Whether Private Equity Funds are a Trade or Business - Sun Capital Partners III v. N. E. Teamsters Truck. Industry Pension Fund

Whether Private Equity Funds are a Trade or Business -
Sun Capital Partners III v. N. E. Teamsters Truck. Industry Pension Fund

1.  Background on Controlled Group Liability

a. Controlled Group Liability.  Controlled group status as a single employer as set forth in IRC §414(b) and (c) apply for termination liability, multiemployer withdrawal liability, PBGC premiums, minimum funding obligations, COBRA continuation coverage, etc.

b. Parent-subsidiary test. A parent-subsidiary controlled group will exist if there is a chain of entities conducting trades or businesses that are connected through a controlling interest with a common parent, with controlling interest being defined: (i) in the case of corporation as at least 80% of the total combined voting power of all classes entitled to vote or at least 80% of the total value of all shares; (ii) in the case of a trust or estate an 80% actuarial interest; (iii) in the case of a partnership (or entity taxed as a partnership) an 80% interest in profits or capital; and (iv) in the case of a sole proprietorship 100% ownership. IRC §1563(a)(1); Treas. Reg. §1.414(c)-2(b)(2).

c. Brother-sister test. A brother-sister controlled group exists where there are two or more trades or businesses which meet two tests: (i) the same five or fewer persons who are individuals, estates or trusts own together 80% or more of “control” as defined above in each of the entities; and (ii) such five individuals own together 50% or more of the entities where ownership is taken into account only to the extent it is identical with respect to each such trade or business.  IRC §1563(a)(2); Treas. Reg. §1.414(c)-2(c). That is, if corporations X, Y and Z are partially owned by individual A with a 20%, 30% and 40% interest, respectively, the identical ownership interest that is counted for individual A is only 20%.

d. Trade or business.  A trade or business is generally interpreted to mean regular and continuous activities that are designed to produce income.  Neither ERISA nor the Treasury Regulations define “trade or business.” Courts have generally adopted the standard articulated in C.I.R. v. Groetzinger, 480 U.S. 23, 35, 107 S. Ct. 980, 987, 94 L. Ed. 2d 25 (1987), where the Supreme Court held that in the context of IRC §162: “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity must be for income or profit. Sporadic activity, a hobby, or an amusement diversion does not qualify.”

e. Liability of sole proprietor engaging in trade or business. Although individual shareholders of corporations are not liable for the corporation's Title IV liabilities under the controlled group rules, a controlled group includes a trade or business, and thus any unincorporated trade or business that an individual operates, e.g., a sole proprietorship or a partnership, would indirectly cause him or her to be individually liable for the plan termination.  Many courts have found shareholders liable by reason of some activity they engaged in as a sole proprietor.

2.  Whether Private Equity Funds are a Trade or Business

a. Trade or Business. Only “trades or business” under common control are treated as part of an ERISA controlled group. Neither ERISA nor the Treasury regulations define “trade or business.” As stated above, courts have generally adopted the standard articulated in C.I.R. v. Groetzinger, where the Supreme Court held that a trade or business is an activity with continuity and regularity and for the primary purpose for income or profit (while sporadic activity, a hobby, or an amusement diversion does not qualify).

b. 2007 PBGC Appeals Board Opinion – Private Equity Investors are Not Passive Investors.  With regard to private equity funds many practitioners had taken the view that since they are generally passive investment vehicles with no employees and minimal involvement in day-to-day operations, they are not trades or businesses, and therefore separate portfolio companies owned by a private equity fund or funds would not be in the same ERISA controlled group. However, the PBGC ruled in a 2007 PBGC Appeals Board Opinion that a private equity fund was a trade or business, because it was engaged in an activity with the primary purpose of income or profit and conducted business through an agent (the general partner) who managed fund investments on a regular basis.

c. 80%-owned portfolio companies of a private equity fund. According to this PBGC ruling, 80%-owned portfolio companies of a private equity fund would generally be in the same ERISA controlled group (except in a rare case where the fund's activity does not meet the Groetzinger standard).

d. Palladium Equity Partners 2010 Case Affirming PBGC Opinion and Investment Plus.  A 2010 Eastern District of Michigan case found the 2007 PBGC Appeals Board Opinion to be persuasive and “investment plus” is a trade or business. Board of Trustees, Sheet Metal Workers National Pension Fund v. Palladium Equity Partners, 722 F. Supp. 2d 854 (E.D. Mich. 2010) (genuine issue of material fact existed as to whether three Palladium limited partnerships, as well as Palladium Equity Partners, LLC which served as advisor, were an ERISA controlled group parent liable for ERISA multiemployer withdrawal liability of the Haden group of companies; the court found the 2007 PBGC Appeals Board Opinion to be persuasive that although investment alone is not a trade or business, where there is “investment plus,” e.g., investment advisory and management services by the fund for the benefit of its partners and compensation for the investment advisory and management services, this  would constitute a trade or business; court found there was a genuine issue of material fact as to whether the Palladium funds had a business purpose other than merely investment; the Palladium funds joined their investments to exert power over financial and managerial activities of the portfolio companies, selected five of the seven board members and set up several committees to control the internal operations of the portfolio companies; there was also general issue of material fact regarding alter-ego liability).

e. Sun Capital Partners III, LP 2013 First Circuit Case.  A 2013 First Circuit case, Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pension Fund, overturned a district court case and it also found the PBGC Appeals Board Opinion to be persuasive.  724 F.3d 129 (1st Cir. 2013), cert. denied, 134 S. Ct. 1492 (2014):

• two private equity funds managed by Sun Capital owned 70% and 30% of Scott Brass, Inc. which withdrew from a multiemployer pension plan prior to filing for bankruptcy; Scott Brass was indirectly wholly owned by Sun Fund III (30%) and Sun Fund IV (70%);
• the district court at 903 F.Supp.2d 107 (D. Mass. 2012), had granted the Sun Capital Partners equity funds’ motion to dismiss holding that the private equity funds were passive investors and not a trade or business and the 2007 PBGC Appeals Board Opinion was found by the district court to be unpersuasive because activity of the general partner should not have been attributed to the investment fund and continuity and regularity of an activity should not be found merely based on the size of the investment and profitability;
• however, the First Circuit overturned the district court ruling regarding the funds being a “trade or business” and held that at least the larger of the two Sun funds (Fund IV) was engaged in a trade or business under an “investment plus” analysis since there was more than mere passive investment, noting that

o   the funds sought out potential portfolio companies that were in need of extensive management intervention,

o   the general partners of the funds had wide range management authority,

o   the funds had the power to appoint a majority of board members,

o   the general partners of the funds could make decisions regarding hiring, termination and compensation of employees in the portfolio companies, and

o   at least with respect to Sun Fund IV (the 70% owners) the active investment in management provided a direct economic benefit that an ordinary passive investor would not derive, i.e., management fees the fund otherwise would have needed to pay its general partner of the fund was offset by fees the underlying company was paying to the general partner.

• both the district court and the First Circuit found in regard to Sun Capital funds that the purchase of Scott Brass, Inc. in a 70%-30% split was not done with a principal purpose to evade or avoid liability under ERISA §4212(c), according to the district court because there were legitimate business reasons for the investment ownership in order to decrease investment risk for each fund and according to the First Circuit because disregarding a 70%-30% split would leave zero ownership;
• the First Circuit remanded the case to the district court to determine if there was a trade or balance in Sun Fund III (the 30% owners) and to determine if there was common control by the 70%-30% ownership (for example if the joint venture is seen as common ownership). 

f. Sun Capital Partners III, LP, 2016 D.C. Mass. Decision on Remand.

On remand of Sun Capital Partners from the First Circuit, the District Court in Massachusetts ruled that: (i) both funds (the Sun Fund IV with a 70% investment and Sun Fund III with a 30% investment) were trades or businesses, and (ii) that there was common control under ERISA by reason of Fund III and IV being a "partnership in fact."  Sun Capital Partners III, LP v. New England Teamsters and Trading Industry Pension Fund, _ F. Supp. 3d _, 2016 WL 1239918 (D. Mass. March 28, 2016).

The District Court of Mass. in 2016 held that:

• under the "investment plus" analysis not only was Sun Fund IV a trade or business, but Sun Fund III was also a trade or business because it too had a direct economic benefit that a passive investor would not have, i.e., an offset of fees otherwise owed by Sun Fund III to its general partner for managing the investments that were indirectly paid by the underlying portfolio company; and
  
  
• with regard to controlled group common ownership, Sun Fund IV and Sun Fund III of Scott Brass, Inc. (with 70% and 30% ownership), while not specifically meeting the requirements for an ERISA controlled group because there was no 80% controlling interest, nevertheless Sun Fund III and Sun Fund IV are a jointly controlled entity where there was a partnership-in-fact since the two funds often co-invest together, and despite the lack of permanently fixed co-investing, these Sun Funds should be considered as joining together as a "partnership-in-fact" to invest in Scott Brass.
  
  
• The district court noted that the fund split in ownership was done because the fund was nearing the end of its investment cycle, a preference for income diversification and a desire to keep ownership below 80% to avoid ERISA withdrawal liability (though avoiding controlled group liability was not the principal purpose of the transaction for purposes of ERISA § 4212(c)).

Sun Capital Partners appealed the District Court decision to the First Circuit on April 8, 2016.

g. Criticism of 2016 District Court Sun Capital Partners Case.  The latter holding of the Sun Capital district court case that there was an ERISA controlled group with regard to the funds because of a partnership-in-fact (resulting in aggregation of the ownership interests despite the lack of partnership formalities) is a puzzling holding for the following reasons:

• partnership-in-fact is tax law concept that should not be automatically applied to ERISA controlled group liability situations;
• finding an ERISA controlled group could have consequences beyond withdrawal liability, such as single employer plan termination liability, non-discrimination testing, being a single entity for COBRA and IRC § 409A purposes and defaults in credit agreements; and
• the bright line ERISA controlled group test was being expanded in a way not contemplated by the statute or regulations.

Supreme Court Strikes Down Yard-Man Inference for Collectively Bargained Retiree Health Benefits to Continue for Life - M & G Polymers v. Tackett - 5/4/2015

M & G Polymers v. Tackett (Supreme Court Jan. 2015) Strikes Down

Yard-Man Inference for Collectively Bargained Retiree Health Benefits

to Continue for Life; Court Holds Ordinary Contract Provisions Apply

·         Since the early 1990s there has been a push by employers to cut back or terminate retiree health plans.

·         In contrast to pension (qualified plan) benefits, welfare benefits do not vest by operation of law, but an employer can contractually obligate to vest benefits.

·         There may be statements or communication implying lifetime benefits, but the plan documents and communication often reserve the right to modify or discontinue the benefits (so that there be no issue of a contractual lifetime obligation).

·         Where retiree health benefits were the subject of collectively bargained negotiations, the Sixth Court in International Union, United Auto, Aerospace and Agr. Implement Workers of Am. (UAW) v. Yard-Man, Inc., 716 F.2d 1476 (6th Cir. 1983), held that there is an inference that the intent was for these bargained-for benefits to continue throughout retirement even after the expiration of the term of the collective bargaining agreement.

·         The First and Eleventh Circuits have followed this Sixth Circuit view of the Yard-Man inference.  The Third, Fifth and Eighth Circuits have rejected it.  (The Seventh Circuit first adopted the Yard-Man view, but then rejected it.)

·         The Sixth Circuit itself also cut back on the Yard-Man inference, limiting it to retiree health, to actual retirees, to cases where union contract evidences an intent to vest benefit and to where retiree health was specifically bargained for.

·         In a January 2015 decision, M & G Polymers USA, LLC v. Tackett, 135 S.Ct. 926 (January 26, 2015), the Supreme Court reversed a Sixth Circuit 2013 decision which had ruled in favor of retirees with respect to lifetime retiree health benefits that were bargained for based on the Yard-Man inference that bargained-for benefits are presumed to continue through retirement.  The Supreme Court struck down the Yard-Man inference and held that collective bargaining agreements are subject to ordinary principles of contract law.  The collective bargaining agreement in M & G Polymers did not promise the retiree benefits for life, and in fact the agreement stated that the benefits would be provided for the duration of the agreement and would be subject to renegotiation in three years.  The Court stated that traditional contract rules would dictate that ambiguous writings in collective bargaining agreements do not created lifetime promises, and contractual obligations will cease in the ordinary course on termination of the bargaining agreement.  Therefore the Supreme Court vacated the Sixth Circuit ruling in this case, and this case was remanded to the lower court to make a finding without the Yard-Man inference.

·         Details of the Case: M & G Polymers USA, LLC v. Tackett, 135 S.Ct. 926 (Jan. 26, 2015) (predecessor employer, Point Pleasant Polyester Plant, had provided to union employees (who were eligible for a pension benefit) employer-paid retiree health benefits, and this was negotiated in the pension & insurance agreement attached to the collective-bargaining agreement; the agreement provided for the benefits to be provided for the duration of the labor agreement (three-year term until next negotiation); these provisions were also included in the collective bargaining agreement negotiated by M & G Polymer USA, LLC, which purchased the plant in 2000; in 2006 M & G Polymers announced that it would begin requiring retirees to contribute to the cost of the retiree health benefits; retirees sued arguing that they were promised lifetime employer-paid benefits; the Sixth Circuit in 2009, 561 F.3d 478, held that, based on the Yard-Man Sixth Circuit 1983 decision, there was an inference that bargained-for retiree benefits would vest for life, and the district court then found for the retirees; the Sixth Circuit affirmed this decision in 2013, 733 F.3d 586; the Supreme Court granted certiorari and reversed the decision; the Court noted that welfare benefits do not vest under ERISA but can be vested by contract, and that collective bargaining agreements are to be analyzed according to ordinary principals of contract law, in contrast to the Yard-Man decision; the Court disagreed with the Yard-Man inference, as collective bargaining agreements should be governed by ordinary contract law, and any inferences as to intent should be drawn from the specific facts; without specific evidence there should be no presumption that the parties intended to continue the benefits throughout retirement; durational clauses in collective bargaining agreements should govern and contractual obligations should generally cease on termination of the collective bargaining agreement; ambiguous writings should not be construed to create lifetime promises; the Court therefore rejected the Yard-Man inference, and this case was remanded for the lower court to apply ordinary principals of contract law to the facts; the decision, which was unanimous, was written by Justice Thomas, but there was a concurrence by Justice Ginsburg noting that in determining whether the parties intended to vest retiree health benefits implied terms of the agreement, e.g., whether the retiree health benefits were equated to pension benefits, should be examined, as should extrinsic evidence).

COST-OF-LIVING ADJUSTMENTS 2015

COST-OF-LIVING ADJUSTMENTS - 2015

Pension Plan and Related Limits	2014	2015
Pre-tax elective deferral maximum under IRC § 401(k), 403(b), and 457(b) plans	$17,500	$18,000
Age 50 and older “catch-up” adjustment for 401(k), 403(b), and governmental 457(b) plans and SEPs	$5,500	$6,000
Annual compensation limit under IRC §§ 401(a)(17), 404(l) and 408(k)	$260,000	$265,000
Annual benefit limit for defined benefit plans under IRC § 415(b)	$210,000	$210,000
Annual contribution limit for defined contribution plans under IRC § 415(c)	$52,000	$53,000
Highly compensated employee threshold for purposes of testing in the following year under IRC § 414(q)(1)(B)	$115,000	$120,000
Key employee threshold for top heavy plan under IRC § 416(i)	$170,000	$170,000
IRC § 430(c)(7)(D)(i)(II) amount for determining excess employee compensation for single-employer defined benefit plans where election has been made	$1,084,000	$1,101,000
ESOP account balance for five-year and one-year distribution rule under IRC § 409(o)(1)(C)(ii)	$1,050,000 and $210,000	$1,070,000 and $210,000
SEP pension compensation threshold under IRC § 408(k)	$550	$600
SIMPLE plan elective deferral limit under IRC § 408(p)(2)(E)	$12,000	$12,500
SIMPLE plan age 50 catch-up	$2,500	$3,000
Basic IRA/Roth IRA contribution limitation under IRC § 219(b)/§ 408A (age 50 $1,000 catch-up for IRAs does not have cost-of-living adjustment)	$5,500	$5,500
Phase-out for deductions for IRA for married couples filing jointly, in which the spouse who makes the IRA contribution is an active participant in an employer-sponsored retirement plan	$96,000 to $116,000	$98,000 to $118,000
Adjusted gross income (AGI) phase-out range for married joint filers taxpayers making contributions to a Roth IRA	$181,000 to $191,000	$183,000 to $193,000
AGI limit for retirement savings contributions (saver's) credit for married couples filing jointly	$60,000	$61,000
Health Savings Account contribution limits (single and family)	$3,300 and $6,550	$3,350 and $6,650
Maximum monthly benefit guarantee by PBGC	$4943.18	$5,011.33
PBGC flat-rate premium for a single-employer plans (as amended by MAP-21 2012 legislation)	$49	$57
Taxable wage base subject to FICA tax	$117,000	$118,500

Rollover Safe Harbors

Regulations provide that where a plan accepts a rollover contribution it will be treated for purposes of the qualification rules as a valid rollover contribution as long as the following two conditions are satisfied.  First, the plan administrator reasonably concludes that the contribution is a valid rollover contribution. Second, if the plan administrator of the receiving plan later determines that the contribution was an invalid rollover contribution, the amount of invalid contribution plus earnings must be distributed to the employee. Treas. Reg. § 1.401(a)(31)-1, Q & A 14(a).

For purposes of the first condition that the plan administrator must reasonably conclude that the contribution is a valid rollover contribution, the regulations note that while evidence of a favorable IRS determination letter is useful in concluding that the contribution is a valid rollover contribution, a determination letter is not necessary to conclude that the contribution is a valid rollover contribution.  Treas. Reg. § 1.401(a)(31)-1, Q & A 14(a).

The regulations give various examples where the plan administrator of the receiving plan may conclude that the contribution as a valid rollover contribution.  For example, a letter from plan administrator of distributing plan that it has a favorable IRS determination letter can be relied upon to conclude there is a valid rollover contribution.  Treas. Reg. § 1.401(a)(31)-1, Q & A 14(c), Ex. 1.  Alternatively, a letter from the plan administrator of the distributing plan representing that the plan is qualified and that the plan administrator is not aware of anything that would result in disqualification could also be relied upon.  Treas. Reg. § 1.401(a)(31)-1, Q & A 14(c), Ex. 2.  

According to a 2014 revenue ruling, a plan administrator of the receiving plan may rely on the fact that Line 8a of Form 5500 for distributing plan, available on www.efast.dol.gov, (or Line 9 of Form 5500-SF) does not include Code 3c for a nonqualified plan for reliance that the contribution is a valid rollover contribution.  Rev. Rul. 2014-9, Situation 1.

Similarly with regard to a rollover from a traditional IRA a check from the trustee payable to the receiving plan that indicates on the pay stub that it is an IRA of the employee (and the employee certifies that there are no after-tax amounts and the employee is not age 70-1/2), the plan administrator may conclude that the contribution from the IRA is a valid rollover contribution.  Rev. Rul. 2014-9, Situation 2.

Whether Private Equity Funds are a Trade or Business

Only “trades or business” under common control are treated as part of an ERISA controlled group.  Neither ERISA nor the Treasury regulations define “trade or business.”  Courts have generally adopted the standard articulated in Commissioner v. Groetzinger, where the Supreme Court held that in the context of IRC § 162: “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit.  Sporadic activity, a hobby, or an amusement diversion does not qualify.”  480 U.S. 23, 35, 107 S.Ct. 980, 987, 94 L.Ed.2d 25 (1987). 

With regard to private equity funds many practitioners have taken the view that since they are passive investment vehicles with no employees and no involvement in day-to-day operations, they are not trades or businesses, and the portfolio companies owned by a private equity fund would not be in the same ERISA controlled group.  However, a 2007 PBGC Appeals Board ruling held that a private equity fund was a trade or business, because it was engaged in an activity with the primary purpose of income or profit and conducted business through an agent (the general partner) who managed fund investments on a regular basis.  PBGC Appeals Board Opinion dated Sept. 26, 2007, http://www.pbgc.gov/prac/appeals-board/appeals-decisions.html (a private equity fund is a “trade or business” under the standard set forth in Comm’r v. Goetzinger, 480 U.S. 23 (1987) that “trade or business” depends on (i) whether the taxpayer is engaged in an activity with the primary purpose of income or profit, and (ii) whether the act is conducted with continuity and regularity; in the fact of the letter that the private equity fund engaged in an activity with the primary purpose of income or profit and it conducted its business through an agent who managed the fund’s investments on a regular basis; the private equity fund was therefore in the same controlled group as its bankrupt portfolio company that sponsored a pension plan).  According to this ruling, 80%-owned portfolio companies of a private equity fund may be in the same ERISA controlled group.  In the rare case that the facts and circumstances indicate that the private equity fund does not meet the Groetzinger standard, it would not be part of the controlled group.  (See ABA JCEB Q & As for PBGC (May 2008), Q & A 11, that in unusual circumstances that the fund is not a trade or business, it would not be in the controlled group.) 

A 2010 district court in the Sixth Circuit found the 2007 PBGC Appeals Board Opinion to be persuasive.  Board of Trustees, Sheet Metal Workers National Pension Fund v. Palladium Equity Partners, LLC, 722 F. Supp. 2d 854 (E.D. Mich. 2010) (genuine issue of material fact existed as to whether three Palladium limited partnerships and Palladium Equity Partners, LLC which served as advisor (the Palladium funds) were an ERISA controlled group parent liable for ERISA multiemployer withdrawal liability of the Haden group of companies: court found 2007 PBGC Appeals Board Opinion to be persuasive that although investment alone is not a trade or business, "investment plus" where there is investment advisory and management services by the fund for the benefit of its partners and there is compensation for the investment advisory and management services would constitute a trade or business; court found there was a genuine issue of material fact as to whether the Palladium funds had a business purpose other than merely investment; the Palladium funds joined their investments to exert power over financial and managerial activities of the portfolio companies, selected five of the seven board members and set up several committees to control the internal operations of the portfolio companies; there was also general issue of material fact regarding alter-ego liability). 

Likewise, a 2012 First Circuit case overturned the district court and found the PBGC Appeals Board Opinion to be persuasive.  Sun Capital Partners III, L.P. v. New England Teamsters and Trucking Industry Pension Fund, __ F.3d. __, 2013 WL 3814984 (1st. Cir. July 24, 2013) (two private equity funds managed by Sun Capital owned 70% and 30% of Scott Brass, Inc. which withdrew from a multiemployer pension plan prior to filing for bankruptcy; the district court at 903 F.Supp.2d 107 (D. Mass. 2012), had granted the Sun Capital Partners equity funds motion to dismiss since the private equity funds were passive investors and not a trade or business  and the 2007 PBGC Appeals Board Opinion was found by the district court to be unpersuasive because activity of the general partner should not have been attributed to the investment fund and continuity and regularity of an activity should not be found merely based on the size of the investment and profitability; however, the First Circuit overturned the district court ruling regarding the funds being a “trade or business” and held that at least the larger of the two Sun funds was engaged in a trade or business since there was more than mere passive investment, noting that the funds sought out potential portfolio companies that were in need of extensive management intervention, indirect management and consulting fees were provided, the funds had the power to appoint a majority of board members, and the general partners had authority regarding hiring, firing and compensation which could be attributed at least to the larger of the two funds through limited partnership agreements;  both the district court and the circuit court found in regard to Sun Capital funds that the purchase of Scott Brass, Inc. in a 70%-30% split was not done with a principal purpose to evade or avoid liability under ERISA § 4212(c), according to the district court because there were  legitimate business reasons for the investment ownership in order to decrease investment risk for each fund  and according to the First Circuit because disregarding a 70%-30% split would leave zero ownership; the First Circuit remanded the case to the district court to determine if there was common control by the 70%-30% ownership (for example if the joint venture is seen as common ownership)).

 Nevertheless, to avoid any doubt it may be advisable to specify in agreements with representations about controlled group members that representations are (or are not) made with regard to private equity investors and other portfolio companies.

Cost of Living Adjustments for 2013

See December 2013 post with 2014 and 2013 COLA numbers

RULES RELATING TO 401(K) FEE DISCLOSURE OR INVESTMENT ADVICE GUIDANCE

See June 2012 for updated memo