Carried Interests: Current Developments

Joseph Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. This post is based on an article by Mr. Bachelder which first appeared in the New York Law Journal.

The tax status of so-called “carried interests,” held by private equity fund sponsors (and benefitting, in particular, the individual managers of those sponsors) is the subject of this post. A decision by the U.S. Court of Appeals for the First Circuit holding that a private equity fund was engaged in a trade or business for purposes of the withdrawal liability provisions of ERISA (Employee Retirement Income Security Act) has caused considerable comment on the issue of whether a private equity fund might also be held to be in a trade or business (and not just a passive investor) for purposes of capital gains tax treatment on the sale of its portfolio companies. Proposed federal income tax legislation, beginning in 2007 and continuing into 2013, also has raised concern as to the status of capital gains tax treatment for holders of carried interests. The following post addresses both of these developments.

The Sun Capital Case

In a multiemployer pension plan withdrawal liability case, Sun Capital Partners III v. New Eng. Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. 2013), the First Circuit held that a private equity fund could be found liable for the liability of one of its portfolio companies. [1] In doing so it reversed the district court, remanding as to the issue of “common control” for the equity fund involved in its decision. The First Circuit’s decision is the subject of a petition for a writ of certiorari filed by Sun Capital with the U.S. Supreme Court Nov. 21, 2013.

The portfolio company’s liability was incurred under ERISA [2] for its pro rata share of a multiemployer pension fund’s unfunded benefit liabilities upon the portfolio company’s ceasing to make contributions to the pension fund due to its bankruptcy. [3] Under ERISA, an employer’s affiliates can be liable for the unfunded pension benefit liabilities of the employer under a “two-pronged test.” 29 U.S.C. §1301(b)(1) (ERISA §4001(b)(1)) provides that “all employees of trades or businesses…which are under common control shall be treated as employed by a single employer and all such trades or businesses as a single employer…” [4] The “common control” part of the test was not before the First Circuit and is subject to further proceedings before the district court.

Thus, the issue decided by the First Circuit was limited to whether the private equity fund was engaged in a trade or business within the meaning of §1301(b)(1) and applicable Pension Benefit Guaranty Corporation (PBGC) regulations thereunder. It is not a requirement under section 1301(b)(1) or PBGC rules that an affiliate be in the same trade or business as the employer with the primary obligation. It is sufficient that the affiliate (in this case, the private equity fund) be in a trade or business whether or not the same as that of the employer. [5]

In reaching its holding, the First Circuit imputed to the private equity fund certain activities of the fund’s sponsor, Sun Capital Advisors Inc., the fund’s general partner and the fund’s investment manager (including employees, as well as agents, of these affiliates). The First Circuit looked initially at a wide range of activities, including acquisitions, management operations and the sale of portfolio companies. In reaching its conclusion that the fund was in a trade or business, it focused on the activities involved in the management and operations of the fund’s portfolio company, Scott Brass Inc., whose withdrawal from the union pension fund gave rise to the unfunded benefit liability. [6] Taken together, these different activities involved in the management and operation of Scott Brass Inc. added up, in the opinion of the First Circuit, to the private equity fund being in a trade or business for purposes of §1301(b)(1).

The court, alternatively, might have found that the private equity fund was engaged in the trade or business of acquiring, developing, and promoting portfolio companies for later sale. It made explicit it was not so deciding because that issue had not been raised in a timely manner by the plaintiff labor union. [7]

The First Circuit’s opinion raises the question whether that court would have concluded that the private equity fund was engaged in a trade or business if the Sun Capital case had been a tax case (instead of an ERISA case) and had involved the issue whether the holder of a carried interest in the fund was entitled to capital gains treatment for its share of the gain realized by the fund on the sale. (This assumes that Scott Brass Inc. was profitable, not in bankruptcy, and was being sold for a gain).

It would seem possible, if not probable, that the same court with the same facts would find a trade or business for purposes of Internal Revenue Code §1221(a)(1). In order to qualify a sale for capital gains tax treatment the property sold must be a capital asset. Section 1221(a)(1) excludes from capital asset treatment “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.”

If a court finds that a private equity fund was in the trade or business of acquiring portfolio companies for development and sale it would seem likely that it would also find the fund was holding the portfolio company in question primarily for sale to customers in that trade or business within the meaning of Code section 1221(a)(1) above. There is case law to support this view. [8] Notwithstanding this, it is noted again that Sun Capital is not a tax case and, further, the First Circuit explicitly did not address the issue of whether the private equity fund was in the trade or business of developing, promoting or selling portfolio companies for sale to customers. At the time this column was written, the Supreme Court had not decided whether to grant a writ of certiorari in the Sun Capital case. [9]

Carried Interest Legislation

On Feb. 11, 2013, Senator Carl Levin introduced S.268, entitled, “Cut Unjustified Tax Loopholes Act,” which includes a proposal to require treatment of certain carried interests as ordinary income rather than capital gains. [10] Legislation to similar effect has been introduced in the Senate and House of Representatives for a period that began in 2007. [11]

A carried interest, for this purpose, means an interest in profits and gains from an investment to the extent such interest is given in consideration for services rendered in connection with the management of the investment rather than in exchange for a capital contribution toward the funding of such investment.

Carried interests are most frequently granted by private equity funds, hedge funds and other investment funds organized as partnerships or limited liability companies, to the fund’s investment managers and, typically, will entitle those persons to receive 20 percent of the fund’s income and gains, although they generally contribute only 1 to 5 percent of the fund’s total initial capital. [12]

Under current tax law, gains realized by a private equity fund from the sale of its portfolio companies are treated as capital gains, and their character as capital gains “flows through” to all of the fund’s partners, including those holding carried interests. The fund’s partners holding carried interests thus receive capital gains treatment for their distributive share of the fund’s gains to the same extent as to the fund’s other partners.

The proposed legislation, beginning in 2007, reflects the view that to the extent a carried interest holder receives an allocation of the fund’s income and gains in excess of what he would receive based on his own capital contributions, the excess amounts should be treated as being paid to the carried interest holder as compensation for his services, rather than as a return on the holder’s own capital investment. Accordingly, each of such legislative proposals has sought to tax all, or some portion, of the gains attributable to carried interests as ordinary income.

As noted above, the most recent legislative proposal for changing the tax treatment of carried interests is contained in S. 268, introduced by Senator Carl Levin in February 2013. The bill would add a new Code section 710, entitled “Special Rules for Partners Providing Investment Management Services to Partnerships.” Set out below is a summary of some key features of the Levin bill.

  • 1. The Levin bill would change the tax treatment of carried interests only in the case of such interests held by certain partners in an “investment partnership,” which, as defined in the Levin bill, [13] is any partnership meeting the following conditions: (a) substantially all of its assets are in securities, real estate held for rental or investment, interests in a partnership, commodities, cash or cash equivalents, or options or derivative contracts regarding any of the foregoing (“specified assets”); [14]and (b) more than 50 percent of the capital of the partnership is attributable to interests in it that are held by persons in whose hands such interests are “qualified capital interests” and do not constitute property held in connection with a trade or business.A “qualified capital interest” for this purpose means so much of the partner’s interest in the capital of the partnership as is attributable to (i) the fair market value of money or other property contributed in respect of such interest, (ii) amounts included in gross income under Code section 83 as a result of transfer of such interest to the holder or (iii) the excess of items of income and gain over specified items of deduction and loss previously allocated to the holder, reduced by (iv) distributions made to the holder. This is a general statement of the meaning of a “qualified capital interest” as provided in the legislation. Proposed section 710(d)(7) should be reviewed for the more complete definition.
  • 2. The Levin bill’s tax changes would apply to a carried interest in an investment partnership only if the carried interest constitutes an “investment services partnership interest” (ISPI). As defined in the Levin bill, [15]an ISPI is an interest in an investment partnership acquired or held by any person in connection with such person’s providing to the investment partnership with respect to its “specified assets” (as described in clause (a) of paragraph 1. above) services that constitute a “trade or business.” A “trade or business” for this purpose is defined as one in which the service provider is providing, primarily to the investment partnership, services specified in proposed section 710(c)(2):
    • (A) advising as to the advisability of investing in, purchasing, or selling any specified asset;
    • (B) managing , acquiring, or disposing of any specified asset;
    • (C) arranging financing with respect to acquiring specified assets;
    • (D) any activity in support of any service described in subparagraphs (A) through (C).
  • 3. Under the Levin bill, the holder of an ISPI in a private equity fund (or in its general partner or affiliated management company) generally would be subject to tax at ordinary income rates on his or her distributive share of the net capital gains and dividends realized by the fund from its investments in its portfolio companies. [16]


A review of the recent Sun Capital case and the legislative developments noted above does not suggest an “immediate threat” to capital gains treatment for carried interests. It does suggest that private equity fund sponsors need to take care with regard to the extent of their activities, both direct and indirect, in managing portfolio companies. This is relevant not only at the portfolio operating level but also at the level of promoting and selling the portfolio companies themselves. The latter activities are especially relevant to whether the stock of a portfolio company will qualify as a capital asset under Code section 1221(a)(1). A certain level of activity inevitably must take place but emphasis placed by private equity fund sponsors in publicizing the marketing of portfolio companies held by the funds carries a risk as to capital asset status of the stock of those companies held by the funds.

As to proposed legislation directed at carried interests, if enacted, it would be difficult to avoid its impact on managers holding carried interests simply by reducing somewhat the fund/portfolio company activities of such managers. The proposed statute does not draw any distinction as to “degree” of activity.

At this point, the most comforting feature of both the Sun Capital case and the proposed legislation regarding carried interests is the unlikelihood that either will cause a change in the capital gains treatment of carried interests in the near future.


[1] The Sun Capital case involved two private equity funds, but the First Circuit holding was limited to only one of the funds, Sun Capital Partners IV, LP. The other fund is subject to further proceedings before the district court.
(go back)

[2] Employee Retirement Income Security Act of 1974 (ERISA), 29 U.S.C. §1001, et seq. (ERISA §1, et seq.), as amended by the Multiemployer Pension Plan Amendment Act of 1980 (MPPAA), 29 U.S.C. §1381, et seq. (ERISA §4201, et seq.).
(go back)

[3] See 29 U.S.C. §1381 (ERISA §4201) for statement as to an employer’s obligation for unfunded benefit liabilities upon its withdrawal from such a fund.
(go back)

[4] 29 U.S.C. §1301(b)(1) (ERISA §4001(b)(1)); see also, PBGC (Pension Benefit Guaranty Corporation) Reg. §4001.2 (definitions of: “controlled group” and “employer”) and PBGC Reg. §4001.3(a) (rules for determining trades or businesses under common control).
(go back)

[5] See Central States, Southeast and Southwest Areas Pension Fund v. Personnel, 974 F.2d 789, 793 (7th Cir. 1992), and Third and Ninth circuit cases cited therein.
(go back)

[6] In its initial description of the activities of the Sun Capital group, including the sponsoring entity, Sun Capital Advisors, Inc. (SCAI), the funds themselves and the entities affiliated with them, the First Circuit describes locating, managing and operating and selling portfolio companies. In this initial description of these activities of the Sun Capital group, the court does not describe the activities as constituting a trade or business. After that opening description, the First Circuit focuses on the activities in relationship to Scott Brass Inc., the particular portfolio company giving rise to the withdrawal liability for unfunded pension liabilities. In focusing on the activities relating to Scott Brass Inc., the court notes that two of the three directors of the Scott Brass holding company were SCAI employees, that SCAI employees were directly involved in the management and operations of Scott Brass Inc., that the general partner of the fund had the authority to hire and fire, as well as make compensation arrangements with, Scott Brass Inc. employees. Also, the court emphasized that the 2 percent annual management fee due from the private equity fund to the general partner of the fund was reduced by the payments made by Scott Brass Inc. to the general partner to reimburse it for the management services noted.
(go back)

[7] See footnote 26 of the First Circuit’s opinion in the Sun Capital case.
(go back)

[8] See, for example, Barham v. United States, 301 F.Supp. 43 (M.D. Ga. 1969), aff’d, 429 F.2d 40 (5th Cir. 1970); Katz v. Commissioner, T.C. Memo. 1960-200.
(go back)

[9] Whether or not the First Circuit’s decision in Sun Capital is reversed by the Supreme Court, the IRS is likely to be very cautious about adopting the First Circuit’s trade or business view, expressed in an ERISA decision, for purposes of Code section 1221(a)(1) or other tax purposes. The First Circuit’s standard for determining trade or business, if applied for tax purposes, would represent a significant departure from tests based on long-standing Supreme Court decisions and other judicial precedents that private equity investors have relied on in making their investments in those funds.
(go back)

[10] The carried interest provisions of S. 268, as introduced by Senator Levin, are virtually identical to the carried interest legislation introduced by Representative Sander Levin as H.R. 4016, Carried Interest Fairness Act of 2012 (Feb. 14, 2012).
(go back)

[11] The original legislation directed at treating certain carried interests as ordinary income rather than capital gains was introduced by Representative Sander Levin, as H.R. 2834 (June 22, 2007). Numerous bills, some directed exclusively at carried interests, others incorporating carried interests as part of a broader set of proposed tax changes, have been introduced during the period since 2007. To date, no legislation changing the tax treatment of carried interests has been enacted.
(go back)

[12] The Tax Policy Briefing Book, Business Taxation: What is carried interest and how should it be taxed? Tax Policy Center Urban Institute and Brookings Institution, June 25, 2008, updated Feb. 7, 2013.
(go back)

[13] Proposed Code section 710(c)(3)(A).
(go back)

[14] Proposed Code section 710(c)(4).
(go back)

[15] Proposed Code section 710(c)(1) and (2).
(go back)

[16] Proposed Code section 710(a)(1)(A); but see proposed Code section 710(a)(5). Exception for certain capital interests is made in proposed Code section 710(d).
(go back)

Both comments and trackbacks are currently closed.