Earlier this month, Travis was featured in the BNA Daily Tax Report, speaking about the implications of the Sun Capital case. In Sun Capital, the First Circuit Court of Appeals surprised most of the tax world in ruling that, for ERISA purposes, a private equity limited partnership was engaged in a “trade or business.” If that conclusion were to hold true for income tax purposes, and investment funds holding the securities of portfolio companies were treated as engaged in a trade or business, the tax consequences for tax-exempt organizations, foreign investors, and the carried interest for fund sponsors would be dramatically negative.
Although the implications for private equity received the most attention, the author of the article was correct in putting front-and-center the consequences to ordinary entrepreneurs of using Sun Capital to tax carried interests as ordinary income without special legislation. To wit, a private equity sponsor is, at least tax-wise, in much the same position as an entrepreneur who both works at and invests in his or her own business. Let’s imagine that Raj and Louise start a software company, which they own through an LLC. Sure, they’re putting their labor into it, writing the code for which they receive a reasonable salary. But this endeavor is also about capital appreciation, and when they develop a kickass software program and sell the assets for $80 million, they’re going to be taxed at capital gains rates. Under the current law, private equity sponsors who earn a carried interest by improving the value of portfolio companies are in the same position.
It’s up for debate whether ordinary income and capital gains should be taxed differently, or whether Congress should enact special legislation taxing carried interests at ordinary rates. But the fact is that active participants in a business are earning capital gains every day in the American economy. Trying to twist Sun Capital to target such gains would hit Main Street far more than it would Wall Street.