Special Industries

 

Transactions between Private-Equity-Fund-Owned Portfolio Corporations

In 2005, more than 400 private equity funds in the market raised in excess of $170 billion. With record-breaking buyout fundraising in recent years, transactions between fund-owned portfolio corporations are presenting challenging new tax issues. Two of these, which are common in today’s private equity climate, include (1) asset sales between fund-owned portfolio corporations and (2) the acquisition by a fund-owned portfolio corporation of another portfolio corporation’s debt.

 

Sec. 267 Loss Disallowance Provisions

Example 1: X Corp. and Y Corp. are both C corporation portfolio investments wholly owned by the same private equity fund, F. F is a large, diversely held limited partnership (i.e., no five or fewer persons own more than 50%), engaged primarily in long-term investing that generates a preponderance of income from long-term capital gains and dividends. F’s general partner manages its assets full-time. Although the investment purpose of any particular underlying portfolio corporation might vary, F is a typical leveraged buyout fund, primarily dedicated to the capital appreciation of its underlying investments. X and Y each operate a separate trade or business, with separate and distinct management. They have no commonalities other than being owned by F. X has just sold certain of its business assets to Y at a significant loss.

 

Related parties: At first glance, Sec. 267’s general loss disallowance provision would appear to apply to these “related taxpayers.” But, does it? Ac-cording to Sec. 267(a)(1), no deduction is allowed for a loss from the sale or exchange of property (directly or indirectly) between persons specified in Sec. 267(b), which lists 13 tests for relatedness. Under Sec. 267(b)(3), related persons include two corporations that are members of the same controlled group (as defined in Sec. 267(f)). Sec. 267(c) provides that, in applying Sec. 267(b), there are five situations in which stock owned by one party will be deemed constructively owned by another. Under Sec. 267 (c)(1), stock owned (directly or indirectly) by a partnership is deemed owned proportionately by its partners.

Controlled group: Sec. 267(f) defines a controlled group as having the same meaning as under Sec. 1563(a), except that “more than 50%” is substituted for “at least 80%” whenever it appears in Sec. 1563(a). Under Sec. 1563(a), the term “controlled group of corporations” is defined in four ways. According to Sec. 1563 (a)(2), a brother-sister controlled group includes two or more corporations if five or fewer persons who are individuals, estates or trusts own (within the meaning of Sec. 1563 (d)(2)) more than 50% of the total voting power or value of all of the classes of stock, taking into account the stock ownership of each such person, but only to the extent such ownership is identical for each such corporation. According to Sec. 1563 (d)(2), in determining whether a corporation is a member of a brother-sister controlled group, stock owned by a person who is an individual, estate or trust means stock owned directly by that person, and stock owned under Sec. 1563(e). Under Sec. 1563(e)(2), stock owned (directly or indirectly) by a partnership is deemed owned by any partner having a 5% or more interest in either the partnership’s capital or profits in proportion to his or her interest in capital or profits, whichever is greater.

Under Sec. 267(c)(1), stock owned by a partnership is deemed owned proportionately by its partners. Thus, each F partner is deemed to own proportionately the stock of X and Y. No five or fewer persons own more than 50% of F nor, hence, the vote or value of the stock of any underlying portfolio corporation. Thus, X and Y are not related businesses under Sec. 267(b).

Under Sec. 267(b)(10), related businesses include a corporation and a partnership if the same persons own more than 50% in value of the corporation’s stock and more than 50% of the partnership’s capital or profits interests. As was discussed above, the F partners are deemed to own proportionately both the X and the Y shares. In this respect, F is related to both X and Y, under Sec. 267(b)(10). However, X and Y are not related under Sec. 267(b)(3). Thus, Sec. 267 does not restrict X from deducting the loss, a result that can be easily overlooked when dealing with corporations with the same diversely held private-equity-fund parent.

 

Sec. 108 COD Income

Example 2: The facts are the same as in Example 1, except Y also acquires certain debt of X from an unrelated third-party creditor at a substantial discount. If X settled its debt for a discount, cancellation of debt (COD) income would result (assume that none of the Sec. 108(a)(1) exclusions apply). However, because Y acquired the debt, and assuming X services the debt’s full face amount, does X recognize the discount as COD income, or does Y recognize it as gain (over the appropriate timing)?

According to Sec. 108(e)(4)(A), the acquisition of debt by a person bearing a relationship to the debtor, as specified in Sec. 267(b) or 707(b)(1), from a per- son who does not bear such a relationship to the debtor, is treated as the acquisition of such debt by the debtor. In addition, Sec. 108(e)(4)(C) provides that two entities, treated as a single employer under Sec. 414(b) or (c), are treated as bearing a relationship to each other as described in Sec. 267(b). Thus, similar to a disallowance of loss on a sale of certain assets, Y’s acquisition of X’s debt will result in COD income to X, if X and Y are “related” under Sec. 108(e)(4). But, are they?

As was discussed, X and Y are not related taxpayers under Sec. 267. Sec. 707(b)(1) provides that related businesses include a partnership and a person owning more than 50% of the capital or profits interests, or any two partnerships in which the same persons own more than 50% of such interests. Thus, Sec. 707(b)(1) does not apply to X and Y. According to Sec. 414(b), all employees of corporations that are members of a controlled group are treated as employed by a single em-ployer. As was discussed, X and Y are not members of a controlled group under Sec. 414(b). Thus, they are clearly not related under Sec. 267, 707 or 414(b); however, their relationship under Sec. 414(c) is less clear.

Trades or businesses under common control: According to Sec. 414(c), all employees of trades or businesses (whether or not incorporated) that are under common control are treated as employed by a single employer. Regs. Sec. 1.414(c)-2(a) defines two or more trades or businesses under common control to include a brother-sister group of trades or businesses under common control, a parent-subsidiary group of trades or businesses under common control and a combined group of trades or businesses under common control.

Under Regs. Sec. 1.414(c)-2(c)(1), a brother-sister group of trades or businesses under common control means two organizations conducting trades or businesses, if the same five or fewer persons who are individuals, estates or trusts own a controlling interest in each organization and, when such person’s ownership of each organization is identical, such person is in effective control of each organization. Under Regs. Sec. 1.414(c)-2(c)(2)(iii)’s definition of effective control, if the brother-sister group is owned by a partnership, such five or fewer persons must own more than 50% of that partnership. Thus, X and Y are not members of a brother-sister controlled group, because the five-or-fewer/50% test is not met.

Parent in trade or business: According to Regs. Sec. 1.414(c)-2(b), a parent-subsidiary group of trades or businesses means one or more chains of organizations conducting trades or businesses connected through ownership of a controlling interest (80%) with a common parent organization, if a controlling interest in each organization (except the parent), is owned by one or more of the other organizations, and the parent owns a controlling interest in at least one of the other organizations. For this purpose, under Regs. Sec. 1.414(c)-2(a), “organization” means a sole proprietorship, a partnership, a trust, an estate or a corporation. The regulations do not explicitly state whether the parent in a parent-subsidiary group must itself conduct a trade or business. However, the regulation’s examples strongly imply that this is a must. Moreover, the relevant distinction between a parent-subsidiary group and a brother-sister group would appear to be meaningless without a requirement that the parent in a parent-subsidiary group itself be engaged in a trade or business. Regs. Sec. 1.414(c)-2(e), Example (1)(a), offers the following facts:

ABC partnership owns stock possessing 80% of the total combined voting power of all classes of stock entitled to vote of S corporation. ABC partnership is the common parent of a parent-subsidiary group of trades or businesses under common control consisting of the ABC partnership and S corporation.

This example does not specify that ABC partnership conducts a trade or business. Instead, this is implied in the conclusion that ABC is the common parent of this parent-subsidiary group of trades or businesses under common control. The very reference to trades or businesses (in the plural) makes this apparent. In addition, Regs. Sec. 1.414 (c)-2 is titled, “[t]wo or more trades or businesses under common control.” Regs. Sec. 1.414(c)-2(e), Example (3), has the following facts:

…ABC partnership is treated as the owner of stock possessing 100% of the voting power and value of all classes of stock of X and Y corporations. Thus, ABC is the common parent of the parent-subsidiary group of trades or businesses under common control consisting of ABC partnership, X corporation and Y corporation.

Although this might at first appear similar to the facts of Example 2 above, the regulation’s example does not specify that ABC partnership conducts a trade or business. Instead, it is again implied, via the conclusion that ABC is the common parent of this parent-subsidiary group of two chains of organizations conducting trades or businesses under common control. The ABC/X chain is one chain of organizations conducting trades or businesses; the ABC/Y chain is the other. Thus, as there are two chains of organizations conducting trades or businesses connected through ownership of a controlling interest with a common parent (ABC), there is a parent-subsidiary group, consisting of ABC, X and Y. Inasmuch as Regs. Sec. 1.414(c)-2(b) literally requires a chain of organizations conducting trades or businesses, for such a chain to exist, both the parent and the subsidiary must each conduct a trade or business.

Distinction: There also is a distinction between the parent-subsidiary group provisions under Regs. Sec. 1.414(c)-2(b) and the brother-sister group provisions under Regs. Sec. 1.414(c)-2(c). A brother-sister group exists if organizations conducting trades or businesses are under the common control of the same five or fewer persons. If the brother-sister group is owned by a partnership, such persons must own more than 50% of that partnership. However, the brother-sister regulations do not require the group to be connected by a parent in a chain of organizations conducting trades or businesses. In other words, the parent’s trade or business is irrelevant in the brother-sister regulations; it is only relevant that the brother-sister organizations conduct trades or businesses. Thus, if the brother-sister group is owned by a partnership, it is irrelevant whether the partnership conducts a trade or business in determining whether a brother-sister group ultimately exists below the partnership.

In contrast, a parent-subsidiary group exists if there are one or more chains of organizations conducting trades or businesses connected through a common parent. Absent the reference to “one or more chains of organizations conducting trades or businesses,” the brother-sister regulations would have little (if any) distinction from the parent-subsidiary regulations when, for example, multiple subsidiaries exist under a partnership parent (i.e., in Example 2 above). Because a law, presumably, cannot be read to be meaningless, it is apparent that the distinction under the parent-subsidiary regulations is the requirement that the parent itself (whether incorporated or not) conduct a trade or business. In other words, to have a chain of organizations conducting trades or businesses under the parent-subsidiary regulations, both the parent and the subsidiary must conduct trades or businesses. The subsidiary alone conducting a trade or business is not sufficient.

Further, a leading treatise cites Regs. Sec. 1.414(c)-2(b)(1) to describe a parent-subsidiary group under Sec. 414(c); according to Lokken and Bittker, Federal Taxation of Income, Estates & Gifts (Warren Gorham & Lamont, 2d/3d ed., 2004), 61.11.2:

One or more chains of organizations, each of which carries on a trade or business, one of which is a common parent organization, and a controlling interest in each of which (other than the parent) is owned by the common parent or another member of the group. (Emphasis added.)

Accordingly, in Example 2 above, unless F is deemed to be engaged in a trade or business, F, X and Y would not be a parent-subsidiary group as defined in Sec. 414(c). The comment “unless F is deemed to be engaged in a trade or business” is, of course, an important one and raises an interesting issue.

Defining “trade or business”: There is no statutory or regulatory definition of the phrase “trade or business,” although the term appears literally in hundreds of Code provisions. Thus, the definition has fallen to the courts. In Groetzinger, 480 US 23 (1987), the Supreme Court identified two main requirements for an activity to constitute a trade or business when claiming business deductions under Sec. 162: the activity must be conducted (1) for profit (rather than for recreation) and (2) with continuity and regularity. In holding that a full-time gambler conducted a trade or business, the Groetzinger Court recognized that these two factors were not always exhaustive, but it did not identify other factors for a court to consider.

Almost all of the cases cited in Groetzinger have dealt with the definition of a trade or business, as used in Sec. 162 and its predecessors. Not only is the term as used in Sec. 414(c) not defined in the Code or regulations, but also, the definition appears to have never been considered by the courts in a tax case or by the IRS in its rulings. However, the term as used in the Multiemployer Pension Plan Amendment Act of 1980 (MPPAA) has been frequently interpreted and applied by the courts.

In the absence of a clear definition of “trade or business” under Sec. 414(c), the courts in the MPPAA cases generally have held that the term should be interpreted in light of the intentions of the Employee Retirement Income Security Act of 1974; see, e.g., Pension Benefit Guaranty Corp. v. Center City Motors, Inc., 609 FSupp 409, 412 (SD CA 1984) (“It clearly intended to prevent a business from limiting its responsibilities under ERISA by the fractionalization of its business operations.”) and Pension Benefit Guaranty Corp. v. American Shelter Industries, 821 FSupp 1465, 1468 (MD FL 1983) (“The purpose of ERISA is to prevent trade or businesses from limiting their responsibilities under ERISA by fractionalizing their business operations.”) (quoting Central States, Southeast and Southwest Areas Pension Fund v. Lloyd L. Sztanyo Trust, 693 FSupp 531, 536 (ED MI 1988)).  Thus, the vast majority of MPPAA cases finding that a separate entity that merely engages in limited economic activity is a trade or business, involved entities with some economic nexus with the principal business. More recently, many courts in MPPAA cases have accepted the Supreme Court’s analysis in Groetzinger, in distinguishing trades or businesses from investments; see Central States, Southwest and Southwest Areas Pension Fund v. Fulkerson, 238 F3d 891, 895 (7th Cir. 2001), finding that property subject to triple net leases did not constitute a trade or business, and Connors v. Incoal, Inc., 995 F2d 245, 250–251 (DC Cir. 1983), commenting that the Groetzinger construction of “trade or business” is the most authoritative pronouncement available.

The courts in the MPPAA cases appear not to have yet addressed whether a private securities partnership, such as F, constitutes a trade or business. However, based on case law, particularly Groetzinger and its progeny, and considering F’s activities and sources of income, it is unlikely that F would be classified as being in a trade or business under Sec. 414(c). The common thread of these cases is that, for a taxpayer to be a trader rather than an investor, its securities activities must be almost daily, not sporadic. In addition, its income must be from short-term trading-type income, rather than from long-term capital gains, dividends and interest (i.e., investment-type income).

Combined group: Finally, Regs. Sec. 1.414(c)-2(d) provides that a “combined group of trades or businesses under common control” means any group of three or more organizations, if (1) each such organization is a member of either a parent-subsidiary group of trades or businesses under common control or a brother-sister group of trades or businesses under common control; and (2) at least one such organization is the common parent organization of a parent-subsidiary group of trades or businesses under common control and is also a member of a brother-sister group of trades or businesses under common control. F, X and Y are not a combined group, because there is no parent-subsidiary (i.e., F has no trade or business, as discussed above), nor a brother-sister group. Further, although F is the common parent of X and Y, it is not also a member of a brother-sister group.

Thus, with respect to the COD income matter, X and Y are not related under Sec. 267(b), 707(b)(1) or 414(b). Further, they also appear unrelated under Sec. 414(c). Thus, Y’s acquisition of X’s debt appears not to result in COD income to X under Sec. 108(e)(4). Instead, Y should recognize the discount as gain over the appropriate timing as the debt is serviced, another result that can be easily overlooked in the context of corporations with the same diversely held private-equity-fund parent.

From Brian E. Keller, CPA, Oak Brook, IL