Carried Interest Tax Break Risks Being Undercut by Court

A federal court ruling that’s captured the attention of the private equity world and U.S. government officials has the potential to undercut the legal tax foundation of the buyout industry.

The ruling, in a pension-law case involving Sun Capital Partners Inc., determined that private-equity funds were engaged in a “trade or business” and weren’t merely passive investors who could back out of pension-funding liabilities.

If courts or regulators apply that logic to the U.S. tax code, the changes could jeopardize the structure of the industry by altering some core benefits of private equity. Those are low-taxed carried interest for fund managers, tax-free income for universities and an exemption from U.S. taxes for foreign investors.

“The size of the risk is huge,” said Steve Rosenthal, a visiting fellow at the Tax Policy Center in Washington. “The likelihood of the IRS pursuing this is unclear.”

The court case poses a significant challenge to private equity, beyond the often-discussed proposals from President Barack Obama and other Democrats to raise taxes on fund managers’ carried interest -- a push that has foundered for six years in Congress.

So far, the Treasury Department and the Internal Revenue Service have been cautious in reacting to the legal ruling, saying publicly only that they’re looking at the issue carefully.

No ‘Rush’

“There’s a recognition that the court’s decision may give us an opportunity to reassess what ‘trade or business’ means, but I think that there won’t be any rush to issue guidance on this,” said Craig Gerson, an attorney-adviser in the Treasury Office of Tax Legislative Counsel. He spoke at an American Bar Association conference in San Francisco Sept. 20, according to Bloomberg BNA.

The Sun Capital case “could potentially have important implications” in the pension context, said Steve Judge, president and chief executive officer of the Private Equity Growth Capital Council, an industry trade group in Washington.

“This case, at its heart, is not a tax case,” he said in a statement. “Speculation that there are implications for tax law is simply that, speculation. The court did not opine on tax issues in its ruling.”

Democrats have been maintaining since 2007 that carried interest received by fund managers should be taxed as ordinary income, at rates of up to 39.6 percent, not capital gains income with a basic top rate of 20 percent.

Fund Managers

Carried interest is the profits share that fund managers receive as part of their compensation. It’s currently taxed as capital gains, because the purchase and sale of companies is treated like a stock transaction.

If and when the Sun Capital case is brought into the tax world, it could affect the “entire legal infrastructure” of private-equity funds, which are set up to protect foreign investors and tax-exempt organizations from U.S. taxation, said Victor Fleischer, a law professor at the University of San Diego.

“There’s no extra leap that a court would have to take other than applying the same reasoning and interpretation to the tax context,” Fleischer said.

The case stems from Sun Capital funds’ investment in Scott Brass Inc., a Rhode Island company that made brass and copper and was in bankruptcy protection in 2008 with pension obligations. Sun Capital claimed the funds were passive investors that weren’t in a trade or business and thus weren’t liable for pension payments.

Refused Request

A three-judge panel of the First Circuit Court of Appeals ruled against the private-equity funds on July 24 and sent the case back to a lower court to address additional issues. On Aug. 23, the judges refused Sun Capital’s request for a rehearing by the full appeals court.

Sun Capital, led by co-chief executive officers Marc Leder and Rodger Krouse, declined to comment on the case, said Thomas Faust of Stanton Public Relations and Marketing, which represents Sun Capital.

Obama’s budget would generate $16 billion over the next decade by making the change on taxation of carried interest. Democrats pushed the proposal through the House of Representatives in 2010 when they controlled the House; it never passed the Senate.

Rosenthal said that private equity funds are in the business of developing companies for resale and should be treated like real estate developers for tax purposes and pay ordinary income tax rates.

Fleischer, who maintains that carried interest should be taxed as ordinary income, said he isn’t sure whether that issue would be affected even if courts determine that the private equity funds are engaged in a trade or business.

‘Uncharted Territory’

“We’re kind of on uncharted territory here,” he said.

The IRS may have to act, Fleischer said, because an individual investor could cite the Sun Capital case. If the funds are active businesses, investors would be able to take bigger deductions for the fees they pay.

The IRS would either accept that taxpayer’s position, which would have negative consequences for the fund and its tax-exempt investors, or challenge it, hoping courts would analyze the issue in a different way than the First Circuit did.

“If it lands on their doorstep,” Fleischer said, “people will run it up the chain and somebody will have to make a policy decision.”

    Before it's here, it's on the Bloomberg Terminal. LEARN MORE