By Eileen Appelbaum
FORTUNE -- With the annual tax deadline approaching next week, middle class Americans may be wondering how private equity titans like Mitt Romney get away with such low tax rates on their millions in income. The answer is that private equity firms are treated as passive investors in the companies they buy and -- unlike you and me -- partners in these firms are taxed at the lower capital gains rate (typically 20%) on most of their income. But are private equity firms merely investors, or are PE partners active managers and employers of their acquired companies?
The Internal Revenue Service recently established a taskforce to review the way private equity is taxed. At issue is the question of whether PE funds are similar to mutual funds or whether they are in the business of buying, developing, and then selling companies at a profit -- much as real estate developers buy properties and develop them for resale to customers. Much hinges on the answer.
In our new book, Private Equity at Work: When Wall Street Manages Main Street, Cornell University Professor Rosemary Batt and I show that private equity is a different breed of investor. The partners in a PE firm do much more than simply decide which companies their funds should acquire. They decide how much debt to use in acquiring the company, and this debt structure drives the management plan the company is required to follow. The management plan sets the strategic direction of the company -- which units to sell off or shut down; whether to demand wage and benefit concessions to cover payments on the new debt; whether to replace top managers loyal to the company and its creditors and employees with new managers loyal to the PE firm; and who should sit on the company's board of directors.
What's more, the general partner (GP) oversees hiring and compensation practices, participates in labor negotiations, decides whether to exit an employee pension plan, collects fees from the company for advisory and consulting services, and may require the company to pay dividends to the PE fund partners (its shareholders) out of current cash flow or by selling junk bonds to raise funds for a dividend recapitalization.
As the cases in our book illustrate, PE firms actively manage the companies they acquire. Yet the courts and the tax authorities have long treated private equity partners as passive investors and not active managers, exempting them from laws and regulations that apply to other businesses. For example, under current interpretations of laws, they are exempt from the Worker Adjustment and Retaining Notification (WARN) Act that governs notification of employees in case of a plant shutdown. Partners at private equity firms and at the funds they sponsor are also exempt from the Employee Retirement Income Security Act (ERISA) that governs treatment of a pension plan in case of bankruptcy, as well as provisions of the tax code that govern the tax liabilities of a trade or business.
This happy state of affairs for private equity was abruptly upended last July by a surprise appeals court ruling in a pension case involving PE firm Sun Capital Partners. Less than two years after the firm was acquired by brass and copper manufacturer Scott Brass in a leveraged buyout, the company declared bankruptcy and stopped making payments to the employees' pension fund. The question before the appeals court was whether Sun Capital and its funds were passive investors and not liable for a $4.5 million payment to the pension fund or were actively engaged in managing Scott Brass and should be treated as engaged in a "trade or business" under ERISA
The appeals court last year ruled that Sun Capital was engaged in a trade or business, a move that could have far-reaching tax implications for partners at PE funds; it could cost them billions of dollars more. As for the payment to the employee pension fund, a final decision on that has been returned to the lower court. Sun Capital owns 100% of Scott Brass but divided this ownership between two of its funds, neither of which individually owns at least 80% of the company as required under ERISA to be obligated to make the pension payment.
Three major changes could follow if the IRS finds that a PE fund is engaged in a trade or business: First, the profits earned through buying and selling portfolio companies would be taxed as ordinary income rather than at the lower capital gains rate. Second, tax-exempt limited partners could owe taxes for unrelated business income on the PE fund's profits. And third, foreign investors who currently aren't taxed in the U.S. could be taxed as effectively connected with a trade or business in this country.
The facts on the ground belie private equity's claim that it is merely a passive investment vehicle. Ending the charade would ensure that private equity partners are treated the same way as other businesses. It's unclear whether Congress is ready to engage with the private equity industry over tax fairness, but perhaps the IRS, which is in charge of interpreting the tax code in a fair and consistent manner, will take on the job of ending the special tax breaks the industry currently enjoys.
Eileen Appelbaum is a senior economist with the Center for Economic and Policy Research and a co-author of the forthcoming book, Private Equity at Work: When Wall Street Manages Main Street.
Why Sun Capital didn't take a bath on American Standard.
FORTUNE -- Private equity firm Sun Capital Partners last week agreed to sell kitchen and bath company American Standard Brands to Japan's LIXIL Corp., in a $542 million deal that more than doubles Sun's original investment. Not exactly what too many folks would have imagined six years ago, when Sun was the only thing standing between American Standard and an "Out of MOREDan Primack - Jul 1, 2013 3:01 PM ET
Frozen strawberry company switching private equity sponsors.
FORTUNE -- Paine and Partners is in talks to acquire frozen strawberry producer Sunrise Growers from Sun Capital Partners, according to an FTC filing.
Sunrise was founded more than 40 years ago, and provides both frozen and fresh strawberries and other fruit products to retailers, food-service operators and industrial customers (both branded and private-label). It also markets and distributes strawberries.
The Placentia, Calif.-based company was acquired MOREDan Primack - Mar 4, 2013 3:43 PM ET
Scooter Store has a big problem, but it's not really a private 'equity' problem.
FORTUNE -- Yesterday the FBI raided the Texas headquarters of The Scooter Store, a maker of motorized scooters for the elderly and disabled.
This was just the latest twist in the company's long-running trouble with the government, over alleged Medicare over-billing. For example, The Scooter Store agreed to pay $4 million -- and forego $13 million in claims MOREDan Primack - Feb 22, 2013 2:47 PM ET
Hostess may have a buyer.
FORTUNE -- Private equity firm Sun Capital Partners wants to buy bankrupt bakery Hostess Brands Inc., Fortune has learned.
The proposal would be to operate Hostess as a going concern, including reopening the shuttered factories and continuing union representation of Hostess workers.
Sun Capital privately expressed interest in acquiring Hostess earlier this year, but the bakery's creditors chose for an alternate reorganization plan that ultimately failed. Following Friday's MOREDan Primack - Nov 19, 2012 12:43 PM ET
Private equity firms will pay out $166 million, but will it change behavior?
FORTUNE -- Cerberus Capital Management and Sun Capital Partners are part of an investor group that has agreed to pay $166 million to creditors of Mervyn's, a now-defunct retailer carved out of Target Corp. (TGT) for $1.2 billion in 2004.
The suit had accused the private equity firms of fraudulent conveyance, stemming from their decision to separate the company's retail MOREDan Primack - Oct 9, 2012 4:14 PM ET
FORTUNE -- In June I wrote that Sun Capital Partners had agreed to acquire Goldmax USA, a Chicago-based operator of over 200 retail locations for selling gold and other precious metals. There was an FTC filing and everything.
But sources familiar with the situation tell me that Sun has since called off the deal. Unfortunately, those same sources declined to explain why. And neither Sun nor GoldMax are talking.
Did Sun find something MOREDan Primack - Aug 2, 2012 4:44 PM ET
Private equity firm looks to capitalize on the 'cash for gold' trend.
FORTUNE -- Gold and silver prices might have leveled off from last fall's heights, but Sun Capital Partners still thinks there is a fortune to be made from one of the nation's larger "cash for gold" outfits.
The Boca Raton, Fla.-based private equity firm quietly has agreed to acquire GoldMax USA, a Chicago-based operator of over 200 retail locations for selling MOREDan Primack - Jun 18, 2012 12:44 PM ET
Private equity firm Sun Capital Partners is beginning to talk to investors about plans for its sixth fund, Fortune has learned.
The Boca Raton, Fla.-based firm plans to target $3 billion, with formal fundraising to kick off just after Labor Day 2012 and a final close slated for early 2013. That's just half of what Sun raised for its fifth fund in early 2007, even though the firm later cut the fund MOREDan Primack - Dec 7, 2011 3:12 PM ET
Friendly's has a lot of problems. But the biggest one is at the heart of its business.
Family restaurant chain Friendly's is expected to file for Chapter 11 bankruptcy protection next week, just three years after being acquired by private equity firm Sun Capital Partners for $216 million (including assumed debt).
There is a lot of blame to go around, including the sluggish economy, rise of fast-casual alternatives and the chain's inability MOREDan Primack - Sep 30, 2011 3:55 PM ET
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