HEAD-TO-HEAD: Is your fund a business?

The tax concept of a “trade or business” became a hot topic in the private funds world following 2013’s highly publicized Sun Capital case. A federal court deemed certain Sun Capital funds a trade or business for purposes of the Employee Retirement Income Security Act (ERISA). Although the court stressed that its ruling was limited to the applicability of ERISA, the decision led many to wonder whether US tax authority the Internal Revenue Service (IRS) would take note of the court’s analysis.

If the IRS began designating private equity funds as a trade or business, the ramifications would be huge. Namely, carry could be taxed as ordinary income (at a rate of up to 39.6 percent) instead of as a capital gain (at a rate of 20 percent); foreign investors might have what is called “effectively connected income” (ECI), which would subject them to US tax; and tax-exempt investors’ gains from the fund could be treated as “unrelated business taxable income” (or UBTI).

While some argue that US tax law supports the current interpretation, others say that further analysis proves that a private equity fund operates as a trade or business. To hear both sides, we invited Steven Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center, and Amanda Nussbaum, partner in Proskauer’s tax department and member of the private investment funds group, to represent and defend each side.

Question: Should a private equity fund be taxed as a trade or business?


Steven Rosenthal, a senior fellow at the Urban Institute, researches, speaks, and writes on a range of federal income tax issues, with a particular focus on business taxes. He practiced tax law in Washington, DC for over 25 years, most recently as a partner at Ropes and Gray. Rosenthal also was a legislation counsel with the Joint Committee on Taxation, where he helped draft tax rules for financial institutions, financial products, capital gains, and related areas. He is the former chair of the Taxation Section of the District of Columbia Bar Association.


Amanda Nussbaum is a partner in the tax practice of Proskauer’s New York office. Nussbaum is also a member of the law firm’s private investment funds group. Her practice concentrates on planning for and the structuring of domestic and international private investment funds, including venture capital, buyout, real estate and hedge funds, as well as advising those funds on investment activities and operational issues. She also represents many types of investors, including tax-exempt and non-US investors, with their investments in private investment funds.

Steven Rosenthal: A private equity fund generally is, and should be taxed as, a trade or business. The stakes are large: the income from a trade or business may be taxed at ordinary rates to non-profit, foreign, and other partners – who otherwise pay no tax (or tax at reduced rates) on their income from the fund.

A private equity fund is organized as a limited partnership, with a general partner, who pursues the fund’s business, and limited partners (often tax exempt or foreign investors) who provide the bulk of the capital. A fund makes its money by buying the stock of new or struggling companies at a low price, developing or repairing these companies, and reselling them at a higher price.

A “trade or business” distinguishes an active from a passive investor – with distinct tax consequences. The determination of whether a fund engages in a trade or business is based on the fund’s activities. A fund does not itself need employees, equipment, or offices to engage in a trade or business. For US tax purposes, the efforts of the fund’s agents (including its general partner and any contractors) are attributed to the fund.  

In Commissioner v. Groetzinger – the leading and most recent US Supreme Court case on trade or business – the Court held that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and . . . the taxpayer’s primary purpose for engaging in the activity must be for income or profit.”

The fund’s general partner, and other contractors, work extensively to improve the operations, governance, capital structure, or strategic position of the portfolio companies. These efforts exceed the “mere caring for one’s own investments.” There is a world of difference between managing the businesses in which one invests – and managing one’s own investments. When the fund’s efforts to buy portfolio companies, develop them, and sell them are substantial, continuous and regular, the fund engages in a trade or business.

Amanda Nussbaum: No, a private equity fund generally is not, and should not be taxed as, a trade or business. Rather, a fund would be classified as an “investor” since it buys and sells securities in order to derive income from dividends, interest and long-term capital appreciation. Two key US Supreme Court cases (and a line of cases following them) make clear that investing is a passive activity that does not give rise to a trade or business, irrespective of the extent, continuity, variety and regularity of that investing.

In Higgins v. Commissioner, the Court highlighted that “no matter how large the estate or how continuous or extended the work required may be, managerial attention to your own investments does not constitute a trade or business.” Similarly, in Whipple v. Commissioner, the Court found that “[d]evoting one’s time and energies to the affairs of a corporation is not of itself, and without more, a trade or business of the person so engaged.” The Court further explained that “when the only return is that of an investor, the taxpayer has not satisfied his burden of demonstrating that he is engaged in a trade or business since investing is not a trade or business and the return to the taxpayer, though substantially the product of his services, legally arises not from his own trade or business but from that of the corporation.”

There are a limited number of cases that have found taxpayers, in special circumstances, to be engaged in a trade or business for purposes of the business bad debt rules (the same rules applied in the Whipple case) – specifically, the trade or business of promoting business enterprises. Under these cases, a taxpayer’s promotional activities may be treated as a trade or business where (i) the activities of a taxpayer are continuous and extensive, and (ii) the taxpayer seeks a return from fees or the quick resale of the business, rather than a typical investor-like return. However, these cases clearly would not apply to private equity funds, which invest primarily for the purpose of generating long-term returns, rather than to capitalize on quick exits or from fee income. 

Aside from the limited application of this promoter theory generally, there has been only one case outside of the business bad debt context in which this theory has been successfully applied to a taxpayer who was not technically a “dealer” (Katz v. Commissioner). While the Tax Court held that the taxpayer had ordinary income on the gain from the sale of corporations, the activities of the taxpayer in this case were very different from the activities of a private equity fund. Under this case, the taxpayer formed shell companies to invest in new businesses that were sold shortly after establishment. By contrast, private equity funds invest in existing businesses, with the purpose of realizing gain from capital appreciation over a significant period of time.

Accordingly, taxing a private equity fund as a trade or business generally would be inconsistent with current law.

Rosenthal: There is no blanket “investor” exemption notwithstanding dicta of Higgins and Whipple that might appear otherwise. Broadly extending the reach of these cases, and their sloppy dicta, has been roundly criticized. In Groetzinger, the Court complained that Higgins, was “devoid of analysis and not setting forth what elements, if any, in addition to profit motive and regularity, were required to render an activity a trade or business.” And the activity in Higgins and Whipple is easily distinguished from the activity of a typical private equity fund. Rather, the tax law is clear that an enterprise that invests regularly, continuously, and substantially is a trade or business.

In Higgins, the taxpayer “merely kept records and collected interest and dividends from his securities, through managerial attention for his investments.” He did not participate directly or indirectly in the management of the corporation in which he held stock or bonds. In Whipple, the taxpayer was not in the business of organizing, promoting, managing or financing corporations or any other business separate from that of the corporation.

Private equity funds are enterprises: they buy multiple companies, extensively develop (or repair) the companies, and resell the companies. The funds regularly and continuously improve the operations, governance, capital structure, and strategic position of their portfolio companies.

In Sun Capital Partners III LP v. New England Teamsters & Trucking Indus. Pension Fund, the 1st Circuit found that a private equity fund engaged in a trade or business (to determine ERISA liability). And the court’s findings are based on the very tax cases that we are discussing now. The court distinguished private equity funds from passive investors with an “investment plus” test (the “plus” included the fund’s controlling stakes, its active management of the portfolio companies, and the management fees that it collected indirectly).

The 1st Circuit’s interpretation is the only sensible result, even when a fund earns its profit from dividends and stock gains. There are thousands of hedge funds that are organized substantially the same as the private equity fund described above. (Although a typical hedge fund, unlike a private equity fund, does not develop its portfolio companies. As a result, hedge funds do not have customers and, thus, do not have ordinary income.) All agree that a hedge fund that invests regularly, continuously, and substantially, is a trade or business – even if its profits are derived solely from dividends and gains from the resale of stock. These securities traders derive profit from their own enterprise, not just from their corporations’ success.  So, also, a private equity fund engages in a trade or business.

Nussbaum: Even if a private equity fund assisted in the development of its portfolio companies, under Section 1221(a)(1) of the Internal Revenue Code, such fund would not have ordinary income unless it held its portfolio companies “primarily for sale to customers in the ordinary course of [its] trade or business.” Having customers requires the performance of a merchant function such as a securities dealer or a retailer of goods. A merchant, such as a dealer, generates its profits by serving as a middleman to its customers, whereas an investor, such as a private equity fund, generates its profits from appreciation in the value of the portfolio companies over time.

Any portfolio company development activities are conducted by either the general partner or the manager, rather than by the private equity fund itself, and should not be attributed to the fund.  The Tax Court, in the 2011 Dagres v. Commissioner case, which held that the general partners of venture capital funds were engaged in a trade or business of managing venture capital funds (rather than mere investment), concurred with this conclusion. Significantly, the Tax Court stated that “similar to any bank or brokerage firm that invests other people’s money, the manager of venture capital funds provides a service that is an investment mechanism for the customer but that is a trade or business of the manager.” Further, notwithstanding the trade or business finding, the Tax Court acknowledged that the general partners were entitled to capital gain treatment with respect to the carried interest under current law (as well as the gain from the general partners’ investment in the funds).

While in the Sun Capital case the 1st Circuit found that a private equity fund was engaged in a trade or business, this conclusion was for ERISA purposes only. The 1st Circuit specifically noted that its ruling was limited to ERISA, and, therefore, nothing in the opinion should be interpreted as changing the definition of trade or business for tax purposes. Accordingly, this case should not impact the taxation of a private equity fund as a trade or business.


Case in point

A rundown of the cases cited by Rosenthal and Nussbaum

Commissioner v. Groetzinger, 480 U.S. 23 (1987): The Supreme Court held that a gambler, who wagered full time as a source of livelihood rather than as a hobby, was engaged in a trade or business. The case explains that, in deciding whether an activity is a trade or business, courts need to examine the facts on a case-by-case basis, looking into whether the taxpayer devoted full-time efforts towards the activity on a regular, continuous and substantial basis.

Higgins v. Commissioner, 312 U.S. 212 (1941): Higgins claimed the salaries and expenses incident to looking after his extensive investments in real estate, bonds and stocks were deductible. The Supreme Court found that there was not sufficient evidence to establish that Higgins was carrying on a business. Rather, he was managing his personal portfolio.

Whipple v. Commissioner, 373 U.S. 193 (1963): Whipple owned 80 percent of the stock in a corporation, and he was also the chief executive. He made a number of loans to the corporation to try to keep it in business, then deducted the loss as business bad debt. The Supreme Court found that Whipple’s deduction was a non-business bad debt stating that a shareholder is not in a trade or business just because the corporation is in that trade or business.

Katz v. Commissioner, T.C. Memo 1960-200: Katz organized luncheonettes in order to develop and sell them. He held the stock of eight of these corporations for sale to customers in the ordinary course of business and accordingly the Tax Court ruled that the stock was not a capital asset in his hands.

Sun Capital Partners III LP v. New England Teamsters & Trucking Indus. Pension Fund, 723 F.3rd 129  (1st Cir. 2013). Scott Brass, a portfolio company held by multiple Sun Capital funds, went into bankruptcy and defaulted on its withdrawal obligations to the pension fund. Teamsters asserted that the Sun Capital Funds were jointly and severally liable for the Scott Brass pension withdrawal obligations. The District Court in Massachusetts sided with Sun Capital, but the US Court of Appeals for the First Circuit endorsed the view of the pension that a private equity fund can be held liable for the unfunded pension obligations of its portfolio companies, stating Sun Capital fund was engaged in a trade or business for the purposes of ERISA.

Dagres v. Commissioner 136 T.C. 263 (2011) Dagres, a manager of several venture capital funds, made a loan to a business associate and claimed the loss as a business bad debt deduction when the company went bankrupt. The IRS disallowed the deduction, claiming it was a personal loan unrelated to his trade or business. The court ultimately ruled the taxpayer was in the trade or business of managing venture capital funds, his bad debt loss was proximately related to that trade or business, and was deductible.