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Private Equity Funds Held Liable for Pension Benefits of a Portfolio Entity

Berdon Tax Team
09.08.2016 | Client Alert
A Massachusetts district court found two private equity funds jointly and severally liable for a portfolio entity’s share of the unfunded vested benefits of a pension fund.1 The case could have broad implications as the structure used to own and manage the portfolio entity is commonly applied by private equity funds.

In reaching its decision, the court reasoned that the private equity funds were engaged in a trade or business and, even though neither fund independently owned the 80% of the portfolio entity necessary to establish common control, the funds had formed a partnership or joint venture that was engaged in a trade or business under common control with the portfolio entity.

Tax TeamThe decision in Sun Capital involved the multiemployer pension rules of the Employee Retirement Income Security Act of 1974 (ERISA). The ERISA provisions interpreted by the district court are based upon provisions that originated in the Internal Revenue Code of 1986 (Tax Code), and most of the district court’s analysis involved interpretation of the Tax Code and the regulations thereunder.

The statutory provisions discussed in Sun Capital are also found in the Affordable Care Act (ACA). As a result, some of the court’s conclusions could affect whether certain employers with less than 50 full-time employees may have to provide affordable health insurance to their employees.


The funds here, Sun Capital Partners III, LP (Sun Fund III) and Sun Capital Partners IV LP (Sun Fund IV and, collectively, the Sun Funds), acquired indirect 30% and 70% ownership interests, respectively, in Scott Brass, Inc. (SBI) in 2007. At the time of the acquisition, SBI was committed to a multiemployer pension fund.

Both Sun Funds are managed by Sun Capital Advisors, Inc. (Sun Advisors). Sun Advisors structures the deals for the funds that it manages and provides management consulting and employees to the portfolio companies owned by the funds.

The Sun Funds’ investment in SBI was not financially successful. SBI filed for bankruptcy in 2008 and stopped payments to the pension fund to which it was obligated. When it stopped making payments, it incurred withdrawal liability for its share of the pension’s unfunded vested benefits. Since SBI did not have sufficient funds to meet its withdrawal liability, the pension fund asserted that the Sun Funds were jointly and severally liable for the liability of SBI.

Legal Analysis

Under ERISA, when an employer ceases payments to a pension plan, it incurs withdrawal liability for its proportionate share of the pension fund’s unfunded vested benefits. Liability may extend to other entities that are related to the employer if the entity is engaged in a trade or business and is under common control with the employer. Common control is present when the entity owns 80% or more of the employer.

The statutory language in ERISA is similar to section 414(c) of the Tax Code. Regulations adopted with regard to withdrawal liability apply the concepts that are in the tax regulations pursuant to section 414(c).

The Sun Funds argued that they did not incur withdrawal liability because (i) neither fund was engaged in a trade or business and (ii) neither fund owned at least 80% of the stock of SBI.

The court, however, found that both Sun Funds were engaged in a trade or business. The district court then found that even though neither Sun Fund independently owned 80% of SBI, the Sun Funds were effectively managing SBI in a partnership (or joint venture), and this deemed partnership owned 100% of SBI (indirectly by attribution). The court also held that the deemed partnership was engaged in a trade or business for the same reasons that each Fund was engaged in a trade or business.

Trade or Business

The Sun Funds argued that they were mere investment vehicles and taxpayers that invest in stocks and other securities are not engaged in a trade or business. However, the district court held that the Sun Funds were more than mere passive investors in SBI and were actively involved in the management and operations of SBI and controlled SBI’s board of directors.

The First Circuit, in an earlier opinion for the case, had adopted an “investment plus” standard to determine whether an investor was engaged in a trade or business for withdrawal liability purposes. Under this standard, a mere passive investor will not meet the trade or business test. The court adopted an “investment plus” approach without setting general guidelines as to what the “plus” is.

The Sun Funds were treated as meeting the “investment plus” test since each Sun Fund received an economic benefit that an ordinary, passive investor would not have derived. Through their limited partnership agreements, the Sun Funds were liable to their general partner for an annual management fee. SBI was obligated to pay some of the Sun Funds share of the management fee. Although some of SBI’s payments of the funds’ share of the management fee were deferred, the court treated this obligation to the Sun Funds as a direct or indirect benefit to the Sun Funds.

The court’s ruling is novel because private equity funds have generally taken the position that they are not engaged in a trade or business. There is a great deal of uncertainty as to whether the “investment plus” standard could or should be applied in determining whether a person is engaged in a trade or business for income tax purposes. However, the First Circuit’s adoption of the “investment plus” standard was premised, in part, on the purposes behind the ERISA withdrawal liability rules. This may be an indication that the test is not to be applied for other statutory provisions that apply the same common control test.

Common Control

Neither of the Sun Funds owned at least 80% of the stock of SBI, and the funds admitted that an important purpose in keeping ownership below 80% was to avoid withdrawal liability. Since neither Sun Fund owned at least 80% of the stock of SBI, the court tried to determine if the two funds were managing or operating their investment as part of a partnership or joint venture.

The court acknowledged that a number of factors pointed to the structural independence of the Sun Funds. The two Sun Funds were “non-parallel” funds, in that they did not make investments in fixed ratios. The two funds had largely non-overlapping sets of limited partners and portfolio investments. The funds filed separate financial statements and tax returns. In addition, when the two funds did co-invest, their agreement disclaimed any intent to form a partnership or joint venture.

Nevertheless, the court determined that the Sun Funds intended to acquire SBI pursuant to a partnership or joint venture. Sun Advisors determined to split the ownership 70/30% based upon factors that would not have existed with respect to independent investors. Sun Fund III was nearing the end of its investment cycle and, accordingly, received a lesser portion of the investment. The court found it important that the 70/30% split did not result from two independent funds choosing how much to invest for their own independent reasons. The fact of keeping the individual investments below 80% further solidified the court’s view.

Other factors that the court found relevant in its conclusions include: (i) that the Sun Funds co-invested with each other but never co-invested with independent investors, and (ii) that the Sun Funds never had a disagreement as to how to manage and operate SBI.

The district court concluded that because of this coordination and joint action, the Sun Funds had formed a partnership-in-fact such that their separate ownership interests could be aggregated for the purpose of finding common control.

Much of the court’s analysis involved a discussion of relevant rules under the Tax Code (and regulations and cases thereunder) as to when a partnership or joint venture exists. As a result, it is very possible that Sun Capital could be treated by the IRS or another court as a relevant authority for income tax purposes. This could be significant as there is only a small number of cases that have determined whether investors have entered into a deemed partnership or joint venture.

Finally, the court found this deemed partnership/joint venture between the Sun Funds was a trade or business for the same reasons that the Sun Funds were trades or businesses. The partnership/joint venture actively managed SBI and passed on the benefits (i.e., the reduction in management fees) to its partners. Therefore, the Sun Funds were jointly and severally liable for SBI’s share of the pension fund’s unfunded vested benefits.

Questions? Contact your Berdon advisor. Berdon LLP, New York Accountants

1 Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Fund, 2016 US Dist. LEXIS 40254 (D. Mass. Mar. 28, 2016) (“Sun Capital”)