.
Parent-subsidiary group: According to Regs. Sec. 1.414(c)-2(b), a parent-subsidiary group of trades or businesses refers to one or more chains of organizations conducting trades or businesses connected through ownership of a controlling interest (80%) with a common parent organization, if a controlling interest in each organization (except the parent) is owned by one or more of the other organizations, and the parent owns a controlling interest in at least one of the other organizations.
The regulations do not explicitly state whether the parent in a parent-subsidiary group must itself conduct a trade or business. However, the regulation’s examples strongly imply that this is necessary. Moreover, the relevant distinction between a parent-subsidiary group and a brother-sister group would appear to be meaningless without a requirement that the parent in a parent-subsidiary group itself be engaged in a trade or business. Regs. Sec. 1.414(c)-2(e), Example (1)(a), offers the following facts:
ABC partnership owns stock possessing 80% of the total combined voting power of all classes of stock entitled to vote of S corporation. ABC partnership is the common parent of a parent-subsidiary group of trades or businesses under common control consisting of the ABC partnership and the S corporation.
This example does not specify that ABC partnership conducts a trade or business. However, this is implied in the conclusion that ABC is the common parent of a parent-subsidiary group of trades or businesses under common control. The very reference to trades or businesses (in the plural) makes this apparent. In addition, Regs. Sec. 1.414(c)-2 is titled, “Two or more trades or businesses under common control.”
Regs. Sec. 1.414(c)-2(e), Example (3), has the following facts:
ABC partnership is treated as the owner of stock possessing 100% of the voting power and classes of stock of X and Y corporations. Thus, ABC is the common parent of the parent-subsidiary group of trades or businesses under common control consisting of ABC partnership, X corporation, and Y corporation.
Although this might at first appear similar to the facts in Regs. Sec. 1.414(c)-2(e), Example (1)(a) (above), Example (3) does not specify that ABC partnership conducts a trade or business. Instead, it is again implied, via the conclusion that ABC is the common parent of this parent-subsidiary group of two chains of organizations conducting trades or businesses under common control. The ABC–X chain is one chain of organizations conducting trades or businesses; the ABC–Y chain is the other. Thus, because there are two chains of organizations conducting trades or businesses connected through ownership of a controlling interest with a common parent (ABC), there is a parent-subsidiary group consisting of ABC, X, and Y. Inasmuch as Regs. Sec. 1.414(c)-2(b) literally requires a chain of organizations conducting trades or businesses, for such a chain to exist, the parent and the subsidiary must each conduct a trade or business.
Distinction: There also is a distinction between the parent-subsidiary group provisions under Regs. Sec. 1.414(c)-2(b) and the brother-sister group provisions under Regs. Sec. 1.414(c)-2(c). A brother-sister group exists if organizations conducting trades or businesses are under the common control of the same five or fewer persons. If the brother-sister group is owned by a partnership, such persons must own more than 50% of that partnership. However, the brother-sister regulations do not require the group to be connected by a parent in a chain of organizations conducting trades or businesses.
In other words, the parent’s trade or business is irrelevant in the brother-sister regulations; it is only relevant that the brother-sister organizations conduct trades or businesses. Thus, if the brother-sister group is owned by a partnership, it is irrelevant whether the partnership conducts a trade or business in determining whether a brother-sister group ultimately exists below the partnership.
In contrast, a parent-subsidiary group exists if there are one or more chains of organizations conducting trades or businesses connected through a common parent. Absent the reference to “one or more chains of organizations conducting trades or businesses,” the brother-sister regulations would have little (if any) distinction from the parent-subsidiary regulations when, for example, multiple subsidiaries exist under a partnership parent (i.e., in Regs. Sec. 1.414(c)-2(e), Example (3)). Because a law presumably cannot be read to be meaningless, it is apparent that the distinction under the parent-subsidiary regulations is the requirement that the parent itself conduct a trade or business.
Further, a leading treatise cites Regs. Sec. 1.414(c)-2(b)(1) to describe a parent-subsidiary group under Sec. 414(c). According to Bittker and Lokken, Federal Taxation of Income, Estates and Gifts ¶61.11.2 (WG&L 2004), a parent-subsidiary group is
[o]ne or more chains of organizations, each of which carries on a trade or business, one of which is a common parent organization, and a controlling interest in each of which (other than the parent) is owned by the common parent or another member of the group. [Emphasis added.]
Accordingly, in the example from the 2006 Clinic item, unless F is deemed to be engaged in a trade or business, F, X, and Y would not be a parent-subsidiary group as defined in Sec. 414(c). The comment “unless F is deemed to be engaged in a trade or business” is, of course, an important one and is where the September 26, 2007, PBGC Appeals Board decision comes in.
The good news is that in its decision the PBGC Appeals Board clearly agrees that F must be in a trade or business—a conclusion that, until this decision, was never specifically addressed, in either a federal income tax or a benefit plan context. The bad news is that the PBGC Appeals Board decided that F was in fact engaged in a trade or business, and it did so in a stream of thought process specifically and squarely applicable to the typical fund-owned portfolio corporation setting so common in today’s private equity environment.
Defining “Trade or Business”There is no statutory or regulatory definition of the phrase “trade or business,” although the term appears in literally hundreds of Code provisions. Thus, the definition has fallen to the courts. In Groetzinger, 480 U.S. 23 (1987), the Supreme Court identified two main requirements for an activity to constitute a trade or business when claiming business deductions under Sec. 162: The activity must be conducted (1) for profit (rather than for recreation) and (2) with continuity and regularity.
Almost all of the cases cited in Groet-zinger have dealt with the definition of a trade or business, as used in Sec. 162 and its predecessors. Not only is the term as used in Sec. 414(c) not defined in the Code or regulations, but the definition appears to have never been considered by the courts in a tax case or by the IRS in its rulings. However, the term as used in the Multiemployer Pension Plan Amendments Act of 1980, P.L. 96-364 (MPPAA), has been frequently interpreted and applied by the courts. The September 2006 item cited a number of MPPAA cases in which the vast majority, in finding that a separate entity that merely engages in limited economic activity is a trade or business, involved entities with some economic nexus with the principal business.
Further, many courts in MPPAA cases have accepted the Supreme Court’s analysis in Groetzinger in distinguishing trades or businesses from investments. However, the courts in the MPPAA cases had not yet (and still have not yet) specifically addressed whether a private securities partnership, such as F, constitutes a trade or business. The September 2006 Tax Clinic discussion concluded that, based on case law (particularly Groetzinger and its progeny) and considering F’s activities and sources of income, it is unlikely that F would be classified as being in a trade or business under Sec. 414(c). The common thread of these cases is that for a taxpayer to be a trader rather than an investor, its securities activities must be almost daily, not sporadic, and its income must be from short-term trading-type income, rather than from long-term capital gains, dividends, and interest (i.e., investment-type income).
Now fast forward to today and consider the September 26, 2007, PBGC Appeals Board decision. Although not a judicial decision and, of course, not decided in a federal income tax context (so one might immediately decide it is not determinative for federal income tax purposes), the PBGC decision appears to be the most dedicated analysis of this issue specific to the private equity environment to date.
PBGC Appeals DecisionThe company that is the subject of the Appeals Board decision (the subject company) is a management company of a private equity fund. It made the appeal as a result of the PBGC’s determination that the fund, and certain other companies owned by the fund, were members of a controlled group and were jointly and severally liable to the PBGC for the unfunded benefit liabilities of one of the company’s plans. The appeal was made with respect to two issues: (1) the fund’s liability for the unfunded benefit liabilities of the plan and (2) the other companies’ joint and several liability for the same.
With respect to the first item, the PBGC Appeals Board denied the appeal and sustained the PBGC’s determination that the fund was under common control with the sponsor of the plan and that the fund and the sponsor were jointly and severally liable to the PBGC for the liability imposed. With respect to the second item, the PBGC Appeals Board granted the appeal. Of particular interest in the appeal is the Appeals Board’s analysis of whether the fund is conducting a trade or business.
The fund at issue was a limited partnership established under Delaware law by its general partner and numerous independent institutional investors as limited partners. The fund’s governing documents delegated full control over the fund’s business affairs to its general partner, which has a 1% capital interest and a 20% carried interest in all profits realized by the fund. Further, the fund’s governing documents described the fund’s purpose of organization to include creating and realizing long-term capital gains including, without limitation, the general buying, selling, holding, and otherwise investing in securities of every kind and nature, entering into, making, and performing all contracts and other undertakings with respect to such investments, and managing and supervising such investments, etc. All of the background facts presented in the appeal for the fund at issue are typical among numerous funds in today’s private equity environment.
The Subject Company’s ArgumentsThe subject company asserted various grounds in its appeal for changing the PBGC’s determination. The primary ground was that the fund was not conducting a trade or business and therefore could not be part of the controlled group at issue. The subject company argued that the fund was not conducting a trade or business either because the fund’s general partner did not have responsibility for managing the fund or because the fund was engaged in passive investment activities and its activities did not qualify as trade or business under the Groetzinger test. The subject company did not dispute the PBGC’s determination that a parent-subsidiary relationship exists between the fund and the plan sponsor.
In analyzing whether or not the fund was engaged in a trade or business, the Appeals Board concluded that it is appropriate to consider the duties and responsibilities delegated to and assumed by the general partner of the fund. The Appeals Board further took into account that in Delaware, as a matter of law, an agency relationship exists between the fund and its general partner whereby each partner is an agent of the partnership for the purpose of its business, purposes, or activities.
In the appeal, the subject company contended that because it was responsible for the day-to-day management of the fund, the general partner was not. However, the Appeals Board countered by citing the terms of the fund’s partnership agreement, which provided that the appointment of a management agent (i.e., the subject company) “shall not in any way relieve the general partner of its responsibilities and authority vested pursuant to the fund’s governing documents or relieve the general partner of any fiduciary duties to the fund and its partners.”
According to the Appeals Board, based on the partnership agreement and the management agreement with the subject company, the fund’s general partner had hired the subject company as the fund’s management agent to assist in managing the fund’s investments but did not relinquish all management responsibilities. The Appeals Board found that while the management and partnership agreements proved that the subject company was hired to assist the fund by providing investment and management services, they did not prove that such activities were conducted only by the subject company.
Therefore, the Appeals Board concluded that the general partner participated in the fund’s investment activities and also received compensation in the form of its 20% carried interest in exchange for its services. As the fund’s agent, all of the general partner’s acts within the scope of its agency were attributable to the fund.
The Appeals Board also applied the Groetzinger trade or business test to the fund in making its decision. As noted above, a taxpayer is engaged in a trade or business under this test if it engages in an activity primarily with a profit motive and if the activity is carried out with continuity and regularity. Based on the fund’s tax returns and language in the partnership agreement, the Appeals Board concluded that the fund met the profit motive requirement described in Groetzinger. The Appeals Board further analyzed the size of the fund’s portfolio, the profits generated by its investments, and the fees that it had paid to the subject company in concluding that the general partner’s management of the fund’s investments was conducted with regularity. It thus determined that the fund, through the activities of its agent (the general partner), met the second prong of the Groetzinger test.
The subject company also asserted in its appeal that the fund is not engaged in a trade or business because “investment activities do not constitute a trade or business.” The subject company described the fund as “a passive investment vehicle that has no employees, no involvement in the day-to-day operations of its portfolio investments, and no income other than passive investment income such as dividends, interest, and capital gains.” Essentially, the argument was that the fund is a passive investor, predicated on the suggestion that “in the income tax context, it is universally accepted that passive investment activities do not constitute a trade or business.” The subject company cited several cases to this effect, most notably Higgins, 312 U.S. 212 (1941); Whipple, 373 U.S. 193 (1963); and Zink, 929 F.2d 1015 (5th Cir. 1991).
The Appeals Board considered all these cases and ultimately concluded that the “passive” investment activities described in all three, as well as other cases the subject company had cited, were distinguishable from the much more active involvement of the fund (through its general partner) with respect to its investments. The Appeals Board further concluded that the fund’s delegation of many of its management functions to other entities did not establish that the fund was merely a “passive investor.” Accordingly, the Appeals Board, having claimed to have fully analyzed the holdings in all the court cases the subject company cited in its appeal, ultimately decided that the fund was in a trade or business for purposes of controlled group liability under ERISA.
ConclusionThe September 2006 Tax Clinic item concluded that, with respect to the COD income matter, X and Y appear unrelated under Sec. 414(c). Thus, Y’s acquisition of X’s debt appears not to result in COD income to X under Sec. 108(e)(4). Instead, Y should recognize the discount as gain over the appropriate timing as the debt is serviced. The September 26, 2007, PBGC Appeals decision certainly gives cause to reconsider this conclusion. And of course this might be only one example of numerous instances in which the relatedness of two portfolio corporations under the same fund might be important to some federal income tax analysis.
As mentioned above, because this is a nonjudicial decision in an ERISA setting, it is not itself determinative in the context of federal income taxation. However, a discussion in the Appeals decision should cause concern about dismissing the decision too quickly. In the appeal, the subject company suggested that the PBGC lacks authority to interpret 29 U.S.C. Section 1301(a)(14)(B) (ERISA Section 4001(a)(14)(B)) related to controlled group determinations because Congress granted such interpretive authority to Treasury. In its decision, the PBGC Appeals Board disagreed and suggested that the only restriction ERISA imposes on the PBGC’s authority to interpret 29 U.S.C. Section 1301(a)(14)(B) is that its regulations must be “consistent and coextensive” with the applicable regulations issued under Sec. 414.
Further, the subject company asserted that the PBGC lacked authority to adjudicate this case under ERISA in any fashion contrary to the judicial definition of “trade or business” in the federal income tax context, stating that this definition excludes investment activities. The Appeals Board disagreed, stating that, as several courts have noted, interpretations under the Internal Revenue Code are not determinative of whether an entity is in a trade or business under ERISA. The Appeals Board further suggested that, in this case, the PBGC’s determination does not involve an interpretation of “trade or business” that differs from the judicial definition in the tax context. The Appeals Board believed that the PBGC’s determination was consistent with the trade or business test articulated in Groetzinger and with judicial decisions that have applied the Groetzinger test in determining liability under ERISA.
Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Chizek.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.