Florida A & M University Law Review

Volume 11 | Number 1 Article 7

Fall 2015 "Trade or Business": The Relevance of a Deceptively Simple Income Tax Phrase to the Labor Code, Federal Statutes, and Private Equity Activity Arthur Acevedo

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Recommended Citation Arthur Acevedo, "Trade or Business": The Relevance of a Deceptively Simple Income Tax Phrase to the Labor Code, Federal Statutes, and Private Equity Activity, 11 Fla. A&M U. L. Rev. (). Available at: http://commons.law.famu.edu/famulawreview/vol11/iss1/7

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For more information, please contact [email protected]. 37680-fam_11-1 Sheet No. 84 Side A 09/19/2016 08:25:28 R R R R R R R R R R R R R R ..... 165 AX ...... 181 , T ...... 187 ODE RIVATE ELEVANCE OF P C ...... 166 NCOME R ND I ...... 175 A ...... 177 HE ABOR ...... 166 , A CTIVITY ...... 167 L ”: T IMPLE ...... 163 159 A USINESS S B Arthur Acevedo APITAL TATUTES C QUITY ...... 170 S ...... 179 USINESS UN E RADE OR S ...... 188 T ...... 184 B QUITY ...... 160 E Operational Decisions HRASE TO THE ECEPTIVELY A P Determining Whether an Activity is a Trade or Determining Whether an Activity Business Requires an Active and Influential Involvement in the Requires an Active and Influential Merely Recording Portfolio Company and Excludes the Portfolio and Monitoring the Activities of Company” Investment Return is Required –A Plus Factor Underlying Required by the Taxpayer in the Activity 1. Use of Controlling Stake 2. Use of a Management Company 3. Participation in Corporate Policy Making and EDERAL NALYSIS OF RIVATE UMMARY OF D F E. Invoking Not-for-Profit Analysis as a Guide in A. No. 1: “Carrying on a Trade or Business Proposition B. an Proposition No. 2: Something More Than Simply C. is Proposition No. 3: A Direct and Active Involvement D. Court Cases Synthesis of the Three Supreme A. and Control Mechanisms Operation of the Funds A. Between Structural Distinction Arthur Acevedo is an Associate Professor of Law at the John Marshall Law School RADE OR M K I. S A II. P C Y III. A NTRODUCTION “T in Chicago, Illinois. He received his Juris Doctor, Master of Science in Taxation, and Bacca- in Chicago, Illinois. He received his Juris Doctor, Master of Science in Taxation, received his laureate Science in Commerce degrees from DePaul University. He also to thank his certificate as a Certified Public Accountant (Illinois). The author would like for their re- research assistants Gennafer Garvin, Cullen Baldwin, and Jennifer Hunter to research search assistance. He would also like to extend a special acknowledgement fellow Priyavathi Reddy for her assistance and diligence in finalizing this paper. I \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 1 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 84 Side A 09/19/2016 08:25:28 A 09/19/2016 84 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 84 Side B 09/19/2016 08:25:28 R R R R R R R M K Sun C Y . 1071, EV . L. R Vol. 11:1:159 HI 3 (6th ed. 2009). unique is that Under traditional 3 , 75 U. C ...... 203 XPLANATIONS E , the First Circuit found a ...... 198 , 134 S. Ct. 1492 (2014)...... 205 ...... 199 XAMPLES AND The Tax Advantage to Paying Private Equity Sun Capital Partners : E cert. denied NTRODUCTION I ...... 194 ...... 202 ORPORATIONS , C liable for the 4.5 million dollar withdrawal pen- liable for the 4.5 million dollar 2 FLORIDA AFLORIDA &REVIEW LAW M UNIV. ALMITER ROPOSALS ...... 208 P R. P Implications Plain and Ordinary a Common, Illustrating Phrase of Such Understanding a Burden Benefit or Imposing WO LAN Corporate law is premised upon two fundamental principles: Corporate law is premised upon However, a decision by the First Circuit Court of Appeal casts a However, a decision by the First The privilege of limited liability assures investors that personal The privilege of limited liability F. Business with Trade or Federal Statutes Other G. or Business the Phrase Trade Law Uses of Common H. Policy Interests Competing A. Warranted? Administrative Guidance B. - Accessing a The Dual Posture of “Trade or Business” 1 3. Teamsters & Trucking Indus. Pension Sun Capital Partners III, LP v. New Eng. 2. the capital of sophisticated investors, “The prototypical ‘private equity’ fund pools 1. A IV. T ONCLUSION 1073 (2008). Fund, 724 F.3d 129, 137 (1st Cir. 2013), purchases ailing companies, restructures the companies, and then resells them—at a profit, if all goes well.” Chris William Sanchirico, it is the first reported decision holding a private equity fund liable for it is the first reported decision corporate law principles, an investor’s liability is limited to its invest- corporate law principles, an investor’s ment in the venture. What makes private equity fund sion liability of one of its portfolio companies. sion liability of one of its portfolio the pooling of moneys for investment purposes and the privilege of lim- the pooling of moneys for investment enables promoters and investors to ited liability. The pooling of money substantial sums for investment pur- efficiently amass and organize poses. liability for the underlying invested activity is limited to the moneys liability for the underlying invested sacrosanct principle and a quintessen- invested. Limited liability is a the investment community. Private tial investment assumption within exploited these two policies. equity firms have successfully the privilege of limited liability. In shadow of doubt on the scope of Fund Managers with Profit Shares: What Is It? Why Is It Bad? C 160 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 2 6-SEP-16 15:52 Capital Partners III, LP v. New England Teamsters & Trucking Indus- Capital Partners III, LP v. New Partners”) try Pension Fund (“Sun Capital 37680-fam_11-1 Sheet No. 84 Side B 09/19/2016 08:25:28 B 09/19/2016 84 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 85 Side A 09/19/2016 08:25:28 161 The Derek 6 Predict- 4 Sun Capi- see also 5 (Oct. 9, 2013), http:// (Aug. 14, 2013), http:// N ’ OMM 7 DVISOR . C 2013.pdf. . A US DMIN B MACRS A _ UPRA , JD S ETIREMENT decision represents a departure from represents a departure decision A Warning Shot for Private Equity Funds: First SUNCAPITAL R _ , 724 F.3d at 138. WED MPLOYEE E UBLIC : P GOV . also exposes a deeper problem – the underlying tension the underlying problem a deeper also exposes – Sun Capital Partners Sun Capital ASS “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE John Boyd & Jason Cabico, at 134. at 132-33 (“This case presents important issues of first impression as to with- at 132-33 (“This case presents important , M The There are over 1,000 references to the phrase “trade or busi- There are over 1,000 references determination of whether an ac- For income tax purposes, the Sun Capital Partners III, LP v. New England Teamsters & Trucking Industry Pen- See Sun Capital Partners III, LP Id. Id. M K 6. 7. 5. 4. C Y Moitoso, the pension withdrawal liability of its portfolio companies. of its portfolio liability withdrawal pension the labor statute cross-references Section 401(c) of the Income Tax Code Section 401(c) labor statute cross-references Section 401(c) does not or business.” Regrettably, when defining “trade litigants, regulators, and courts define “trade or business,” leaving Second, there is substantial evi- with no guidance as to its meaning. that the private equity fund was dence in the record demonstrating activities of the portfolio company, aggressively involved in the daily that it was engaging in the “trade thereby exposing itself to the claim company. or business” of operating the portfolio www.mass.gov/perac/training/Legal/ ably, the reaction by the private equity investment community was investment private equity reaction by the ably, the case. liability in this of a finding of disapproving swift and www.jdsupra.com/legalnews/a-warning-shot-for-private-equity-funds-93409/; the traditional view that an investor’s liability is limited because two view that an investor’s liability the traditional applicable labor stat- converged in this case. First, the critical factors constitutes a “trade or when an investor’s activity ute imposes liability issue provides that “[t]o the labor statute at business.” In particular, other than the one obli- liability on an organization impose withdrawal be satisfied: (1) the Fund, two conditions must gated to the [pension] the obligated organ- be under ‘common control’ with organization must trade or business.” the organization must be a ization, and (2) between competing federal and state policy objectives. and state competing federal between drawal liability for the pro rata share of unfunded vested benefits to a multiemployer drawal liability for the pro rata share Scott Brass, Inc. (SBI).”). pension fund of a bankrupt company, here, ness” in the tax code, each with different policy objectives and ness” in the tax code, each or business” is not defined in the In- implications. The phrase “trade in the Income Tax Regulations. Three come Tax Code nor is it defined the question of whether the activity at Supreme Court cases address However, the Supreme Court issue constitutes a trade or business. “trade or business.” does not define the meaning of a variety of consequences ranging tivity is a trade or business imports Circuit Court of Appeals Holds Fund Engaged in a “Trade or Business” for Purposes of Allo- Circuit Court of Appeals Holds Fund Engaged in a “Trade or Business” for Purposes cating ERISA Pension Withdrawal Liability sion Fund 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 3 6-SEP-16 15:52 tal Partners 37680-fam_11-1 Sheet No. 85 Side A 09/19/2016 08:25:28 A 09/19/2016 85 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 85 Side B 09/19/2016 08:25:28 M K C Y Vol. 11:1:159 of the Income Tax Code of the Income 8 10 exposes a sharp conflict between compet- exposes a sharp conflict between In contrast, Section 882 burdens foreign Section 882 In contrast, State governments seek to encourage in- State governments seek to encourage 9 11 FLORIDA AFLORIDA &REVIEW LAW M UNIV. Pension Protection Act of 2006, 29 U.S.C. § (penalizing com- 1001 et al. (2006) at § 162(a). Sun Capital Partners For labor law purposes, the determination of whether an activ- the determination of For labor law purposes, the use of the phrase “trade In what sense does Congress intend of this disputed and elusive This paper explores the meaning Id. See 8. 26 U.S.C. §9. 162 (2012). 10. U.S.C. § 26 882(a) (providing the general rule that “[a] foreign corporation engaged 11. from granting a tax benefit, to qualifying tax benefits, to imposing an imposing to tax benefits, to qualifying benefit, a tax granting from 162 instance, Section tax burden. For income grants taxpayers the benefit of deducting from gross income “ordinary from gross of deducting the benefit grants taxpayers year in carrying the taxable “incurred during expenses and necessary” trade or business.” on any ing federal and state policy justifications. The federal government ing federal and state policy seeks to protect pensions. taxpayers “engaged in a trade or business” within the United States to United States within the a trade or business” “engaged in taxpayers pay their corresponding connected income” and report their “effectively tax liability. U.S.-based income vestment and broaden economic activity in order to benefit an array of vestment and broaden economic panies with underfunded pensions by requiring them to pay higher premiums). in trade or business within the United States during the taxable year shall be taxable as in trade or business within the United States during the taxable year shall be con- provided in section 11, 55, 59A, or 1201(a) on its taxable income which is effectively nected with the conduct of a trade or business within the United States”). ity is a trade or business under the labor statute imports only one business under the labor statute ity is a trade or liability. The function of imposition of a withdrawal consequence, the is radically different requirement in this context the trade or business policy objective within tax context. This singular than in the income differently than justifies reading “trade or business” the labor statute Income Tax Code. when used in the Labor statute? Did Congress intend the or business” when applying the adopt the permissive sense of an “ordi- phrase “trade or business” to deduction under section 162? Or, did nary and necessary” business of the use of the phrase? Congress intend some other sense tax forum. It examines the term within term as applied outside of the its relevance to other federal statutes the context of the labor code, to private equity investment activity, generally, and its significance advancing two proposals. The first specifically. It concludes by “trade or business” when applying prescribes a definition of the term second is a method of construction al- the contested labor statute. The but never before applied to this statute. ready recognized by our courts, relevant for use within the context of These proposals are especially in private equity investment. tiered structures as typically found 162 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 4 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 85 Side B 09/19/2016 08:25:28 B 09/19/2016 85 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 86 Side A 09/19/2016 08:25:28 UN 163 , S (June The 14 Id. RADERS Sun Capital , 4-T see also About Us 13 16 The “two private equity 15 APITAL . L.J. 553, 589 (1994). States seek to Affiliate of Sun Capital Partners, Inc. C US UN . B S M , 31 A , the New England Teamsters & Truck- , the New England UMMARY OF The Evolution of the Government-Business Relationship in the The Evolution of the Government-Business I. S ., http://www.suncappart.com/?page_id=10 (last visited Jan. 31, NC , I These competing policies present a conflict with broad with a conflict present policies competing These 12 at 132. “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pen- Sun Capital Partners at 136-38. . Part II examines the business practices of the private equity of the private practices examines the business . Part II ARTNERS Part I of this paper analyzes the relevant facts of the relevant this paper analyzes Part I of In See Id. See id. P M K 14. 15. 16. 12. Deborah A. Ballam, 13. describes itself as “a pioneer in private The litigant, Sun Capital Partners, Inc., C Y APITAL 4, 2014), http://www.4-traders.com/news/Affiliate-of-Sun-Capital-Partners-Inc-Enters-Into- Definitive-Agreement-to-Sell-Emerald-Performance—18545971/; constituents. Teamsters argued that the equity funds were engaged in a trade or Teamsters argued that the equity law. As a result, the Teamsters business under applicable federal pension liability payment from sought a 4.5 million dollar withdrawal members. the equity fund on behalf of its broaden economic activity for investors, employers, employees, and consumers. broaden economic activity for investors, funds [asserted] they are mere passive investors” in the portfolio com- funds [asserted] they are mere engaged in a trade or business as pany and, therefore, are not Pension Fund. maintained by the Teamsters ing Industry Pension Fund (“Teamsters”) challenged the activities of ing Industry Pension Fund (“Teamsters”) equity investment funds. two commonly controlled private 2016) (“Sun Capital affiliates have invested in more than 340 companies worldwide with 2016) (“Sun Capital affiliates have invested in more than 340 companies worldwide basis, combined sales in excess of $45 billion since our inception in 1995. On a consolidated of Fortune Sun Capital’s affiliated portfolio companies would rank in the top 100 Magazine’s listing of the 500 largest companies in the United States.”). implications for investors, regulators, and labor. regulators, for investors, implications sion Fund, 724 F.3d 129, 129 (1st Cir. 2013). industry and presents arguments by proponents and critics of private and arguments by proponents and presents industry debate regarding informing the a view toward with equity investment Part III examines constitutes a “trade or business.” when an activity or business,” its applica- of the phrase “trade the historical significance by Congress labor statute, its habitual deployment tion within the presumed meaning by federal statutes, and its throughout various conclusion. Part IV states a proposal and courts. Finally, Enters into Definitive Agreement to Sell Emerald Performance Materials Enters into Definitive Agreement to Sell equity investing, uniquely combining the financial skills and resources of a traditional equity investing, uniquely combining expertise of a world class operating team. The firm private equity firm with the insight and that can benefit from our in-house professionals, focuses on market-leading companies to materially improve operating performance. Sun resources, and expertise in their efforts than 335 companies worldwide with combined sales Capital affiliates have invested in more in 1995.” in excess of $45 billion since our inception United States: Colonial Times to Present C 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 5 6-SEP-16 15:52 Partners 37680-fam_11-1 Sheet No. 86 Side A 09/19/2016 08:25:28 A 09/19/2016 86 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 86 Side B 09/19/2016 08:25:28 M K Un- C Y 17 Vol. 11:1:159 New Eng. Teamsters & Truck- pooled investors’ money and 19 , 724 F.3d at 132. The ownership structure of the Sun Funds in- structure of the Sun Funds The ownership 21 18 ]. FLORIDA AFLORIDA &REVIEW LAW M UNIV. at 132-33. before “an involuntary Chapter 11 bankruptcy proceeding was before “an involuntary Chapter The equity funds initiated a suit in district court seeking a de- seeking court district a suit in funds initiated equity The The problems for the Funds began when market conditions ad- The problems for the Funds began Id. Sun Capital Partners III, LP 20 20. Sun Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension 21. Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Sun 18. Court of Appeals could have articulated a standard that would be limited to The 19. 17. fortunately, the First Circuit did not offer a standard of review to aid in First Circuit did not offer a standard fortunately, the equity fund constitutes an investment activity by an determining when a trade or business. claratory judgment establishing that they were not engaged in a trade were not engaged that they judgment establishing claratory request for a de- the plaintiff’s court granted The district or business. Appeals for the the Court of on appeal, judgment. However, claratory that it was plaintiff’s assertion rejected the reversed and First Circuit found that Court of Appeals or business. The in a trade not engaged trade or business and, Fund IV, was engaged in a one of the funds, fee. The Court to payment of the pension withdrawal therefore, subject for a determination the case to the district court of Appeals remanded trade or business. III was likewise engaged in a of whether Fund organized two investments funds, Sun Fund III L.P., and Sun Fund IV organized two investments funds, created a series of intermediary compa- L.P. (“Funds”). The Funds then acquiring the target portfolio nies for the purposes of ultimately the Funds created SSB-LLC, which in company, SBI. In the process, acquired 100% of the target portfolio turn created SBHC, which then of entities in this corporate structure, company, SBI. Within the chain and, as such, conducted business oper- SBI was the operating company and employed a labor force. SBI ations with customers and suppliers brass and copper coil for industrial pur- operated as “a manufacturer of poses” Fund, 903 F. Supp. 2d 107, 111 (D. Mass. 2012) [hereinafter vestment is complicated and multilayered. Several tiers of companies and multilayered. Several vestment is complicated the investors from the ownership interests separate with interlacing Inc., (“Fund Orga- In 2007, Sun Capital Advisors target investment. nizer”), “a private equity firm,” Fund, 724 F.3d 129, 136 (1st Cir. 2013). investor activities in an ERISA context. brought against [it].” versely changed in late 2008. The change in conditions caused its versely changed in late 2008. technical breach of its loan covenants. portfolio company, SBI, to be in but was denied. Conditions wors- SBI sought relief from its creditors failed to make a 4.5 million dollar ened for SBI. It subsequently Teamsters and Trucking Industry contribution to the New England ing Indus. Pension Fund 164 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 6 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 86 Side B 09/19/2016 08:25:28 B 09/19/2016 86 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 87 Side A 09/19/2016 08:25:28 22 165 Predictably, the Funds advanced the argument Predictably, the Funds advanced 24 all employees of trades or businesses (whether or not all employees of trades or businesses 23 “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE at 134. “[A] mutual fund is an investment company, which, typically, is continu- at 134. “[A] mutual fund is an investment A. Control Mechanisms Operation of the Funds and The Fund Organizers used a combination of LLCs, limited part- of LLCs, limited a combination Organizers used The Fund The Fund Organizers used three key control mechanisms to es- The Fund Organizers used three The artificial separation of the structures, while permitted The artificial separation of the Id. M K 23. This acronym stands for the Pension Benefit Guaranty Corporation. 24. 29 U.S.C. § 1301(b)(1) (2012) (emphasis added). 22. C Y Pension Fund. In due course, the Plan asserted its rights against SBI against rights its Plan asserted the course, In due Fund. Pension against the asserted its rights The Plan also payment. and sought legislation. control group ERISA’s Funds invoking the investment to effectuate company and a holding nerships, to was designed structure layer in the overall at issue. Each structure securing financ- purpose, such as limiting liability, serve a particular structure, while legally This complex investment ing, or holding assets. upon the Court of state law, did not go unnoticed permissible under private equity funds en- commented that “[t]hese Appeals. The court [that is] to be type of investment approach gaged in a particular fund investments.” mere stock holding or mutual distinguished from that they are not engaged in a trade or business and thus are not sub- that they are not engaged in a ject to the mandate of the statute. incorporated) which are under common control shall be treated as em- incorporated) which are under all such trades and businesses as a ployed by a single employer and single employer.” ously engaged in the issuance of its shares and stands ready at any time to redeem the ously engaged in the issuance of its shares closed-end investment company typically does not securities as to which it is the issuer; a not stand issue shares after its initial organization except at infrequent intervals and does their ready to redeem its shares. Because open-end investment companies will redeem contrast, the shares, they must constantly issue securities to prevent shrinkage of assets. In if its capital structure of a closed-end company is similar to that of other corporations; obligation to shareholders wish to sell, they must do so in the marketplace. Without any Governors of redeem, closed-end companies need not continuously seek new capital.” Bd. of omitted). the Fed. Reserve Sys. v. Inv. Co. Inst., 450 U.S. 46, 51 (1981) (internal quotes tablish, oversee, and maintain control of the portfolio company’s tablish, oversee, and maintain However, despite the complex and multi-layered ownership structure, the complex and multi-layered However, despite simple and straight- the ultimate issue is relatively it bears noting that should be held liable whether a private equity fund forward: namely, its portfolio companies pension liability of one of for the withdrawal directly or indirectly, engages in the op- when the private equity fund, erations of the portfolio company. under state law, would prove to be problematic under federal law. The under state law, would prove to that, “under regulations prescribed federal legislation at issue provides by the [PBGC], 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 7 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 87 Side A 09/19/2016 08:25:28 A 09/19/2016 87 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 87 Side B 09/19/2016 08:25:28 M K The C Y This 30 25 Vol. 11:1:159 and “acted as a middle- 29 The Fund Organizer set investor ex- The Fund Organizer 26 , 724 F.3d at 133. , 724 F.3d at 134. 1. Use of Controlling Stake 2. Company Use of a Management FLORIDA AFLORIDA &REVIEW LAW M UNIV. The management company structure provided operational, The management company structure 28 at 136. This level of control is critical to attract investors, to minimize This level of control is critical First, the private equity fund organizer (“Fund Organizer”) equity fund organizer (“Fund First, the private Next, the Fund Organizer employed the use of a management Next, the Fund Organizer employed Sun Capital Partners III, LP Id. Id. Sun Capital Partners III, LP Id. 27 30. 26. 25. 27. 28. bears noting that, in an independent setting, buyers of management services are It 29. management company acted as a conduit between the investors and management company acted as both parties with information, assess- the portfolio company, providing ability to use control figured prominently in the “private placement figured prominently in ability to use control investors.” memos to potential used its “controlling stakes in portfolio companies . . . to implement stakes in portfolio companies used its “controlling teams, become operational plans, build management restructuring and and otherwise cause in company operations, intimately involved Funds] invest.” companies in which [the growth in the portfolio operations and policies. Leaving nothing to chance, the legal conse- the to chance, nothing Leaving and policies. operations Organizers the the Fund mechanisms assured of these control quence of the port- and operations control the activities the power to right and folio company. man, providing SBI with employees and consultants from SCAI.” man, providing SBI with employees pectation by communicating that the Funds would be able to control that the Funds pectation by communicating Specifically, the operations of the portfolio company. the policies and Funds would “ha[ve] direct contractual Fund Organizer stated that the in or substantially influence the rights to substantially participate . . . and . . . in the ordinary course management of operating companies such management rights with of [their businesses], actively exercis[e] operating companies in which [they in- respect to at least one of the vest].” managerial, and oversight services to the Funds and enabled the managerial, and oversight services portfolio company. The management Funds to engage directly with the professionals” company employed “about 123 company. any risk associated with the investment, and to optimize the return on any risk associated with the investment, of the investment. investment upon the disposition free to select from a group of competitors. SBI did not have the opportunity to decide for free to select from a group of competitors. SBI did not have the opportunity itself whether it needed a consultant. The consultant was forced upon SBI. 166 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 8 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 87 Side B 09/19/2016 08:25:28 B 09/19/2016 87 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 88 Side A 09/19/2016 08:25:28 167 32 The Court of Appeals cited the 31 and Operational Decisions and Operational 3. Policy Making Participation in Corporate “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE Finally, the Fund Organizer actively participated in the poli- Organizer actively participated Finally, the Fund The heightened level of participation by private equity funds or The heightened level of participation Id. Id. After the acquisition, the general partners in the private equity After the acquisition, the general strategic direction of the portfolio fund are actively involved in the control over the company company. They normally have operational of directors. The general partners through their control of its board act as advisors to the portfolio company’s management and as members of the company’s board of directors, and draw on their ex- pertise in corporate restructurings and their contacts throughout the industry to assist in creating value. However, when needed, the private equity partners can use their control to swiftly alter com- M K 31. 32. C Y cymaking and operations of the portfolio company. The Court of operations of the portfolio cymaking and individuals with affiliations to various Appeals noted that “[n]umerous substantial operation and managerial Sun Capital entities . . . exerted control over [the portfolio company].” ment, and expertise. The management company received a payment received company management The and expertise. ment, services. exchange for providing company in from the portfolio directly would credit the Organizer the Fund of the payment, As a result services pro- for investment from the Funds otherwise due amount company. This to the portfolio company the management vided by of costs be- was no duplication that there feature ensured crediting Thus, every dollar paid and the portfolio company. tween the investors management com- company to the Fund Organizer’s by the portfolio the Funds would receive a corresponding credit that pany resulted in Organizer. from the Fund following examples as evidence of control and influence by the Fund following examples as evidence Meeting’”;Organizers: “attend[ing] a ‘Jumpstart approving “the hiring approving “the hiring of a [com- of three [portfolio company] salesmen”; possible acquisitions, capital puter systems] consultant”; “discussing levels”; receiving “email chains dis- expenditures, and working capital dividend payouts, and concerns cussing liquidity, possible mergers, at [the portfolio company]”; and “re- about how to drive revenue growth . . . key financial data, market ceiving weekly flash reports [containing] notes and action items.” activity, sales opportunities, meeting equity fund organizers in the policy decisions and operations of the equity fund organizers in the feature in most private equity invest- portfolio company is a common ments. One writer notes, 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 9 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 88 Side A 09/19/2016 08:25:28 A 09/19/2016 88 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 88 Side B 09/19/2016 08:25:28 37 36 URT M K . 219, C Y NIFORM EV A. H U . L. R HI EVISED Vol. 11:1:159 HRISTINE R C by an investor, HE 34 See , T , 76 U. C (2001) 3 (2014). CT decision may advance A , amended 1984); Del. Code Ann. N ’ was part of an intended was part ARTNERSHIPS SS P 35 A Does Private Equity Create Wealth? The AR ARTNERSHIP . B P M IABILITY 33 L IMITED L IMITED L Sun Capital Partners Second, opponents may argue that substantial Second, opponents may argue NIFORM 38 Sun Capital Partners Sun Capital U HE IBSTEIN ON . §§ 1.20-1.24 (2008) (A T R CT FLORIDA AFLORIDA &REVIEW LAW M UNIV. AND . A , CT ORP A . C ET AL At the time the labor statute was enacted, LLC’s were in a nas- labor statute was enacted, LLC’s At the time the The control mechanisms and the level of participation by the of participation and the level mechanisms The control US Opponents of the ROMBERG AND B pany policies, remove underperforming executives, or challenge executives, underperforming remove policies, pany better. to perform management ., B 34. Teamsters & Trucking Indus. Pension Sun Capital Partners III, LP v. New Eng. 35. v. Comm’r, 312 U.S. 212, 215 (1941). Higgins 36. first state to adopt an LLP statute was Texas in 1991. The 37. Pub. L. 93-406, Title IV, §38. 4002, Sept. 2, 1974, 88 Stat. 1004. Many states simply require the filing of a form, which discloses basic information 33. Ronald W. Masulis & Randall S. Thomas, ODEL ARTNERSHIP 223 (2009), https://lawreview.uchicago.edu/sites/lawreview.uchicago.edu/files/uploads/76.1/ 76_1_Masulis_Thomas.pdf. Fund, 724 F.3d 129, 134 (1st Cir. 2013). crossing instead well onto the grounds of active participation. The IRS well onto the grounds of active crossing instead never constitute “mere personal investment activities maintains that much of one’s time or of or business, no matter how carrying on a trade time they may occupy.” one’s employees’ and the payment of a fee in exchange for accessing the privilege of limited liability, be it in and the payment of a fee in exchange for accessing the privilege of limited liability, See the form of a corporation, limited liability company, or a limited liability partnership. M several arguments in support of the position that they are not engaged several arguments in support of may argue these arrangements are in a trade or business. First, they has enabling legislation granting in- legally permissible. Every state liability, so long as statutory minimum vestors the privilege of limited requirements are met. structural design feature to ensure complete control and domination control to ensure complete design feature structural engineering and of operational This type portfolio company. over the organizers is atypical by private equity fund subsequent involvement this type of oper- investor environment. Moreover, within a traditional goes beyond “mere stock holding” ational engineering economic benefits are realized through private equity activity. Specifi- economic benefits are realized cent stage and LLPs were not in contemplation by state legislators. LLPs were not in contemplation cent stage and Fund Organizers in Fund Organizers Effects of Private Equity and Derivatives on Corporate Governance Effects of Private Equity and Derivatives P Congress enacted Section 1302, the applicable labor statute, in 1974, Congress enacted Section 1302, investors did not engage in the actual during a period when traditional Indeed, one of the key distinguish- operations of the invested activity. equity investment from traditional ing features of modern private direct or indirect, that equity investors is the degree of involvement, operational decisions of its portfolio funds exert in most of the daily investment company. 168 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 10 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 88 Side B 09/19/2016 08:25:28 B 09/19/2016 88 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 89 Side A 09/19/2016 08:25:28 ; 43 Id. 169 OMMIS- C OF . ONF C L ’ AT note 39. approach to limited approach to 40 supra 2001, 2001, § 303 cmts. (N CT OF CT OF A A “recommended” 39 ARTNERSHIP . 215/303 (2005). ARTNERSHIP P P TAT . S . L. 2001), http://www.uniformlaws.org/Shared/Docs/Limited%20Part IMITED T IMITED OMP . L . L 42 . S . C NIF NIF NIF LL Specifically, Section 303 provides: “A limited partner is not 303 provides: “A limited Specifically, Section “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE U U U 41 SIONERS ON Private equity firms can be expected to cite to the Uniform Lim- can be expected to cite to Private equity firms Private equity firms will also point to the comments in Section Private equity firms will also point The drafters of the revised Section 303 justify the change in pol- The drafters of the revised Section See See id. See See id. 805 I M K 43. 42. 40. 41. of January 2015, nineteen jurisdictions have adopted part or all of this model As 39. C Y cally, they may cite to the positive effects of increased economic and economic of increased effects positive to the may cite they cally, opponents position. Finally, support of this activity in employment limited partners by prohibiting participation that the law may argue in to participate partners to allow limited explicitly relaxed was itself a last point is This underlying investment. of the the undertakings attention. deserves additional argument that compelling Act’s ited Partnership liability. nership/ulpa_final_2014.pdf (amended in 2013). personally liable, directly or indirectly, by way of contribution or other- directly or indirectly, by way personally liable, solely by reason of of the limited partnership wise, for an obligation participates in the partner, even if the limited partner being a limited Admittedly, this control of the limited partnership.” management and merely harmonizes argument in that the revised policy is a persuasive LLPs and LLCs. LPs with its sister entities, the treatment of rationale for relaxation in the partic- 303. These comments explain the Specifically, the comments to ipation standard for limited partners. provides a full, status-based lia- Section 303 indicate that the section partner, “even if the limited partner bility shield for each limited and control of the limited partner- participates in the management the so-called “control rule” with ship.” The section thus eliminates entity obligations and brings limited respect to personal liability for members, LLP partners, and corporate partners into parity with LLC shareholders. icy by acknowledging that “[i]n a world with LLPs, LLCs, and most icy by acknowledging that “[i]n rule has become an anachronism. This importantly, LLLPs, the control step in the evolution of the limited Act therefore takes the next logical renders the control rule extinct.” partner’s liability shield and statute, including Section 303, which shields a limited partner from liability “even if the statute, including Section 303, which shields a limited partner from liability limited partner participates in the management and control of the limited partnership.” see also Granted, the policy of state legislatures has been one toward relaxation Granted, the policy of state legislatures tit. 8, § 5/1.10 (2011); N.Y. Bus. Corp. Law § 391 (2014); 805 Ill. Comp. Stat. Ann. 104-104-A (2008); Cal. Corp. Code § 200 (2015); Cal. Corp. Code § 17702.01 (2014). 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 11 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 89 Side A 09/19/2016 08:25:28 A 09/19/2016 89 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 89 Side B 09/19/2016 08:25:28 , . 2 EV M K C Y , 23 R ORMATION “Virtually F 45 Vol. 11:1:159 UND F QUITY E Unlike ordinary inves- 46 RIVATE QUITY ., P O E Id. C AW The Economics of Private Equity Funds L RIVATE Throughout its life cycle, “[a][private eq- Throughout its life cycle, “[a][private 47 Growth Equity – The Crossroads Sector Comes to the Fore II. P RACTICAL , P AIDECH confounds state and federal policy objectives. The and federal policy objectives. confounds state FLORIDA AFLORIDA &REVIEW LAW M UNIV. (July 31, 2013), http://www.goodwinprocter.com/Publications/Newslet- 44 W. N ROCTER . 2303, 2304 (2010), http://gsm.ucdavis.edu/sites/main/files/file-attachments/ COTT P What it means to be an investor for purposes of a limited liabil- of a limited investor for purposes means to be an What it The private equity investment sector is an exclusive and eco- The private equity investment TUD . S 46. Andrew Metrick & Ayako Yasuda, 47. S 44. Teamsters & Trucking Indus. Pension Sun Capital Partners III, LP v. New Eng. 45. John R. LeClaire et al., OODWIN IN G F (2011), http://www.chadbourne.com/files/Publication/3d5a9a56-734c-4d30-a5e4-0a8c593967 ab/Presentation/PublicationAttachment/12cdc9fc-964d-4b0e-a0d4-c48ce9dd7c2f/Naidech_ funds to PrivateEquityFundFormation_Nov11.pdf. It is not uncommon for private equity moneys re- use a series of related subsidiaries or brother-sister entities as it deploys the ceived to acquire the target portfolio company. all private equity funds are organized as limited partnerships, with all private equity funds are organized the general partners (GP) of the funds, private equity firms serving as and wealthy individuals providing the and large institutional investors (LPs).” bulk of the capital as limited partners and permissiveness of participation by the investor. However, one However, the investor. by of participation permissiveness and varying policy among the when distinguishing caution must exercise objectives. whether an question from different is a fundamentally ity analysis or business; and a trade activity constituting is engaged in an investor that it is a “mere pas- difference. Sun Fund’s argument therein lies the sive investor” tors who invest directly in the particular enterprise, private equity tors who invest directly in the which then invests and operates the investors invest in a pooled fund, targeted portfolio company. ters/Private-Equity-Update/2013/Growth-Equity-The-Crossroads-Sector-Comes-to-the- Fore.aspx?article=1. determination of whether one is an investor under state law principles whether one is an investor under determination of of pooling capital re- to investors the flexibility is designed to furnish liability. In contrast, the the privilege of limited sources and securing purposes of Title 29, let whether one is an investor for determination of labels of LLC, LLP, and is irrelevant and blind to the alone Title 26, labor statute is not relevant inquiry under the LP, because the inquiry is whether the investor. Rather, the relevant whether one is an a “trade or business.” activity engaged in constitutes metrickyasuda2010.pdf. nomically significant sector. Private equity is characterized by two nomically significant sector. Private and venture capital sector. broad sectors: the buyout sector Fund, 724 F.3d 129, 132 (1st Cir. 2013). 170 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 12 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 89 Side B 09/19/2016 08:25:28 B 09/19/2016 89 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 90 Side A 09/19/2016 08:25:28 171 ROWTH G (Mar. 19, L.J. 1228, XIAL ALE QUITY In form, the In form, , A . E 48 RIV , 123 Y , P (Jan. 30, 2012), http:// The Separation of Funds and ORKER 50 Y EW N HE , T A Tutorial for the President on ‘Profit Maximiza- The private equity industry is “an important The private equity industry is 52 Private Inequity A Primer on the Structure of Private Equity Firms A Primer on the Structure of Private Equity 51 49 . J. (May 23, 2012), http://www.wsj.com/articles/SB1000142405270230361050 , http://www.pegcc.org/education/growth/ (last visited Oct. 11, 2015). T “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE S The other key investment strategy is control. Private equity investment strategy is control. The other key is significant to the econ- The role of private equity investment Two key investment strategies distinguish private equity in- strategies distinguish private Two key investment Private Equity Investment Drives Broad Economic Growth ALL OUNCIL In a typical deal, a private-equity firm buys a company, using some a private-equity firm buys a company, In a typical deal, private equity and some borrowed money. . . . [The of its own money as possible, encourages firms to borrow as much investment] model put down, the a mortgage, the less money you since, just as with return on investment. bigger your potential M K . C ’, W 49.consist of small businesses with only a few Professional management teams may 50. Surowiecki, James 51. costs by eliminating unneeded resources is one way for private equity Controlling 52. 48. Cody Boyte, Organization/Formation (Year 0); Fund Raising (Years 0 to 2); 4); Deal Sourcing and Investing (Years 1 to Portfolio Management (Years 2 to 7); and Exiting Investments (Years 3 to 10). C Y AP 2014), http://www.axial.net/forum/primer-structure-private-equity-firms/. The overlapping 2014), http://www.axial.net/forum/primer-structure-private-equity-firms/. stages are: John Morley, employees, or large financial conglomerates. 1238 (2014). uity] fund goes through a number of overlapping stages.” overlapping of a number through fund goes uity] www.newyorker.com/magazine/2012/01/30/private-inequity. firms to maximize profits. Paul H. Rubin, various entities of the equity fund are separated by layers of common separated by layers equity fund are entities of the various they are But in substance, objectives. to achieve strategic ownership of a profes- the assistance and operated with organized collectively of the targeted the operations to direct team sional management investor of maximizing the purpose company for portfolio profitability. asset class with over $1 trillion under management, two thirds of asset class with over $1 trillion 4577419970054445432. firms will secure organizational and operational control, upon acquir- firms will secure organizational enable the firm to make immediate ing the portfolio company, to seek to control costs while maximizing changes as private equity firms profitability. $443 billion in more than 2,360 omy. “Private equity firms invested These companies employ approximately U.S. based companies in 2013. of PE-backed IPOs since 2001 is well 7.5 million people. And the value over a trillion dollars.” vesting from regular investing – debt and control. investing vesting from regular – Managers: A Theory of Investment Fund Structure and Regulation Managers: A Theory of Investment Fund tion C 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 13 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 90 Side A 09/19/2016 08:25:28 A 09/19/2016 90 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 90 Side B 09/19/2016 08:25:28 . . M K CON OUND C Y , (Nat’l . F Id. ES of private , 23 J. E 56 note 33, at 260. , 2 R Vol. 11:1:159 This statement supra 57 , However, there is However, 54 Id. and the vices and the 55 Private Equity, Technological Investment, funds. Furthermore, fundraising is growing is fundraising Furthermore, funds. Beware of Venturing into Private Equity Private Equity Performance: What Do We Know? Private Equity Performance: What Do Does Private Equity Create Wealth? 53 Investing in Private Equity Funds: A Survey 17 (Working Paper 2013), http://www.usc.edu/schools/business/FBE/ FLORIDA AFLORIDA &REVIEW LAW M UNIV. Ludovic Phalippou, Masulis & Thomas, . 2, 14 (2007), http://www.cfapubs.org/doi/pdf/10.2470/rflr.v2.n2.4626. One paper in support of private equity investment activity ad- investment activity private equity in support of One paper See See advances two dramatic conclusions concerning private equity dramatic conclusions concerning advances two NST . 147, 152-54 (2009) (discussing how investors may not be aware of hidden fees in . 147, 152-54 (2009) (discussing how investors 58 58. Robert S. Harris et al., 55. 57. Ashwini Agrawal & Prasanna Tambe, 56. 53. buyout fund. “BO” is an acronym used to describe a 54. Ludovic Phalippou, ERSP P CFA I Bureau of Econ. Res., Working Paper No. 17874, 2012), http://faculty.chicagobooth.edu/ Bureau of Econ. Res., Working Paper of the paper call into question numerous ear- steven.kaplan/research/HJK.pdf. The authors is stale and lier studies by implicitly stating that the data of many of these earlier studies the outdated. The authors of this study make the following claim: “Our research highlights it provides importance of high quality data for understanding private equity and the returns upon data to investors. Some of the existing papers in the academic literature have relied also have whose reliability has recently been questioned. Most previously published papers in investor focused on funds raised up until the mid- or late-1990s. The enormous growth a re-evalua- allocations to private equity funds since the late 1990s has created a need for of a new tion of private equity performance. This paper is the first to take advantage research-quality cash flow data set from Burgiss, using data as of March 2011.” Among the benefits cited are that “[p]rivate equity offers several attractive benefits to help Among the benefits cited are that “[p]rivate . . . [by concentrating] share ownership . . . with offset . . . corporate governance problems blockholder . . . plac[ing] control in the hands of the creation of a controlling, monitoring in the firm . . . ensur[ing] that these directors directors representing large fractional owners motivated to carefully monitor senior managers are financially sophisticated and strongly portfolio companies [with] the power and incen- . . . [and providing] boards at private-equity senior management.” tives to discipline and if necessary replace equity investment activity. The scholarship is itself fractured and is itself The scholarship activity. equity investment inconclusive. that employees of firms that “[t]he raw data indicate vances the claim employed for by PE investors are subsequently that get acquired than workers employed elsewhere.” longer durations which is managed by BO by is managed which negates claims by opponents of private equity investment activity that by opponents of private equity negates claims on the acquired target activity has a harmful effect such investment paper, touting itself as employee labor pool. Another company and its cash flow data advantage of a new research-quality “the first to take set,” considerable debate concerning the virtues debate concerning considerable fast from $5 billion in 1980 to $400 billion in 2006.” to $400 billion $5 billion in 1980 fast from FOM/papers/FOM-Session5_2.20p_AGRAWAL.pdf. fund investments. First, the authors assert that “it seems likely that First, the authors assert that fund investments. particularly the S&P outperformed public markets, buyout funds have private equity transactions and suggesting that fees should be computed by reference to private equity transactions and suggesting “an internal rate of return” model and a “multiple” alternative performance measures using model). and Labor Outcomes 172 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 14 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 90 Side B 09/19/2016 08:25:28 B 09/19/2016 90 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 91 Side A 09/19/2016 08:25:28 59 IMES 173 , N.Y. T , http://www.cvc.com/Our- These claims praise the These claims 61 ARTNERS funds outperformed public funds outperformed P 60 APITAL , CVC C The Very Big Business of Private Equity 63 In response, it answered: In response, it 62 note 58, at 28. The paper goes on to note: “Since 2000, the note 58, at 28. The paper goes on to note: supra William J. Holstein, Not only does the statement suggest something more than Not only does the statement suggest “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE 64 Carlo V. di Florio, Director, Office of Compliance Inspections and Examina- see also One private equity firm engaging in a hypothetical Q&A session Q&A engaging in a hypothetical equity firm One private This response is illuminating. It conveys to readers an active This response is illuminating. Id. See Id. Key Facts About Private Equity To succeed in improving the performance of a portfolio company a the performance of a portfolio To succeed in improving than just fi- needs to supply a great deal more private equity firm is key to Developing organic revenue growth nancial creativity. enhance a value within a company. To further securing increased substantial it is also crucial to undertake company’s performance improving cost and waste reductions, operational improvements, and ability to product repositioning the company’s competitiveness, execution of a as well as the development and enter new markets, sound business strategy. M K 63. 64. 59. 60. buyout fund. It specifically refers to venture “VC” is an acronym used to describe a 61. Harris et al., 62. C Y 500, net of fees and carried interest, in the 1980s, 1990s, and 2000s.” 1990s, 1980s, in the interest, carried and net of fees 500, Industry/Key-Facts-About-Private-Equity.htmx (last visited Oct. 11, 2015). Industry/Key-Facts-About-Private-Equity.htmx virtues of private equity investment and its positive results on society its positive investment and of private equity virtues growth. and economic of employment in terms equity firms improve question: “How do private asked the following company performance?” markets substantially until the late 1990s.” substantially markets average VC fund has underperformed public markets by about 5% over the life of the fund.” average VC fund has underperformed public mere “financial creativity,” it illustrates a communication strategy by mere “financial creativity,” it illustrates investors the investment, manage- equity firms to convey to targeted tions, SEC, Speech by SEC Staff: Private Equity International’s Private Fund Compliance tions, SEC, Speech by SEC Staff: Private Equity International’s Private Fund fund-rais- (May 3, 2011), 20120418P NYCBAR 43 (discussing potential conflicts during the ing stage); involvement by many private equity firms in the operations of their involvement by many private communication strategy behind state- target portfolio company. The to potential investors both an obvious ments such as this one conveys This statement must be analyzed not and an understated message. also for its persuasive value to potential only for its obvious content but investors. capital. (May 23, 2004), http://www.nytimes.com/2004/05/23/business/office-space-armchair-mba- if not more, the-very-big-business-of-private-equity.html (“Our investors know as much, have a more about our investments and returns than do public companies’ investors. We have 75 or limited audience, so it’s easier to communicate with them. A firm like ours might 80 investors. That’s a target audience that’s easier to communicate with.”). Id. Second, the authors also note that “VC the authors also Second, 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 15 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 91 Side A 09/19/2016 08:25:28 A 09/19/2016 91 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 91 Side B 09/19/2016 08:25:28 . , US M K . B after C Y ARV , H Vol. 11:1:159 8 (Jan. 2013), http:// OMPANIES C They go on to add that 69 ORTFOLIO note 62. P They add that, “[u]ltimately, lever- 68 QUITY supra The Strategic Secret of Private Equity , E RIVATE P Predictably, the reported response states, “The Predictably, the 66 ?” This statement is striking because of its clear admis- is striking because of its clear This statement FLORIDA AFLORIDA &REVIEW LAW M UNIV. ORKING WITH 65 “Interaction” between private equity firm directors and “Interaction” between private 67 Should private equity executives have operational or indus- equity executives have operational Should private Another proponent of private equity writes that “the fundamen- equity writes proponent of private Another A KPMG research study further illustrates the nuances of the study further illustrates the A KPMG research Private equity firms have also sought to legitimize their eco- Private equity firms have also Id. Key Facts About Private Equity Id. . (Sept. 2007), http://hbr.org/2007/09/the-strategic-secret-of-private-equity/ar/1 (empha- . (Sept. 2007), http://hbr.org/2007/09/the-strategic-secret-of-private-equity/ar/1 67. 69. 66. KPMG, W 65. Barber & Michael Goold, Felix 68. EV R selling them.” www.kpmg.com/GI/en/IssuesAndInsights/ArticlesPublications/Documents/working-with- private-equity.pdf. rial, and operational philosophies of the respective private equity private respective of the philosophies and operational rial, firms. is of return and high rates equity’s growth behind private tal reason it’s so ob- perhaps because little attention, that has received something and then, businesses practice of buying firms’ standard vious: the aged buy-outs of portfolio companies generate greater productivity, aged buy-outs of portfolio companies growth, and have a positive effect on promote employment and salary company.” employee relations within the results of our research show a high degree of consensus on this topic, results of our research show a of operational or management expe- with private equity directors’ lack the way they interact with portfolio rience seen as a weakness in companies.” sion that businesses are “steered,” thereby conveying an active are “steered,” thereby sion that businesses underlying operational the private equity firm in the involvement by investment. activities of the “steering” argument. KPMG asked its research subjects the following KPMG asked its research “steering” argument. question: “ the underlying portfolio company is a commonplace occurrence in the the underlying portfolio company linguistic purist, the word “interact” private equity industry. To the But when viewed through the may not be the equivalent to “steering.” the word “interact” signals an appropri- eyes of a reasonable investor, equity firm to justify the risk of the ate level of activity by the private investment to an interested investor. that “[a]cademic studies have nomic and social impact by asserting and leverage has an overall posi- shown that private equity investment and efficiency of companies, tive impact on the financial performance capital invested fills a critical gap especially since the transitional when capital markets are fragile.” sis added). try sector experience 174 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 16 6-SEP-16 15:52 steering them through a transition of rapid performance improvement a transition of rapid performance steering them through 37680-fam_11-1 Sheet No. 91 Side B 09/19/2016 08:25:28 B 09/19/2016 91 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 92 Side A 09/19/2016 08:25:28 175 85-86 (2010). 70 APITALISM C BOUT A OU Y ELL T T ’ ON D HEY T HINGS , 23 T 71 HANG A. Roles Distinction Between Structural C OON “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE -J A Another factor contributing to the significance of the private eq- This statement reinforces the proposition that many private eq- This statement reinforces the proposition or critic of private equity Whether the speaker is a proponent Nevertheless, private equity investment activity is reputed to activity is reputed investment private equity Nevertheless, Id. In recent years, private equity funds have played an increasingly private equity funds have played In recent years, they have no corporate acquisitions. Even though important role in in theory, ac- in particular industries, they may, in-house expertise experts as for the long term and hire industry quire a company However, in them to upgrade its capabilities. managers and ask upgrade the ac- usually have no intention to practice, these funds with a view for the long term. They acquire firms quired company them in three to five years after restructuring to selling them on horizon, usu- Such restructuring, given the time into profitability. workers and costs (especially sacking ally involves cutting rather than raising capa- refraining from long-term investments), to hurt the long-term prospects bilities. Such restructuring is likely ability to generate productivity of the company by weakening its equity funds may acquire com- growth. In the worst cases, private to engage in asset-stripping, panies with the explicit intention without regard to its long- selling the valuable assets of a company term future. M K 70. 71. H C Y “[s]uperior returns from private equity investments strengthen pen- strengthen investments equity from private returns “[s]uperior of employees.” benefits for millions that provide sion funds uity sector is its ability to successfully exploit the modernization of uity sector is its ability to successfully exploit the modernization business entity statutes. Private equity has seized upon a structural distinction among the various business entity statutes. The distinction uity funds do not “merely invest” in their companies. Instead, this uity funds do not “merely invest” equity funds are regularly and substan- statement asserts that private and organizational policies of the tially engaged in the operational underlying portfolio company. alike speak with a common voice in investment, proponents and critics many private equity funds are reg- namely, that the following respect – in many of the activities of the ularly and substantially engaged portfolio company. have destructive and disreputable characteristics. In response to the In characteristics. and disreputable have destructive in private equity general, and investors in argument that traditional one au- create job opportunities, markets and help to grow particular, thor writes: 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 17 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 92 Side A 09/19/2016 08:25:28 A 09/19/2016 92 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 92 Side B 09/19/2016 08:25:28 M K C Y corporate Vol. 11:1:159 76 , With the notable excep- , amended 1984). N . § 6.22(b) provides that “a share- ’ 74 CT SS Rejecting a shareholder’s de- A . A 73 Galler v. Galler AR ORP . B . § 3.02 provides that “every corporation . . . M . C CT US . A and B 75 ORP , ODEL . C . § 8.01(b) (A US 72 CT B . A ODEL ORP . C FLORIDA AFLORIDA &REVIEW LAW M UNIV. US B Clark v. Dodge ODEL In contrast, the organic laws of LLPs, LLCs, and now LPs, allow In contrast, the organic laws of One key distinction between investors in a corporation and in- between investors in a corporation One key distinction 74. Charlestown Boot & Shoe Co. v. Dunsmore, 60 N.H. 85, 86 (1880). 75. 199 N.E. 641 (N.Y. 1936). 76. 203 N.E.2d 577 (Ill. 1964). 73. M 72. For example, M shareholders, both public and closely-held, remain prohibited from shareholders, both public and managing or overseeing the corporation. The change in the structural rules for active participation by investors. legislatures regarding the level of reflects the policy change by state may exert in the entity. While state participation and control investors of maintaining a separate legal fic- laws allow investors the flexibility between investors in a corporation and investors in a limited partner- in a limited and investors a corporation in investors between adopted by policy change a fundamental or LLC, reflects ship, LLP, control inves- participation and the level of regarding state legislatures to investors State laws allow entity. have in the underlying tors may common owner- entities despite of separate the legal fiction maintain of the activities manage investors to actively permitting ship while as contract law, agency control mechanisms such such entities through law. law, and corporate holder of a corporation is not personally liable for the acts of debts of the corporation . . . .” In holder of a corporation is not personally similar fashion, the Revised Uniform Limited Liability Company Act (2006) § 105 provides: to “A limited liability company has . . . the power to do all things necessary or convenient carry on its activities.” While § of a limited liability com- 304 states that “the . . . liabilities of the pany, whether arising in contract, tort, or otherwise are solely the . . . liabilities .” company [and] do not become the . . . liabilities of a member or manager . . . tions of sire to participate in a liquidation proceeding, one court noted, “When sire to participate in a liquidation granted to a corporation shall be exer- a statute provides that powers particular agents, such powers can be cised by any set of officers or any or agents.” exercised only by such officers has the same powers as an individual to do all things necessary or convenient to carry out has the same powers as an individual to its business and affairs,” while M vestors in a limited partnership, LLP, or LLC, is the fact that the partnership, LLP, or LLC, vestors in a limited from actively en- a corporation prohibits shareholders organic law of operations of the management, oversight, and gaging in the involved in the manage- investors were not corporation. Historically, companies. Corporate activities of the invested rial or operational engaging in the manage- structurally prohibited from investors remain Section 8.01(b) provides, of the corporation. MBCA ment or operations exercised by or under the authority of, “All corporate powers shall be the corporation managed by or under and the business and affairs of the direction of, its board of directors.” 176 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 18 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 92 Side B 09/19/2016 08:25:28 B 09/19/2016 92 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 93 Side A 09/19/2016 08:25:28 . 77 cert 177 with the provides: “To and what is a and what is 78 Id. McDougall v. Pioneer USINESS B RADE OR Sun Capital Partners T before a finding of liability can be made. before a finding of liability can , the Court of Appeals for the Seventh Circuit , the Court of Appeals for the 80 NALYSIS OF ” III. A 29 C.F.R. § control” for 779.221 (2011), which defines the phrase “common In the end, one arrives at the conclusion that common con- In the end, one arrives at the conclusion “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE 79 The phrase “common control” is not defined by the labor code. control” is not defined by The phrase “common Similarly, the phrase “trade or business” is also not defined by Similarly, the phrase “trade or The labor statute at issue in The labor statute But see , 552 U.S. 1098 (2008) (emphasis added). M K 77. 29 U.S.C. § III, LP v. New Eng. Teamsters & Truck- 1301(b); Sun Capital Partners 78. complete analysis of “common control” is beyond the scope of this paper and will A 79. 80. v. Pioneer Ranch Ltd. P’ship, 494 F.3d 571, 577 (7th Cir. 2007), McDougall C Y tion among the entities, state laws should not promote the idea that the idea not promote should laws state the entities, among tion especially when in substance, separation in form promotes separation public policy. would frustrate doing so impose withdrawal liability on an organization other than the one obli- liability on an organization impose withdrawal be satisfied: (1) the Fund, two conditions must gated to the [pension] the obligated organ- be under ‘common control’ with organization must a trade or business.” the organization must be ization, and (2) “trade or business” is indispensable to establishing liability. is indispensable to establishing “trade or business” a dizzying array of are instructed to traverse through Instead, readers concluding that a clear definition is not statutes and regulations before indicated. the labor code. Instead, the labor code instructs readers to look to Sec- the labor code. Instead, the labor code when establishing whether an tion 414(c) of the income tax stated that “the organization must be under ‘common control’ stated that “the organization must purposes of the Fair Labor Standards Act as Applied to Retailers of Goods or Services by purposes of the Fair Labor Standards Act as Applied to Retailers of Goods or splitting this phrase into its component parts and defining “‘control’ . . . as the act of fact of limited to controlling and ‘common’ . . . [as] ‘includ[ing] the sharing of control and it is not sole control or complete control by one person or corporation.” trol means the common relationships existing between trades or trol means the common relationships relationships, brother-sister businesses that have parent-subsidiary of the two. The determination of “com- relationships, or a combination when one searches for a definition mon control” is further complicated as LLPs and LLCs. In this case, the for non-corporate entities, such that the determination of “common applicable statute contemplates similar to” corporate entities. control” is to be made “on principles the scope or illustrating the appli- There is no case law either defining However, in cation of this particular clause. ing Indus. Pension Fund, 724 F.3d 129, 138 (1st Cir. 2013). ing Indus. Pension Fund, 724 F.3d 129, be the topic of a future paper. denied Therefore, determining what is “common control” Therefore, determining 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 19 6-SEP-16 15:52 Ranch Ltd. Partnership obligated organization 37680-fam_11-1 Sheet No. 93 Side A 09/19/2016 08:25:28 A 09/19/2016 93 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 93 Side B 09/19/2016 08:25:28 81 M K C Y Vol. 11:1:159 FLORIDA AFLORIDA &REVIEW LAW M UNIV. Regulators and litigants alike will be forced to examine ancil- Regulators and litigants alike Three Supreme Court cases have considered the question of Three Supreme Court cases have A dilemma thus arises: what is the intended meaning of the intended meaning what is the thus arises: A dilemma phrase trade or are over 1,000 references to the To begin, there 82 81. U.S.C. §1301(b)(1) (2012) instructs that “[t]he regulations prescribed under the 29 82. Oil & Chem. Co. v. Karl O. Helm Aktiengesellschaft, 736 F.2d 1064, 1072 Cosden organization is a “trade or business” for purposes of the labor statute. the labor of for purposes or business” is a “trade organization lary interpretations and common law precedents to inform their lary interpretations and common inquiry and their judgment. for purposes of business deduc- what constitutes a trade or business Admittedly, the individuals in all tions under the Income Tax Code. benefit of a tax deduction instead of three cases sought to access the liability. Nonetheless, the analysis of avoiding the burden of a pension in identifying elements necessary to the three cases can be instructive activity exists, and if so, to what ex- determine if a trade or business to the finding of a trade or tent these elements are determinative business. preceding sentence shall be consistent and coextensive with regulations prescribed for simi- preceding sentence shall be consistent and coextensive with regulations prescribed lar purposes by the Secretary of the Treasury under section 414(c) of Title 26.” (5th Cir. 1984). Regrettably, the Internal Revenue Code itself does not define the term itself does not Revenue Code the Internal Regrettably, the phrase 414(c). Moreover, of Section business” for purposes “trade or be has yet to 414(c) itself used within Section business” as “trade or by any court. interpreted cross-referencing fed- business” when not one, but two phrase “trade or its meaning? And, does its use but are silent as to eral statutes invoke or business” in one by a court of the phrase “trade the interpretation the same interpretation tax law in this case, mandate context, income in a labor law context? intended meaning of Internal Revenue Code. The business in the is undefined by the stat- itself within Section 414(c) “trade or business” the common law. “The regulations, or by ute, by the underlying does not permit, in this the relevant Code sections interplay among harmonizes all and leaves no loose context, an interpretation that ends.” 178 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 20 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 93 Side B 09/19/2016 08:25:28 B 09/19/2016 93 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 94 Side A 09/19/2016 08:25:28 In 179 89 at 796. The Id. 84 The Court further noted that 87 the Supreme Court examined for the Supreme Court Id. 83 , is an investor of substantial means is an investor of substantial argued that he was engaged in carry- argued that he was engaged in , the Supreme Court distinguished be- , the Supreme Court distinguished Higgins Higgins The Supreme Court describes him as a “tax- The Supreme Court describes Higgins 85 The Supreme Court noted that the taxpayer “did not The Supreme Court noted that the Activities of the Portfolio Company” of the Portfolio the Activities 86 88 and Excludes Merely Recording and Monitoring Merely Recording and Excludes “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE Higgins v. Commissioner at 214. at 214. at 218. at 216. The taxpayer in The taxpayer in In Id. Id. Id. Id. Active and Influential Involvement in the Portfolio Company Involvement in Influential Active and M K 85. v. Comm’r, 111 F.2d 795, 796 (2nd Cir. 1940). The Second Circuit’s descrip- Higgins 88. 89. 83. 312 U.S. 212 (1941). 84. 86. U.S. at 213. 312 87. C Y A. Requires an or Business on a Trade No. 1: “Carrying Proposition Second Circuit concluded that the taxpayer “is not engaged in any business, unless the man- Second Circuit concluded that the taxpayer “is not engaged in any business, unless agement of his fortune be deemed a business.” analyzing the facts in the taxpayer “merely kept records and collected interest and dividends the taxpayer “merely kept records managerial attention for his from his securities, through investments.” the first time the question of whether a taxpayer was engaged in a question of whether a taxpayer the first time the investment expenses The taxpayer sought to deduct trade or business. the year under examina- investment income for incurred in producing was carrying on a this case was whether the taxpayer tion. The issue in the investment expenses and thus eligible to deduct trade or business at the time provided The applicable tax statute against his income. allowed as deductions net income there shall be that “[i]n computing paid or incurred during and necessary expenses . . . [a]ll the ordinary business.” in carrying on any trade or the taxable year with “a fortune of $35,000,000 or more, part of it in real estate and part with “a fortune of $35,000,000 in stocks and bonds.” ing on a trade or business and therefore eligible to deduct his ing on a trade or business rejected this argument, stating that investment expenses. The IRS not constitute a trade or business. mere investment activities do tween an investor who “merely” manages, without more, one’s tween an investor who “merely” payer . . . devot[ing] a considerable portion of his time to the oversight payer . . . devot[ing] a considerable to assist him in offices rented for of his interests and hir[ing] others that purpose.” participate directly or indirectly in the management of the corpora- participate directly or indirectly bonds.” tions in which he held stock or tion reduces the level of abstraction and gives context to the issue in dispute. 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 21 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 94 Side A 09/19/2016 08:25:28 A 09/19/2016 94 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 94 Side B 09/19/2016 08:25:28 . EP M K 90 C Y . 1013, 1020 EV Vol. 11:1:159 R AX In contrast, the . T 93 LA , 8 F . No. 2333, at 74-76 (1942), S. R EP H.R. R denying investors a deduction for denying investors See Section 212 authorizes income tax de- Section 212 authorizes 91 Higgins In contrast, traders and brokers can deduct, In contrast, traders and brokers 95 A Structural Critique of Trader Taxation FLORIDA AFLORIDA &REVIEW LAW M UNIV. thereby eliminating the need for any active conduct by the thereby eliminating the need Unlike Section 162, which authorizes deductions incurred by 162, which authorizes deductions Unlike Section Frank v. Comm’r, 20 T.C. 511, 513 (1953). at 217. 94 92 The Supreme Court held that the taxpayer was not involved in was not involved that the taxpayer Court held The Supreme The income tax code further distinguishes deductions between The income tax code further distinguishes Congress enacted I.R.C. §Congress enacted response to the Su- 212 in 1942 in See Id. 92. 26 U.S.C. § provides that “[i]n 212 captioned “Expenses for production of income” 93. 94. U.S.C. § 26 95. 212. Oei, Shu-Yi 91. 26 U.S.C. § 23(a) in the 1939 Income Tax Code, ad- 212 (2012) (previously section 90. No. 1631 at 87-88 (1942). and neces- the case of an individual, there shall be allowed as a deduction all the ordinary collection of sary expenses paid or incurred during the taxable year (1) for the production or for the pro- income; (2) for the management, conservation, or maintenance of property held of any duction of income; or (3) in connection with the determination, collection, or refund tax.” (2008) (footnote omitted). investments from an investor who is actively engaged in managing the in managing engaged is actively who investor from an investments activity. trade or business underlying and thus, used in a tax context, phrase was or business as that a trade noting the var- Supreme Court, deduction. The for a tax did not qualify may present, circumstances that individual complexities iants and a taxpayer are ‘carrying whether the activities of stated, “To determine facts in each case.” an examination of the on a business’ requires history and jurisprudence of Section 212 contemplates only that tax- history and jurisprudence of Section property for the production of payers “produce, collect, or maintain income,” investment related expenses. investment related ductions for individuals who incur expenses in the production of who incur expenses ductions for individuals income. “under IRC section 162 for ‘all the ordinary and necessary expenses “under IRC section 162 for ‘all taxpayer in the underlying activity. Investors “are not eligible for IRC sec- investors, traders, and dealers. and . . . will deduct most of tion 162’s trade or business deductions IRC section 212 as ‘below the line’ their investment expenses under itemized deductions.” ded by ch. 619, § 56 Stat. 798 (1942)). 121, a taxpayer engaged in a trade or business, Congress eliminated any in a trade or business, Congress a taxpayer engaged enacted I.R.C. § a “trade or business” in the newly requirement for 212. recognizes and distinguishes between By doing so, Congress expressly taxpayers. This distinction in the the conduct of active and passive 162 and Section 212 remains to- statutory framework between Section of Section 162 contemplates day. The history and jurisprudence a trade or business.” taxpayers actively “carrying on preme Court’s holding in preme Court’s 180 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 22 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 94 Side B 09/19/2016 08:25:28 B 09/19/2016 94 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 95 Side A 09/19/2016 08:25:28 181 26 U.S.C. § 23(k)(4) , the Supreme Court see also 96 allows a deduction for bad debts incurred allows a deduction 98 Whipple v. Commissioner 97 Return is Required Return – Factor A Plus “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE 26 U.S.C. § (1952) (providing “[d]ebts which become worthless within 23(k)(1) at 1019. Id. The statute at issue In a second case, In a second case, See Id. M K 97. (1963). The taxpayer advanced the argu- Whipple v. Comm’r, 373 U.S. 193, 194-95 98. 96. C Y B. Investment Simply an More Than No. 2: Something Proposition paid or incurred during the taxable year in carrying on any trade or any trade on in carrying year taxable the during or incurred paid the line’ deduc- . . . are ‘above 162 deductions IRC section business.’ gross income.” reduce adjusted tions that (1952) (stating, “(4) Non-business debts. In the case of a taxpayer, other than a corporation, (1952) (stating, “(4) Non-business debts. In the case of a taxpayer, other than a there- if a non-business debt becomes worthless within the taxable year, the loss resulting year, of a from shall be considered a loss from the sale or exchange, during the taxable a debt capital asset held for not more than 6 months. The term “non-business debt” means than a debt other than a debt evidenced by a security as defined in paragraph (3) and other business.”). the loss from the worthlessness of which is incurred in the taxpayer’s trade or once again examined the question of whether a taxpayer was engaged the question of whether once again examined the question in This time, the court examined in a trade or business. advanced loans to his whether a shareholder who context to determine deduction when the was entitled to a bad debt controlled company loans became worthless. by the taxpayer. However, the statute contemplates two different in- However, the statute contemplates by the taxpayer. depending on whether the debt is come tax treatments for bad debts or a nonbusiness bad debt. Business classified as a business bad debt the taxable year; or (in the discretion of the Commissioner) a reasonable addition to a re- the taxable year; or (in the discretion of that a debt is recoverable only in part, the serve for bad debts; and when satisfied an amount not in excess of the part charged off Commissioner may allow such debt, in This paragraph shall not apply in the case of a within the taxable year, as a deduction. in section 104, with respect to a debt evidenced by a taxpayer, other than a bank, as defined subsection. This paragraph shall not apply in the security as defined in paragraph (3) of this with respect to a non-business debt, as defined case of a taxpayer, other than a corporation, case of a mutual savings bank not having capital in paragraph (4) of this subsection. In the building and loan association, and a cooperative stock represented by shares, a domestic operated for mutual purposes and without profit, bank without capital stock organized and bad debts shall be determined with due regard to the reasonable addition to a reserve for bad debt reserves existing at the close of December the amount of the taxpayer’s surplus or in the preceding sentence, the reasonable addi- 31, 1951. In the case of a taxpayer described year shall in no case be less than the amount tion to a reserve for bad debts for any taxable addition for such year; except that the determined by the taxpayer as the reasonable this sentence shall not be greater than the lesser amount determined by the taxpayer under the taxable year, computed without regard to this of (A) the amount of its net income for sub- section, or (B) the amount by which 12 per centum of the total deposits or withdrawable undivided accounts of its depositors at the close of such year exceeds the sum of its surplus, profits, and reserves at the beginning of the taxable year.”); ment that he was engaged in three separate activities – organizing, financing, and separate activities ment that he was engaged in three – operating. 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 23 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 95 Side A 09/19/2016 08:25:28 A 09/19/2016 95 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 95 Side B 09/19/2016 08:25:28 105 M K C Y for the 104 Vol. 11:1:159 In contrast, 99 An outstanding debt of An outstanding 100 102 claimed a bad debt deduction claimed a bad debt The taxpayer “made sizeable cash advances The taxpayer “made 101 Whipple FLORIDA AFLORIDA &REVIEW LAW M UNIV. , 373 U.S. at 194. at 196-97. “Prior to 1941 petitioner was a construction superintendent and an estimator “Prior to 1941 petitioner was a construction The taxpayer in The taxpayer in Over a period of three years, from 1949 to 1952, the taxpayer to 1952, the years, from 1949 period of three Over a The Supreme Court reviewed the case and held for the Commis- The Supreme Court reviewed the Id. Id. Id. Whipple Id. Id. 103 Devoting one’s time and energies to the affairs of a corporation is Devoting one’s time and energies trade or business of the person so not of itself, and without more, a produce income, profit or gain engaged. Though such activities may in the value of an invest- in the form of dividends or enhancement the process of investing and is ment, this return is distinctive to of the corporation’s business generated by the successful operation 99. 100. 105. v. Comm’r, 373 U.S. 193, 197 (1963). Whipple 102. 103. 104. 101. outstanding debt, arguing that he “was in the business of organizing, arguing that he “was in the outstanding debt, general financing and financing corporations, promoting, managing or all three.” money, operating a bottling business, and lending of bad debts are granted favorable treatment and deductible in full, pro- in full, and deductible treatment favorable granted debts are bad or business. in a trade were incurred vided they nonbusiness bad debts are accorded less favorable treatment by being favorable treatment are accorded less bad debts nonbusiness limitations. to statutory deduction subject $56,975.10 eventually “became worthless in 1953 and is in issue “became worthless in $56,975.10 eventually here.” to Mission Orange in 1952 and 1953.” to Mission Orange for a lumber company but during that year and over the next several ones he was instru- for a lumber company but during that a series of partnerships engaged in the construction mental in forming and was a member of and 1950 he was an original incorporator of seven or construction supply business. In 1949 to the partnerships, and in 1951 he sold his corporations, some of which were successors his equity in five others in the rental and construc- interest in the corporations along with reported as long-term capital gains. In 1951 and tion business, the profit on the sales being Co. of 1952 he formed eight new corporations, one of which was Mission Orange Bottling acquired Lubbock, Inc., bought the stock of a corporation known as Mason Root Beer 3 and bought and an interest in a related vending machine business. From 1951 to 1953 he also ventures.” sold land, acquired and disposed of a restaurant and participated in several oil created fifteen different corporations, one of which, Mission Orange, is Orange, one of which, Mission corporations, fifteen different created at issue. the corporation Id. The taxpayer advanced the argument that, as a result of these activi- the argument that, as The taxpayer advanced or business and thus entitled to deduct ties, he was engaged in a trade The IRS countered, arguing that the the loans as a business bad debt. trade or business. According to the IRS, taxpayer was not engaged in a debt and the deduction is limited. the loans are a nonbusiness bad sioner. The Supreme Court reasoned: 182 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 24 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 95 Side B 09/19/2016 08:25:28 B 09/19/2016 95 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 96 Side A 09/19/2016 08:25:28 183 Car- 110 14 (Univ. of Ordinary in- 108 112 , CNBC (Mar 4, 2014), http:/ The payment of the fixed 111 Three of these fees – manage- Three of these fees – 109 Private Equity Portfolio Company Fees note 46, at 2305. note 46, at 2312. , a reasonable argument may be advanced , a reasonable 107 CNBC Explains: Carried Interest supra supra Whipple , 373 U.S. at 202. When the only return is that of an investor, the taxpayer that of an investor, only return is When the “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE Ludovic Phalippou et al., at 203. 106 One court observed: In light of The Supreme Court noted that, “[a]bsent substantial additional noted that, “[a]bsent substantial The Supreme Court Whipple Id. See has not satisfied his burden of demonstrating that he is engaged in that he is engaged of demonstrating his burden has not satisfied and a trade or business investing is not business since a trade or of his the product though substantially to the taxpayer, the return but from or business from his own trade legally arises not services, corporation. that of the as distinguished from the trade or business of the taxpayer him- of the taxpayer or business the trade from as distinguished self. M K C Y 111. & Yasuda, Metrick 110. contend that this aligns the interests of the money managers with their Proponents 112. 108. 109. & Yasuda, Metrick 106. component. The plus being the 2% fee In contrast, private equity has a return plus 107. Oxford, Working Paper, 2015), http://www.nakedcapitalism.com/wp-content/uploads/2015/ fees are 12/Private-Equity-Portfolio-Company-Fees.pdf (arguing that the various portfolio “ex-post discretionary compensation items for GPs”). ried interest is generally only paid to the Fund Organizer after a ried interest is generally only satisfied. specified hurdle rate has been vestors do not enjoy the advantage of a payment of fixed fees vestors do not enjoy the advantage company is profitable or not). Ordi- (regardless of whether the portfolio in the event of appreciation. nary investors only receive a payment /www.cnbc.com/2014/03/04/cnbc-explains-carried-interest.html. fees to the Fund Organizer represents a payment for “something more” fees to the Fund Organizer represents of the investment. than the appreciation in the value ment fees, transaction fees, and monitoring fees – represent payments monitoring fees ment fees, transaction fees, and – mere appreciation in the investment. for something more than the the performance level of the asset and Only carried interest is based on appreciation of the investment. represents a payment for the clients. Lawrence Delevingne, that the pecuniary rewards private equity investment is designed to rewards private equity investment that the pecuniary returns beyond private equity firms with financial generate provide private equity in the investment. Specifically, the mere appreciation fees, transaction fees, principal fees: management firms charge four monitoring fees, and carried interest. evidence, furnishing management and other services to corporations management and other evidence, furnishing to an investor in those different from that flowing for a reward not s23(k)(4).” not a trade or business under corporations is and the 8% hurdle rate. To earn these amounts, the private equity firms must be active in and the 8% hurdle rate. To earn these amounts, business. the business, thus they are in a trade or 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 25 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 96 Side A 09/19/2016 08:25:28 A 09/19/2016 96 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 96 Side B 09/19/2016 08:25:28 3 M K C Y Vol. 11:1:159 According to the Supreme 115 114 116 , The Dark Side of Financial Innovation Hanging in the balance for the taxpayer Hanging in the balance for the 117 Commissioner v. Groetzinger 113 The record indicates that the taxpayer “went to the The record indicates that the FLORIDA AFLORIDA &REVIEW LAW M UNIV. 118 by the Taxpayer in the Underlying Activity by the Taxpayer in the Underlying was “whether a full-time gambler who makes wagers was “whether a full-time gambler Comm’r v. Groetzinger, 480 U.S. 23, 27 n.6 (1987) ( “Some sections of the Code, at 23. at 24. The taxpayer “worked for 20 years . . . when his position was The taxpayer “worked for 20 years In a third case, See Id. Id. Id. [A] rational investor would not make an investment with a negative with investment make an not would investor [A] rational be- of return materially an expected rate rate of return, or expected risk. A with the same earn elsewhere rate they could low the fees and things, all among other investor would consider, rational transac- or investment business with a proposed costs associated was a reasonable whether there order to determine tion in of profit. possibility 115. 116. 117. 118. 113. Fidelity Int’l Currency Advisor A Fund, LLC, v. United States, 747 F. Supp. 2d 49, 114. J. Henderson & Neil D. Pearson, Brian C. Active Involvement is Required Proposition No. 3: A Direct and (EFA 2009 Bergen Meetings Paper), http://ssrn.com/abstract=1342654. Court examined, yet again, the question of whether a taxpayer was Court examined, yet again, the This time, however, the Court ex- engaged in a trade or business. context. Specifically, the issue in amined the question in a gambling investment theory, rational investors are not prone to make payments rational investors are not investment theory, return is the private a return on investment. That without expecting underlying investment. in the management of the equity engaging whenever a private of a trade or business is justified Thus, a finding portfolio com- in the operations of the underlying equity firm engages beyond the mere appreciation of the pany in exchange for a fixed fee investment. was a deduction for gambling losses incurred by the taxpayer. was a deduction for gambling During the remainder of that year, the terminated in February 1978. wagering, primarily on grey- taxpayer busied himself with parimutuel hound races.” solely for his own account is engaged in a ‘trade or business,’ within the solely for his own account is engaged meaning of [Section] 162.” however, do define the term [“trade or business”] for limited purposes. See . . . §§ 502(b) and 513(b), 26 U.S.C. §§ 502(b) and 513(b) (exempt organizations)”). 188 (D. Mass. 2010). Groetzinger This statement by the court is consistent with portfolio investment the- by the court is consistent with This statement the portfolio choice, . . . “[i]n a standard model of ory, which recognizes, only if its returns co- purchased by an investor a security is rationally utility.” with the investor’s marginal vary positively 184 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 26 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 96 Side B 09/19/2016 08:25:28 B 09/19/2016 96 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 97 Side A 09/19/2016 08:25:28 , 122 185 119 Groetzinger 123 The taxpayer disagreed with the IRS, sued and disagreed with the IRS, sued The taxpayer 121 “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE but never claimed the $2,032 gambling loss as a deduction the $2,032 gambling loss but never claimed The Supreme Court accepted certiorari to resolve a split in the The Supreme Court accepted certiorari The Supreme Court examined carefully the facts in The Supreme Court examined As a result of his gambling activities, the taxpayer incurred a the taxpayer incurred activities, of his gambling As a result 120 Id. Id. M K C Y 119. 120. reported the loss on Schedule E, but never carried the loss amount to Groetzinger 121. in the IRS’s argument is its contention that the gambling losses were non- Implicit 122. v. Groetzinger, 480 U.S. 23, 27 (1987). Comm’r 123. noting in particular the substantial time, financial commitment, re- noting in particular the substantial decision process undertaken by the search conducted, and the the Supreme Court writes “that if one’s taxpayer. In a critical passage, time, in good faith, and with regular- gambling activity is pursued full for a livelihood, and is not a mere ity, to the production of income track 6 days a week for 48 weeks [during] 1978, [spending] a substan- 1978, [spending] weeks [during] for 48 a week 6 days track and other forms, programs, studying racing of time tial amount to each week 60 to 80 hours devoted from The taxpayer materials. for his own ac- gambl[ing] solely endeavors . . . these gambling-related of employment.” profession or type had no other count. He prevailed in Tax Court and again in the Court of Appeals. prevailed in Tax Court and again its analysis by noting that “[t]he circuits. The Supreme Court began been in [Section] 162(a) and in that sec- phrase “trade or business” has Indeed, the phrase is common in tion’s predecessors for many years. 50 sections and 800 subsections and in the Code, for it appears in over and final income tax regulations.” hundreds of places in proposed on his income tax return. On audit, the IRS determined that the tax- return. On audit, the IRS determined on his income tax tax preference item for winnings of $70,000 were a payer’s gambling for AMT purposes, included the winnings in income AMT purposes and However, the IRS a total tax deficiency of $2,522. thereby triggering of $72,032 in gambling taxpayer to claim a deduction did not allow the were not incurred in a that the gambling losses losses on the theory trade or business. net gambling loss of $2,032, earning $70,000 in gambling winnings, of $2,032, earning $70,000 net gambling loss the taxpayer re- $72,032 in gambling losses. However, and sustaining ported, the face of Form 1040 to be claimed as a loss deduction. deductible personal expenses under 26 U.S.C. § 262 reads, “Except as 262. Section for personal, otherwise expressly provided in this chapter, no deduction shall be allowed living, or family expenses.” The Supreme Court recognized that “[t]he concept thus has a well- The Supreme Court recognized presence on our tax-law terrain [and] known and almost constant contained a definition of the words [d]espite this, the Code has never application, and no regulation has been “trade or business” for general for all purposes.” issued expounding its meaning 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 27 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 97 Side A 09/19/2016 08:25:28 A 09/19/2016 97 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 97 Side B 09/19/2016 08:25:28 M K C Y Vol. 11:1:159 127 128 , these factors support the conclu- Without explicitly declaring a stan- explicitly declaring Without 124 125 Groetzinger is significant because it demonstrates the Court’s is significant because it demonstrates FLORIDA AFLORIDA &REVIEW LAW M UNIV. The Supreme Court expressly rejected a reading of the Court expressly rejected a reading The Supreme at 27. at 35. at 36 at 34. 126 Groetzinger In the end, the Supreme Court held for the taxpayer, reasoning Supreme Court held for the taxpayer, In the end, the Id. Id. Id. Id. We accept the fact that to be engaged in a trade or business, the We accept the fact that to be engaged activity with continuity and regu- taxpayer must be involved in the purpose for engaging in the larity and that the taxpayer’s primary A sporadic activity, a hobby, or activity must be for income or profit. qualify. an amusement diversion does not 127. 125. 126. 128. v. Groetzinger, 480 U.S. 23, 35 (1987). Comm’r 124. hobby, it is a trade or business within the meaning of the statutes with statutes of the meaning the within or business a trade it is hobby, are here concerned.” which we sion that private equity firms are engaged in a trade or business when sion that private equity firms are engaged in a trade or business dard for analysis for determining the presence of a “trade or business,” of a “trade the presence analysis for determining dard for litigants. The Su- to future offered guidance Court’s dicta the Supreme and large-scale of “[c]onstant a combination added that preme Court from a mere an activity livelihood” elevates . [s]kill . . . [and] effort . . or business. hobby to a trade acceptance of a direct and personal involvement by the taxpayer in a acceptance of a direct and personal Court noted, trade or business. The Supreme phrase “trade or business” that limited it to the provision of goods or business” that limited it to phrase “trade or the offering of goods and that “[i]n any event, while services reasoning a trade or business, this would qualify the activity as services usually absolute prerequisite.” factor, it seems to us, is not an that he was engaged in a trade or business. The Supreme court noted in a trade or business. The that he was engaged or business” by stating interpreting the clause, “trade the limitation in meaning of the phrase as in this case is to ascertain the that “[o]ur task which we are here con- sections of the Code with it appears in the cerned.” Applying this reasoning to private equity firms leads to the reasonable Applying this reasoning to private are engaged in a trade or business. conclusion that private equity firms are involved with “continuity and For instance, private equity firms the portfolio company. Additionally, the regularity” in the operations of if not sole, purpose for engaging in the private equity firm’s primary, “income or profit.” And finally, it is be- activity is for the production of that private equity investing yond any reasonable contemplation a hobby, or an amusement.” On the amounts to “[a] sporadic activity, than 2,360 U.S. companies is a far cry contrary, $443 billion in more from a hobby. Applying 186 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 28 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 97 Side B 09/19/2016 08:25:28 B 09/19/2016 97 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 98 Side A 09/19/2016 08:25:28 187 The re- 130 advances the something more than Groetzinger is required for an activity to constitute a is required for an activity to constitute note 46, at 2316. supra In this regard, it bears noting that ordinary inves- In this regard, it bears noting Taken together, these two cases require individu- Taken together, 131 129 advances the proposition that advances the proposition that advances the proposition that merely recording and proposition that merely recording advances the D. Cases Supreme Court of the Three Synthesis “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE Unlike ordinary investors, private equity firms are directly in- Unlike ordinary investors, private Whipple Each one of the three Supreme Court cases interpreting the cases interpreting Supreme Court of the three Each one Higgins Id. M K C Y 131. v. Comm’r, 373 U.S. 193, 193 (1963). Whipple 129. 130. & Yasuda, Metrick they provide expertise, consulting, financial engineering, or assistance engineering, financial consulting, expertise, provide they portfolio company. to the target lentless participation by many private equity funds in establishing the lentless participation by many and even in lending reputational policies, managing the operations, are all activities yielding to the con- credence to the portfolio company, are engaged in a trade or business. clusion that private equity firms proposition that active conduct satisfies the trade or business standard active conduct satisfies the trade proposition that and regularity and that is pursued with “continuity when the activity the activity must be for purpose for engaging in the taxpayer’s primary income or profit.” trade or business. tors earn a return through two sources: dividend income and tors earn a return through investment growth. private equity firms earn “something In contrast, dividend more than simply an investment return.” In addition to any any gains income they may receive while holding the investment and equity they may realize upon disposing of the investment, private als who seek to invoke the benefits of a trade or business to have a invoke the benefits of a trade als who seek to engagement in the underlying activity. direct, active, and substantial In this regard, private equity fund volved in the target investment. ordinary investors.organizers are different from investors Ordinary decision-making function of the in- do not engage in the policy and equity fund organizers are active in vested activity. In contrast, private function of the target investment. Ordi- the policy and decision-making or firing decisions on behalf of the nary investors do not make hiring attend “jump-start meetings.” As noted target investment, nor do they provide valuable services (time, by one study, “Private equity investors to their cash investments.” contacts, reputation) in addition monitoring the activities of the portfolio company, without more, does activities of the portfolio company, monitoring the a trade or business activity. not amount to phrase “trade or business” advances important propositions that are business” advances important phrase “trade or activity. to private equity investment acutely relevant 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 29 6-SEP-16 15:52 simply an investment return 37680-fam_11-1 Sheet No. 98 Side A 09/19/2016 08:25:28 A 09/19/2016 98 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 98 Side B 09/19/2016 08:25:28 M K C Y Vol. 11:1:159 Three of these fees are fixed these fees are Three of 132 The income tax regulations indicate 136 135 note 46, at 2315. Only one fee, carried interest, is a variable fee is a variable fee, carried interest, Only one supra 133 However, when a not-for-profit organization en- However, when a not-for-profit 134 Moreover, the policy objective declared in the income Moreover, the policy objective FLORIDA AFLORIDA &REVIEW LAW M UNIV. Whether an Activity is a Trade or Business Whether an Activity 137 The income tax code defines “‘unrelated trade or business’ [to] Examining the not-for-profit literature provides valuable in- not-for-profit literature provides Examining the E. in Determining Analysis as a Guide Invoking Not-for-Profit 133. three fees that are fixed and paid independent of the funds performance are The 134. § 26 U.S.C. 135. 501 (2012). § 26 U.S.C. 136. 512 (2012). § 26 U.S.C. 137. 513 (2012). C.F.R. § 26 1.513-1(c) (2013). 132. & Yasuda, Metrick firms charge four principal fees: management fees, carried interest, carried fees, management fees: principal four charge firms fees. fees, and monitoring transaction fees and are paid to the Equity Fund regardless of the portfolio com- regardless of the Equity Fund are paid to the fees and pany’s performance. that, “[i]n determining whether trade or business from which a partic- that, “[i]n determining whether is regularly carried on . . . regard ular amount of gross income derives continuity with which the activities must be had to the frequency and and the manner in which they productive of the income are conducted are pursued.” management fees, transaction fees, and monitoring fees. and is subject to payment based on performance standards. The design standards. based on performance to payment and is subject provide private calculated to fixed fees are of the three and structure of the performance a guaranteed return, regardless equity firms with investors simply do investment - a luxury ordinary of the underlying not enjoy. gages in a trade or business activity, then the activity itself is subject gages in a trade or business activity, income tax code imposes an unrelated to income tax. Specifically, the “derived by any organization from business income tax on the earnings . . . [which is] regularly carried on” by any unrelated trade or business the not-for-profit organization. tax regulations state, “The primary objective of adoption of the unre- tax regulations state, “The primary to eliminate a source of unfair lated business income tax was mean[ ] . . . any trade or business the conduct of which is not substan- mean[ ] . . . any trade or business or performance by such organization of tially related . . . to the exercise other purpose or function constituting its charitable, educational, or the basis for its exemption . . . .” sight when seeking additional guidance as to how courts evaluate additional guidance as sight when seeking trade or business. Section 501(a) of the when an activity constitutes a not-for-profit organizations from income tax code exempts qualifying income taxation. 188 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 30 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 98 Side B 09/19/2016 08:25:28 B 09/19/2016 98 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 99 Side A 09/19/2016 08:25:28 146 189 , the 140 The “Ameri- , the Supreme 141 As a result, ABE 147 138 National Association of Postal National Association “In 1980 the Internal Revenue 148 “ABE’s primary purposes are to ad- “ABE’s primary purposes are 142 , taken by the tax-ex- the lack of action 144 In the second case, In the second case, United States v. American Bar Endowment States v. American United 139 United States v. American Bar Endowment United States v. “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE at 107. at 105. at § 1.513-1(b). ABE charges participating members a competitive rate. ABE charges participating members However, “ABE [also] raises money for its charitable work by However, “ABE [also] raises money In efforts is the fact that ABE re- “Critical to ABE’s fundraising Two cases offer an interesting study in contrasting how courts contrasting how study in offer an interesting Two cases Id. Id. Id. Id. Id. Id. Id. 145 143 M K C Y 143. 146. 139. 477 U.S. 105, 106 (1986). 140. 21 Cl. Ct. 310 (1990). 141. 105, 106 (1986) (sections 511 United States v. Am. Bar Endowment, 477 U.S. 142. 144. 145. 147. States v. Am. Bar Endowment, 477 U.S. 105, 105 (1986). United 148. 138. competition by placing the unrelated business activities of certain ex- of certain activities business unrelated the by placing competition the nonexempt tax basis as the same upon empt organizations which they compete.” endeavors with business actions taken by the tax-exempt organization resulted in a finding of a the tax-exempt organization actions taken by trade or business. can Bar Endowment (ABE) is a corporation exempt from taxation (ABE) is a corporation can Bar Endowment under § 501(c)(3) of the Code.” Court considered “whether income that a tax-exempt charitable organ- “whether income that a tax-exempt Court considered to its members from offering group insurance ization derives to tax.” business income’ subject constitutes ‘unrelated receives a refund of premiums paid at the end of each period that ABE receives a refund of premiums uses to fund its charitable activities. Service advised ABE that it considered ABE’s insurance plan an ‘unre- Service advised ABE that it considered vance legal research and to promote the administration of justice vance legal research and to . . . .” empt organization resulted in a finding of a trade or business. resulted in a finding of a trade empt organization through 513 of the Internal Revenue Code provide the framework for taxation of not-for- through 513 of the Internal Revenue Code profit organizations). providing group insurance policies, underwritten by major insurance providing group insurance policies, companies, to its members.” quires its members to agree, as a condition of participating in the quires its members to agree, they will permit ABE to keep all of the group insurance program, that them pro rata to the insured mem- dividends rather than distributing bers.” examine the issue of a trade or business within the not-for-profit con- within the not-for-profit trade or business the issue of a examine one case, text. In Because ABE insures a favorable risk pool, its costs of insuring are less Because ABE insures a favorable from its members. than the premiums it collects 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 31 6-SEP-16 15:52 Supervisors v. United States Supervisors v. 37680-fam_11-1 Sheet No. 99 Side A 09/19/2016 08:25:28 A 09/19/2016 99 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 99 Side B 09/19/2016 08:25:28 . M K GMT C Y , 17 J. M Vol. 11:1:159 158 The Court determined However, the Supreme However, the 156 152 ABE successfully challenged the IRS’s challenged ABE successfully The IRS audited ABE’s tax returns for audited ABE’s The IRS of the statutory definition of an “unre- of the statutory The Supreme Court scrutinized the The Supreme 150 149 154 155 The Court of Appeals for the Federal Circuit for the Federal of Appeals The Court , 477 U.S. at 111. This unique asset allowed ABE to charge its This unique asset allowed ABE 151 157 Firm Resources and Sustained Competitive Advantage FLORIDA AFLORIDA &REVIEW LAW M UNIV. 153 at 108. at 105. at 110-11. at 113. Second, the Supreme Court also noted that “ABE has a unique Second, the Supreme Court also Exploitation of a unique asset proved troublesome for ABE. The Exploitation of a unique asset proved The Supreme Court found that “ABE’s insurance program falls found that “ABE’s insurance The Supreme Court Id. Id. Id. Id. Id. Am. Bar Endowment Id. 157. 150. 151. 155. §§ 26 U.S.C. 156. 511(a)(1), 512(a)(1), 513(a). 158. Jay Barney, 149. 152. 153. States v. Am. Bar Endowment, 477 U.S. 105, 105 (1986). United 154. 99, 102 (1991). lated trade or business’ and that the profits thereon were subject to tax subject were thereon profits that the and or business’ trade lated under §§ 513.” 511 [through] these activities constituted activities beyond the scope of ABE’s ap- these activities constituted activities tax. proved exemption from income asset—its access to the ABA’s members and their highly favorable mortality and morbidity rates—and for it has chosen to appropriate that asset, rather than sharing any itself all of the profit possible from with its members.” Court reversed the Court of Appeals holding that ABE was engaged in the Court of Appeals holding that Court reversed unrelated business cor- and therefore subject to the a trade or business poration tax. determination and assessment of income tax deficiency and prevailed tax deficiency of income and assessment determination Court. in the Claims 1979 and 1980 and assessed a tax deficiency on ABE’s net revenues on ABE’s a tax deficiency 1980 and assessed 1979 and insurance program. from the lated trade or business.” lated trade or activities of the taxpayer. Two factors proved critical to the Supreme taxpayer. Two factors proved activities of the activities of “assem- First, the Court found that ABE’s Court’s analysis. risks, negotiating on of better-than-average insurance bling . . . a group companies, and administering a [the insureds] behalf with insurance can be-and are-provided by private com- group policy are activities that a profit.” mercial entities in order to make affirmed the decision of the Claims Court. affirmed the decision members a competitive rate and realize an economic benefit in the members a competitive rate and successfully exploited its competitive form of a premium refund. ABE its low risk insurance pool advantage by unabashedly overcharging a claim for refund. and requiring members to forfeit Supreme Court remarked, “Lacking a factual basis for concluding that Supreme Court remarked, “Lacking within the literal language” within the literal 190 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 32 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 99 Side B 09/19/2016 08:25:28 B 09/19/2016 99 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 100 Side A 09/19/2016 08:25:28 , 191 The ORKER CONOMIC Y 164 E EW “NAPS’s N 165 HE 166 . 1417, 1432 (2009) , T OOL FOR EV T By directing the fo- By directing 162 In fact, monopoly pric- In fact, . U. L. R M OWERFUL 159 58 A : A P to reward one’s risk of engaging one’s risk of to reward 161 ROPERTY , 477 U.S. at 110. P NTELLECTUAL In the Air: Who Says Big Ideas Are Rare? , I The creation of a fourth class allowed “non-postal The creation of a fourth class Appropriability and Property, DRIS 167 I AMIL K National Association of Postal Supervisors v. United States of Postal Supervisors v. National Association “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE at 311 at 312. 163 to the exclusion of others, to the exclusion Prior to 1980, NAPS offered three classes of membership levels: Prior to 1980, NAPS offered three In See generally Am. Bar Endowment Id. Id. Id. See 9 (2003), http://www.wipo.int/edocs/pubdocs/en/intproperty/888/wipo_pub_888_1 160 Id. M K C Y 162. Malcom Gladwell, 164. Ass’n of Postal Supervisors v. United States, 21 Cl. Ct. 310, 310 (1990). Nat’l 165. 166. 167. 161. Yonatan Even, 163. 159. U.S. 105, 113 (1986). United States v. Am. Bar Endowment, 477 160. ROWTH the United States Claims Court examined whether the activities of a Claims Court examined whether the United States or business. organization constituted a trade tax-exempt labor generosity is at the core of ABE’s success, we can easily view this case this easily view we can ABE’s success, core of at the is generosity of monopoly pricing.” example as a standard plaintiff, National Association of Postal Supervisors (NAPS), “is a tax- Association of Postal Supervisors plaintiff, National plan.” that sponsors a health exempt labor organization (“Exclusionary rights promote exclusive use of assets and prevent tragedies of the commons. (“Exclusionary rights promote exclusive the assets are free from the threat of poachers, Such rights also ensure that those exploiting for access to the fruits of their labor. Thus, it is thereby enabling transactions with others and many subsequent commentators have identi- not surprising that Blackstone, Bentham, right at the core of property regimes.”). fied the right to exclude as the central [tax-exempt] purpose was the ‘social and economic advancement of pos- was the ‘social and economic [tax-exempt] purpose service.’”and improvement of the postal tal supervisors cus of analysis to the exploitation of a unique asset, the Supreme Court the exploitation of a unique asset, cus of analysis to of a trade or business activity as one of the hallmarks recognized the activity. ing is the objective of asset exploitation. The whole body of intellectual The whole body exploitation. objective of asset ing is the unique of a the exploitation on this premise law is founded property – asset in the activity and allow for a recovery of costs. for a recovery and allow in the activity federal employees [to become] limited benefit members, but only ‘for federal employees [to become] .pdf. active, honorary, and associate. Membership in these three classes was active, honorary, and associate. 1980, NAPS amended its constitution limited to postal supervisors. In class of membership: the “limited bene- and bylaws to provide a fourth fit” membership. (May 12, 2008), http://www.newyorker.com/magazine/2008/05/12/in-the-air. Intellectual (May 12, 2008), http://www.newyorker.com/magazine/2008/05/12/in-the-air. of simultaneous discovery—whatproperty is justified, “[t]his phenomenon science histori- ans call “multiples”—turnsthe first comprehensive out to be extremely common. One of in 1922, and lists of multiples was put together by William Ogburn and Dorothy Thomas, pat- they found a hundred and forty-eight major scientific discoveries that fit the multiple tern.” G 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 33 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 100 Side A 09/19/2016 08:25:28 A 09/19/2016 100 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 100 Side B 09/19/2016 08:25:28 176 172 M K C Y Limited 168 The brazen Vol. 11:1:159 During this During 179 170 whereas “limited 178 169 to “almost 33,000 federal employees.” to “almost 33,000 171 for NAPS. During 1983 and 1984, NAPS collected for NAPS. During 173 FLORIDA AFLORIDA &REVIEW LAW M UNIV. Upon audit, the IRS “determined that NAPS’s collection IRS “determined that NAPS’s Upon audit, the that it did not perform for the limited benefit members. that it did not perform for the 175 180 at 313. at 314. at 313. at 313. These amounts represented “sixty-four percent” and “sixty one represented “sixty-four percent” These amounts The Claims Court found that the limited benefit membership The Claims Court found that The change in policy by NAPS to expand the membership by NAPS to in policy The change Id. Id. Id. Id. Id. Id. Id. Id. Id. Id. 174 177 at 312. 174. 175. 179. 178. 172. 173. 176. Ass’n of Postal Supervisors v. United States, 21 Cl. Ct. 310, 311 (1990). Nat’l 177.“IRS determined that NAPS owed $696,369.59 in additional tax and interest.” The 180. 168. 169. 170. 21 Cl. Ct. 310, 312 (1990). Nat’l Ass’n of Postal Supervisors v. United States, 171. benefit members paid $25 in dues. members paid $25 benefit distinction in service levels between membership tiers continued. distinction in service levels services for its active and associate “NAPS perform[ed] many other members” the sole purpose’ of obtaining insurance” under the plan. under insurance” obtaining of sole purpose’ the period, limited benefit membership grew dramatically from “149 lim- dramatically membership grew limited benefit period, ited benefit members” benefit members received only the health plan brochure, the insurance benefit members received only cover letter from NAPS.” underwriter’s pamphlet, and a “over $580,000” and “nearly $850,000” in limited benefit membership and “nearly $850,000” in limited “over $580,000” dues. of membership dues in return for health insurance was a trade or busi- dues in return for health insurance of membership tax-exempt purpose.” to the organization’s ness activity unrelated For example, NAPS lobbied on behalf of its active and associate mem- For example, NAPS lobbied on about pay issues, fringe benefits, bers; NAPS had “the right to consult percent of NAPS’s total net operating revenues” for 1983 and 1984, re- total net operating revenues” percent of NAPS’s spectively. differed substantially from the other levels of membership. For exam- differed substantially from the “[u]pon joining NAPS, active and ple, the evidence disclosed that membership kit,” associate members received a proved fruitful. “From 1981 through 1984, NAPS experienced a sub- 1984, NAPS experienced 1981 through fruitful. “From proved membership.” benefit increase in limited stantial Id. NAPS paid the tax and filed suit seeking a refund for payment of the tax and filed suit seeking a refund NAPS paid the tax. During the same period, “[l]imited benefit member dues generated sub- period, “[l]imited benefit member During the same stantial income” 192 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 34 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 100 Side B 09/19/2016 08:25:28 B 09/19/2016 100 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 101 Side A 09/19/2016 08:25:28 Id. 193 are 184 motive in and “NAPS tes- “NAPS and only 181 186 NAPS sought to blunt the risk created NAPS sought to 183 The distinction in service levels was all too apparent to all too apparent levels was in service The distinction “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE 185 at 314. 182 In 1984, NAPS adopted a resolution granting to limited benefit adopted a resolution granting In 1984, NAPS On Appeal, the United States Court of Appeals, Federal Circuit, On Appeal, the United States Court Id. Id. Id. getting nothing for their $25-you know, they are paying the pre- their $25-you know, they are getting nothing for in full-but, second, and more mium on the health benefits also and suggestion of our attorneys important, this was at the urgency be in serious trouble if we left and legal people because we could the people no participating rights this $25 as simply a fee and gave for it. offering insurance to federal employees who were not postal super- offering insurance to federal employees reasons the union installed and visors, it was one of the primary The Claims Court found that kept the $25.00 membership fee. benefit member dues that “NAPS knew before setting the limited less than $25.00,” and each individual would cost the organization the $25.00 dues with knowledge that the “Executive Committee set that this rate would generate profits.” While earning a profit may not have been NAPS’s While earning a profit may not have The reason this resolution is here because, one, these people is here because, one, these The reason this resolution M K C Y 186. Ass’n of Postal Supervisors v. United States, 944 F.2d 859, 862 (Fed. Cir. Nat’l 181. 182. Ass’n of Postal Supervisors v. United States, 21 Cl. Ct. 310, 314 (1990). Nat’l 183. 184. context, the clause “these people” refers to the limited benefit members. In this 185. and other programs affecting its postal supervisors;” its postal affecting other programs and tified before Congress” on behalf of its postal membership. The its postal membership. on behalf of Congress” tified before training and edu- all members NAPS offered did indicate that evidence to inform effort, however, made no specific “NAPS cation programs. education pro- training and of [available] benefit members limited grams.” in providing minimal and disparate benefits to the limited benefit and disparate benefits in providing minimal reason for the resolu- of NAPS explained the members. The Chairman tion by stating: ignore. to serve on committees “to participate in meetings, members the right advice.” and to offer technical 1991). at 321. The Claims Court concluded that the activity of providing limited The Claims Court concluded a trade or business and held for the membership benefits constituted of the Claims Court. IRS. NAPS appealed the judgment affirmed the judgment of the Claims Court. The Federal Circuit rea- affirmed the judgment of the soned that: 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 35 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 101 Side A 09/19/2016 08:25:28 A 09/19/2016 101 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 101 Side B 09/19/2016 08:25:28 M K C Y structuring Vol. 11:1:159 191 and protecting Alaskan 194 187 , 21 Cl. Ct. at 324. The frequency and use of this particular The frequency and use of this the regulation of firearms, 196 190 189 FLORIDA AFLORIDA &REVIEW LAW M UNIV. determining who is eligible to receive federal grants to determining who is eligible to 193 195 extending trade benefits to certain Sub-Saharan extending trade benefits 15 U.S.C. § 1278; 15 U.S.C. §U.S.C. § 7705; 15 7903; 16 U.S.C. § 2708; 16 at 326. at 324-26. 192 The following factors, outlined by the Claims Court, proved crit- proved Court, Claims by the outlined factors, following The At present, forty-seven non-tax federal statutes employ the At present, forty-seven non-tax The phrase “trade or business” is not solely limited to use in the The phrase “trade or business” The disparity in service levels among the different membership service levels among the different The disparity in Id. See Nat’l Ass’n of Postal Supervisors Id. In the end, NAPS failed to demonstrate that its activities satis- failed to demonstrate that In the end, NAPS First, the activity must “benefit . . . membership as a group, rather as a group, . . . membership activity must “benefit First, the as- . . . court[s] should Second individual capacities.” than in their directly organization are charged by the the fees certain whether an receive. . . . Third, that individuals to the benefits proportional an organization’s to be substantially related to activity is less likely is one commonly if “the service provided . . . tax-exempt purpose entities.” provided by for-profit 188 F. or Business Implications Other Federal Statutes with Trade 188. 190. 16 U.S.C. §191. 450oo-5 (2015). U.S.C. § 18 192. 921(a)(21)(A)-(F) (2006). § 31 U.S.C. 193. 5312(a)(4) (2015). § 19 U.S.C. 194. 3721(b)(3)(B)(v) (2015). § 21 U.S.C. 195. 864a(a)(1)(C) (2015). § 43 U.S.C. 196. 687c (2015). 189. 187. transactions to evade the reporting of monetary instrument trans- transactions to evade the reporting actions, ical to the Court of Appeals decision: Court of Appeals ical to the land leases. reduce the production of methamphetamine, U.S.C. § 450oo-5; 18 U.S.C. § 1466; 18 U.S.C. § 1901; 18 U.S.C. §U.S.C. § 921; 19 U.S.C. § 1677; 19 U.S.C. § 1516; 19 2401; 19 U.S.C. § 3721; 20 U.S.C. §U.S.C. § 1087vv; 21 U.S.C. § 2631; 29 U.S.C. § 864a; 28 § 1002; 29 U.S.C. 1082; 29 U.S.C. § 1301; 29 U.S.C. § 1321; 29 associations, phrase “trade or business.” income tax code. The phrase courses throughout the United States income tax code. The phrase of federal statutes, reflecting Congres- Code, touching a diverse range production and sale of handicraft items sional policies in areas such as, by native American tribes, levels, coupled with the intent to generate a profit, resulted in a finding the intent to generate a profit, levels, coupled with its nonmembers consti- of providing insurance to that NAPS’s activity business income business, subject to the unrelated tuted a trade or tax. fied the basis for its income tax exemption triggering exposure to the its income tax exemption triggering fied the basis for tax. corporate income 194 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 36 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 101 Side B 09/19/2016 08:25:28 B 09/19/2016 101 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 102 Side A 09/19/2016 08:25:28 201 195 requires certain 199 Schindler Elevator Corp. v. See also Should the interpretation of non- Should the interpretation 198 to “file a report containing . . . [t]he to “file a report containing . . 200 Congress undoubtedly intended the adoption of intended the adoption undoubtedly Congress 197 at § 102. “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE 42 U.S.C. § relating to self-employment, 411(c) (2015) (relaying the definitions at § a report include 101(f) (The list of enumerated individuals required to file For example, The Ethics in Government Act For example, The Ethics in Government What then is the intended meaning of the phrase “trade or busi- intended meaning of the phrase What then is the Id. See id. See M K C Y 199. in Government Act, Pub. L. No. 95-521, 92 Stat. 1824 (1978) (codified as Ethics 200. 198. Perrin v. United States, 444 U.S. 37, 42 (1979). 201. 197. phrase outside of the income tax code is striking. However, the mean- However, is striking. tax code income of the outside phrase in these non-tax is undefined or business” term “trade ing of the make a scant federal statutes aforementioned Only two of the statutes. of to Section 162 reference by making a passing at a definition attempt tax code. the income United States, 563 U.S. 401 (2011) (“When terms used in a statute are undefined, we give United States, 563 U.S. 401 (2011) (“When terms used in a statute are undefined, them their ordinary meaning.”). amended at 5 U.S.C. App. § 101 (2015)). federal officers and individuals tax statutes import a tax meaning when interpreting the phrase? The a tax meaning when interpreting tax statutes import this phrase beseeches an expansive range of federal statutes adopting Congress’ policy objectives. application of the term to fulfill source, type, and amount or value of income . . . from any source” source, type, and amount or value a general and undefined term. Therefore, courts are left with no legis- courts are left term. Therefore, and undefined a general Presumably, the courts as to the meaning of this term. lative guidance income tax statutes for the phrase has been used in the will look to how guidance. ness” when used in a non-tax context? One must be mindful of the in a non-tax context? One ness” when used [which] is that, unless of statutory construction “fundamental canon as taking their ordinary, words will be interpreted otherwise defined, meaning.” contemporary, common which provides in relevant part that “[t]he term “trade or business,” when used with refer- which provides in relevant part that “[t]he from self-employment, shall have the same ence to self-employment income or net earnings of the Internal Revenue Code of 1986”); 42 U.S.C. meaning as when used in section 162 § for activity outside the 403(k) (2015) (relating to certain reductions of insurance benefits part that the term “‘tradeUnited States, which provides in relevant have or business’ shall 162 of the Internal Revenue Code of 1986”). the same meaning as when used in section the “President, the Vice President, each officer or employee in the executive branch . . . who the “President, the Vice President, each officer or employee in the executive branch of- occupies a position classified above GS-15 . . . Member(s) of Congress . . . [including] ficer[s] or employee[s] of the Congress . . . and judicial employee[s].”). judicial officer[s], U.S.C. § 1322; 29 U.S.C. § § 1382; 31 U.S.C. 329; 31 U.S.C. §U.S.C. § 3901; 31 U.S.C. § § 5318; 31 U.S.C. 31 5312; 5321; 31 U.S.C. § 5324; 31 U.S.C. §U.S.C. § 5326; 31 U.S.C. § 5331; 41 U.S.C. § 5328; 31 § 3101; 42 U.S.C. 1382b; 42 U.S.C. §U.S.C. § 403; 42 U.S.C. § § 410; 42 U.S.C. 409; 42 411; 42 U.S.C. § 418; 42 U.S.C. §§ 42 U.S.C. § 503; 1620; 43 U.S.C. § 9607; 43 U.S.C. 687c; 46 U.S.C. § 2101; 49 U.S.C. §U.S.C. § 30106; 5 U.S.C. App. 4 § U.S.C. § 571; 50 App. 102; 50 App. 596; 6 U.S.C. § 395. including, “[t]he identity and category of value of any interest in prop- including, “[t]he identity and category calendar year in a trade or business, or erty held during the preceding of income, which has a fair market for investment or the production 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 37 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 102 Side A 09/19/2016 08:25:28 A 09/19/2016 102 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 102 Side B 09/19/2016 08:25:28 L. , 24 M K C Y OWA , 89 I Vol. 11:1:159 206 The policy justification for 204 205 The policy for this statute is to ensure statute for this policy The 202 Alternative Sanctions and the Federal Tax Law: Symbols, Alternative Sanctions and the Federal The Congressional Response to Corporate Expatriations: The FLORIDA AFLORIDA &REVIEW LAW M UNIV. Michael S. Kirsch, . 475, 482 (2005). 6 U.S.C. § (regarding prohibition on contracts with corporate 395 (2015) at § 102(a)(3). The policy reason behind this statute is to discourage U.S. behind this statute is to The policy reason EV Another federal statute prohibits the Secretary of Homeland Secretary of prohibits the federal statute Another Yet another federal statute, an immigration statute, invokes Yet another federal statute, an Id. See See R 203 AX . 863, 867 (2004) (“Another recent example of alternative sanctions arises in the context . 863, 867 (2004) (“Another recent example . T 206. L. No. 105-100, 111 Stat. 2160, 2193 (1997) (codified as amended in scattered Pub. 204. 203. 205. S. Kirsch, Michael 202. A EV V R value which exceeds $1,000.” exceeds which value this requirement is described by one writer as an “‘alternativethis requirement is described sanc- and criminal sanctions that is used to tion’ . . . to the traditional civil stop a perceived abuse of tax law.” integrity and establish accountability among federal workers. among federal accountability and establish integrity incorporated with a foreign into any contract from “enter[ing] Security of the properties all acquires “substantially the foreign entity entity” if substantially all corporation or by a domestic or indirectly held directly of a domestic partner- constituting a trade or business of the properties ship.” expatriates). sections of 8 U.S.C.). based businesses from reorganizing with foreign ownership and, from reorganizing with based businesses reaping the U.S. taxation, while simultaneously thereby, avoid paying United States. Congress into a contract with the benefits of entering inversion transac- with the high incidence of corporate was concerned costing the U.S. essentially mere paper transactions tions, that were This statute was en- of dollars in lost tax revenue. treasury millions of an entity, where the to the foreign reincorporation acted in response control remained within managerial and operational substance of the the same group of American individuals. the phrase “trade or business” when determining whether individuals the phrase “trade or business” Nicaragua have satisfied the conditions from the countries of Cuba or Specifically, Title 8, Section 1255 of to adjust their immigration status. that, “for purposes of establishing the United States Code provides presence” has been satisfied, the that the period of continuous physical she “performed service, or engaged individual must demonstrate that the United States.” in a trade or business, within Tension Between Symbols and Substance in the Taxation of Multinational Corporations of corporate inversions, whereby a company organized under the laws of the United States of corporate inversions, whereby a company foreign country, such as Bermuda or the Cayman changes its place of incorporation to a this recent Islands, in order to reduce its future United States tax liability. In response to an alterna- phenomenon, Congress enacted, as part of the Homeland Security Act of 2002, into tive sanction purporting to ban these former United States corporations from entering future contracts with the Department of Homeland Security.”). Shaming, and Social Norm Management as a Substitute for Effective Tax Policy Shaming, and Social Norm Management 196 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 38 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 102 Side B 09/19/2016 08:25:28 B 09/19/2016 102 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 103 Side A 09/19/2016 08:25:28 197 Id. (Feb. 28, 2014), ORTUNE , F Specifically, Section 1278 Specifically, 207 , http://www.toysrusinc.com/about-us/ (last S 210 “R”U OYS , T In still another private equity transaction, In still another private equity 209 Deals of the Day: HubSpot Preps IPO 208 “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE About Toys“R”Us, Inc. One final example, the Federal Hazardous Substances Act Substances Hazardous the Federal example, final One Private equity firms have taken a dominant investment posi- firms have taken a dominant Private equity argue that they are not Private equity firms will undoubtedly M K C Y 207. §§ 15 U.S.C. 208. 1261-78 (2012). § 15 U.S.C. 209. 1278(c)(1)(D)(ii) (2015). See 210.Primack, Dan (“FHSA”), brings certain private equity firms directly into the firms directly private equity brings certain (“FHSA”), or business debate. of the trade crosshairs http://fortune.com/2014/02/28/deals-of-the-day-hubspot-preps-ipo/. of the FHSA requires that certain toys intended for use by children intended for that certain toys requires of the FHSA statute is to pro- of this The purpose a cautionary statement. contain small parts and the hazards of warning about with a vide consumers distributors, retailers, applies to manufacturers, balloons. The statute exempts “an individual private labelers. The statute importers, and not constitute a trade or is intermittent and does whose selling activity business.” visited Apr. 1, 2016). “The acquisition encompassed all worldwide operations of Toys“R”Us, visited Apr. 1, 2016). “The acquisition encompassed all worldwide operations of of this Inc., including the Toys“R”Us and Babies“R”Us businesses. With the completion transaction, each of the investors owns an equal stake in Toys“R”Us, Inc.” the “Transom Capital Group [ Inc., a . . . ] sold Uncle Milton Industries science toys for children, to KCB Man- maker of ant farms and other agement” for an undisclosed sum. tion in the toy industry. For example, “Toys‘R’Us, Inc. . . . the world’s industry. For example, “Toys‘R’Us, tion in the toy . . . , operated as a toy and baby products retailer leading dedicated consisting of affiliates [until] . . . an investment group public company Roberts & Co. (KKR) Partners LLC, Kohlberg Kravis of Bain Capital of Toys‘R’Us, Inc. Trust completed an acquisition and Vornado Realty for $6.6 billion” in 2005. of selling toys. Predictably, they will engaged in the trade or business that separate corporate identities and raise the time-honored defenses justify holding only the operating com- limited liability for investors arise when one considers whether pany liable. However, fair questions consulting services, facilitates dis- a private equity firm that provides alliances, or otherwise engages in tribution, enables manufacturing of the toy company is engaged in an actions affecting the operations or business” for purposes of this “activity” that constitutes a “trade into full relief when one considers the statute. The debate is brought between the states’ economic develop- competing policy implications government’s objective of regulating an ment interests and the federal the most innocent and unsuspecting activity which directly affects our children. members of the population – 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 39 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 103 Side A 09/19/2016 08:25:28 A 09/19/2016 103 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 103 Side B 09/19/2016 08:25:28 215 M K C Y Vol. 11:1:159 , the plaintiff sought to in- , the plaintiff sought The court stated that “[a] The court stated 211 of Such Phrase of Such 216 , 299 U.S. at 194. FLORIDA AFLORIDA &REVIEW LAW M UNIV. , the [United States] Supreme Court held that Ohio’s law , the [United States] Supreme a Common, Plain and Ordinary Understanding Plain and a Common, In upholding the statute, the Supreme Court affirmed In upholding the statute, the Old Dearborn Distributing Co. v. Seagram-Distillers Corpo- Old Dearborn Distributing Co. Caraway v. Ford Motor Company Caraway v. Ford 212 the United States Supreme Court “upheld the Illinois Fair the United States Supreme Court at 194-95 (citation omitted). 214 In The phrase “trade or business” is also a common tool of analysis a common tool of is also “trade or business” The phrase In Old Dearborn Distrib. Co. Id. 213 , [i]t is well settled that the proprietor of the good will “is entitled to [i]t is well settled that the proprietor to deprive him of the bene- protection as against one who attempts using his labels and trade-mark fits resulting from the same, by “Courts afford redress or relief without his consent and authority.” a valuable interest in the good- upon the ground that a party has in the trade-marks adopted to will of his trade or business, and maintain and extend it.” Kewanee 216. 211. v. Ford Motor Co., 144 F. Supp. 295, 295 (W.D. Mo. 1956). Caraway 212. v. Ford Motor Co., 148 F. Supp. 776, 777 (W.D. Mo. 1957). Caraway 213. Distrib. Co. v. Seagram-Distillers Corp., 299 U.S. 183, 194 (1936). Old Dearborn 214. M. Morris Corp. v. Hess Bros., Inc., 243 F.2d 274, 276 (3d Cir. 1957) (citing Norman 215. G. Illustrating or Business of the Phrase Trade Law Uses Common person who has been injured in his trade or business by the activities been injured in his trade or business person who has is entitled to recover combination or restraint of an unlawful monopoly, the loss suffered, recovery being sus- damages in an action at law for and under the federal anti-trust tainable both at common law statutes.” voke the federal court’s jurisdiction by alleging that defendants court’s jurisdiction by alleging voke the federal Act and the Clayton of the Sherman Anti-Trust violated “provisions §§Act, Title 15 U.S.C.A. 1-7, 12 et seq.” of trade secrets, which, . . . granted monopoly protection to processes of trade secrets, which, . . . granted “good will is property in a very real sense, injury to which, like injury “good will is property in a very is a proper subject for legislation.” to any other species of property, Trade Act . . . as affording ‘a legitimate remedy for an injury to the Trade Act . . . as affording ‘a the use of trade-marks, brands or good will which results from names.’” conveying meaning beyond its statutory framework. Courts have in- beyond its statutory framework. conveying meaning protectable property when identifying a litigant’s voked this phrase mandate compelling the the absence of a statutory interest despite or business. presence of a trade Old Dearborn Distrib. Co. v. Seagram-Distillers Corp., 299 U.S. 183 (1936)). “In The Court’s analysis recognized 198 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 40 6-SEP-16 15:52 ration 37680-fam_11-1 Sheet No. 103 Side B 09/19/2016 08:25:28 B 09/19/2016 103 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 104 Side A 09/19/2016 08:25:28 199 The , http:// 219 222 ISTORY H IGITAL , D sought a permanent sought With the advancement of Joint Stock Companies Act 1856, 19 220 Kewanne see also raises significant issues of importance in raises significant The plaintiffs in The plaintiffs 217 H. Interests Competing Policy The concept of limited liability took on greater signifi- The concept of limited liability , Clowes v. Brettell, (1843) 152 Eng. Rep. 885, 886 (Eng.) (finding that the , Clowes v. Brettell, (1843) 152 Eng. Rep. 221 In upholding the Ohio statute, the Court recognized that Court recognized statute, the the Ohio In upholding “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE Limited Liability Act 1855, 18 & 19 Vict. c. 133 (Eng.) (providing limited liabil- at 475. 218 Economic history amply documents the evolution of investment Economic history amply documents Taken together, these cases help illustrate the common gloss these cases help illustrate the Taken together, Sun Capital Partners Sun Capital Partners Id. See, e.g. See See The Rise of Big Business: The Corporate Revolution M K C Y 222. 221. 220. 217. 1474 (Fed. Cir. 1998). Dow Chem. Co. v. Exxon Corp., 139 F.3d 1470, 218. 473 (1974). Kewanee Oil Co. v. Bicron Corp., 416 U.S. 470, 219. www.digitalhistory.uh.edu/disp_textbook.cfm?smtid=2&psid=3165 (last visited Apr. 6. www.digitalhistory.uh.edu/disp_textbook.cfm?smtid=2&psid=3165 (last visited age of free 2016) (pointing out that although some viewed this time period as the golden enterprise, working conditions were appalling and labor conflict was intense). and manufacturing techniques that had been in commercial use for use commercial been in had that techniques manufacturing and preempted by the was not otherwise patentable, year but were over one Patent Act.” federal desire for limited liability continued unabated throughout the nine- desire for limited liability continued injunction to prohibit former employees from disclosing certain trade from disclosing employees to prohibit former injunction secrets. & 20 Vict. c.47 (Eng.) (extending limited liability protection to companies with seven or & 20 Vict. c.47 (Eng.) (extending limited liability protection to companies with more shareholders). economic and social progress, investors insisted on greater legal pro- economic and social progress, by creating the limited tections and legislators responded partnership. tax law, pension law, and corporate law. Its holding creates broad pol- law, and corporate law. Its holding tax law, pension laborers concerning the for regulators, investors, and icy implications entity integrity and promoting limited twin doctrines of preserving liability. and investment vehicles since the opportunities, investment strategies, in the sixteenth century. Ini- early days of the joint-stock company were simple and direct, and they tially, investment opportunities liability. exposed investors to unlimited cance with the proliferation of corporate entities and the advent of cance with the proliferation of century. Legislation tending to limited partnerships in the nineteenth on corporations fell in favor of lax impose a burden of responsibility race of the nineteenth century. regulation during the charter plaintiffs can look beyond the company to the shareholders for payment of debt). ity to companies with 25 or more shareholders); “[t]he subject of a trade secret must be secret, and must not be of public secret, and must secret must be of a trade “[t]he subject or business.” a general knowledge in the trade knowledge or of that the phrase “trade or business” has now acquired in American “trade or business” has now that the phrase jurisprudence. 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 41 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 104 Side A 09/19/2016 08:25:28 A 09/19/2016 104 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 104 Side B 09/19/2016 08:25:28 M K C Y In the 224 . L. 445, 451 IN Sun Capital Vol. 11:1:159 The result of 227 . & F ORP J. C ORDHAM , 14 F These entities perfected the concept perfected These entities 223 Two Decades of “Alternative Entities”: From Tax Rationalization Two Decades of “Alternative Entities”: From Young v. Fortis Plastics, LLC, No. 3:12–CV–364 JD CAN, 2013 WL Young v. Fortis Plastics, LLC, No. 3:12–CV–364 Therefore, the fictional separation of an entity’s ac- Therefore, the fictional separation should private equity funds be held liable. To this should private equity funds FLORIDA AFLORIDA &REVIEW LAW M UNIV. 226 private equity funds should be held liable; rather, the private equity funds should when 225 at 455-56. is no longer atypical. Federal regulators are aggressively en- is no longer atypical. Federal There is a noticeable trend afoot in finding private equity firms There is a noticeable trend afoot Federal law has made it clear that it will not tolerate legal fic- made it clear that it will not Federal law has See id. See generally whether 224. 225. §§ 29 U.S.C. 226. 1001, 1302 (2012). § 29 U.S.C. 1301(b)(1) (“[A]ll employees of trades or businesses (whether or not in- 227. 223. with The Wyoming LLC The Wyoming legislature started the “LLC revolution” (2009). midst of the investors’ quest for expanded participation and liability quest for expanded participation midst of the investors’ designed to protect enacted federal legislation privileges, Congress permissible corporate and to prevent abuse through workers’ pensions structuring. finding a private equity firm liable as demonstrated in finding a private equity firm teenth century and well into the twentieth century as investors sought as investors century the twentieth well into and century teenth preserving the they owned while the businesses rights in participation late in the responded State legislators of limited liability. privilege of the creation allowing for legislation century, enacting twentieth and LLLP entities. LLC, LLP, of limited liability by permitting investors to participate directly in the to participate investors liability by permitting of limited liability. the privilege of limited entity while maintaining 5406276 (N.D. Ind. Sept. 24, 2013); Vogt v. Greenmarine Holding, LLC, 318 F. Supp. 2d 136 5406276 (N.D. Ind. Sept. 24, 2013); Vogt v. Greenmarine Holding, LLC, 318 F. Supp. (S.D.N.Y. 2004). end, Congress has spoken and enacted federal legislation providing end, Congress has spoken and or businesses (whether or not incorpo- that “all employees of trades control shall be treated as employed rated) which are under common tivities by investors that is permissible under state law principles is tivities by investors that is permissible of liability under certain federal law irrelevant to the determination principles. portfolio companies. responsible for the actions of their corporated) which are under common control shall be treated as employed by a single corporated) which are under common control shall be treated as employed employer and all such trades and businesses as a single employer.”). question is forcing statutes where enabling legislation is in place. The question is forcing statutes where enabling not tions to avoid liability. Unlike state laws, where legislation grants to Unlike state laws, where tions to avoid liability. investment ac- flexibility in separating and structuring investors great of liability for certain law has expounded a standard tivities, federal Federal law ex- under prescribed circumstances. investment activities consolidate entities under particular plicitly anticipated the need to circumstances. Through Alphabet Soup to Contract as Deity Through Alphabet Soup to Contract as Act. Daniel S. Kleinberger, 200 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 42 6-SEP-16 15:52 Partners 37680-fam_11-1 Sheet No. 104 Side B 09/19/2016 08:25:28 B 09/19/2016 104 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 105 Side A 09/19/2016 08:25:28 201 , 122 aff’d when it , may be or salary 233 230 Sun Capital or uniform expenses 232 372 U.S. 39 (1963) (adopting the “origin of the claim” test , , 599 F.2d 269, 272 (8th Cir. 1979), the United States Court , 599 F.2d 269, 272 (8th Cir. 1979), the United And, unfortunately, the Court of Appeals for the First And, unfortunately, the Court Congress has chosen instead to leave this determination Congress has chosen Still, the question remains, what constitutes a trade or a trade what constitutes question remains, Still, the 234 are ubiquitous and can make the inquiry into identifying and can make the inquiry into are ubiquitous 229 228 “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE 231 . Quinlivan v. Comm’r Three Supreme Court cases have considered the question of Three Supreme Court cases have To date, neither Congress nor the Supreme Court has articu- Court has nor the Supreme neither Congress To date, M K C Y 232. States v. Gilmore United 233. v. Comm’r, 628 F.2d 467, 469 (5th Cir. 1980) (“[C]ost of clothing is deducti- Pevsner 234.Capital Partners III, LP v. New Eng. Teamsters & Trucking Indus. Pension Sun 231. Brewer Quality Homes, Inc. v. (T.C. 2003), Comm’r, 86 T.C.M. (CCH) 29 230. In 228. 29 U.S.C. §229. 1301(b)(1). “[T]rade or business” in 29 U.S.C. § references to 26 U.S.C. § 1301 cross 514, which F. App’x 88 (5th Cir. 2004). by a single employer and all such trades and businesses as a single as a and businesses trades all such and employer single by a employer.” declared one of the two equity funds to be a trade or business. Both the declared one of the two equity funds the phrase “trade or business.” None- labor code and the tax code use unique to a particular activity, thus making the inquiry into identify- activity, thus making the unique to a particular provoking. challenging and thought ing a trade or business for purposes of business deduc- what constitutes a trade or business The Supreme Court declined the tions under the income tax code. a trade or business under the opportunity to consider what constitutes Labor Code. expenses, for determining whether a legal expense is deductible under Section 162). as a ble as a business expense only if: (1) the clothing is of a type specifically required and condition of employment, (2) it is not adaptable to general usage as ordinary clothing, (3) it is not so worn.”). Fund, 724 F.3d 129, 132 (1st Cir. 2013). of Appeals for the Eighth Circuit stated that “Congress has expressly provided for the de- of Appeals for the Eighth Circuit stated the payments are required to be made for the duction of rental expenses where: (1) (2) the continued use or possession of the prop- continued use or possession of the property; (3) the taxpayer has not taken and is not taking erty is for purposes of the trade or business; has no equity in the property.” title to the property; and (4) the taxpayer Circuit did not provide a standard of analysis in Circuit did not provide a standard to the courts and the regulators. Determining whether a particular ac- the regulators. Determining to the courts and evaluating a myriad of a “trade or business” involves tivity constitutes factors.expenses such as incurring rental Some factors, business for purposes of the labor statute? for purposes of business an activity whether for determining definitive standard lated a between the rele- The cross-references to a trade or business. amounts this point are both and the tax statute on vant labor statute incomplete. the underlying trade or business uncomplicated and predictable. Other trade or business uncomplicated the underlying incurring legal fees factors, such as itself cross references to Section 162 where “trade or business” is statutorily undefined. itself cross references to Section 162 where of the phrase “trade or business” is limited in Moreover, the Supreme Court’s analysis Groetzinger 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 43 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 105 Side A 09/19/2016 08:25:28 A 09/19/2016 105 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 105 Side B 09/19/2016 08:25:28 M K C Y ” And presently Vol. 11:1:159 Sun Capital Partners offers a prime opportunity to ex- offers a prime ROPOSALS P What is a trade or business? trade or is a What WO IV. T ” Specifically, should a reading of the phrase “trade or reading of the should a ” Specifically, Sun Capital Partners FLORIDA AFLORIDA &REVIEW LAW M UNIV. note 196 and accompanying text listing 47 different federal statutes. note 196 and accompanying text listing Possibilities abound to resolving the statutory ambiguity Possibilities abound to resolving Is there a difference in meaning when applying the phrase applying the meaning when a difference in Is there 236 235 The first approach proposes the adoption of a definition of trade The first approach proposes the The labor statute at issue in Several approaches can be articulated to address the uncer- can be articulated to address Several approaches See supra 236.income tax regulations at 26 C.F.R. § The 1.513-1(b) (2013) provide in relevant 235. equally important for purposes of the labor statute is the following labor statute purposes of the important for equally “ question: provides that “all employees of trades or businesses (whether or not provides that “all employees of common control shall be treated as em- incorporated) which are under theless, the question remains: “ remains: question the theless, amine how the distinction in interpretation and application of the distinction in interpretation amine how the operates. subject phrase part, “any activity of a section 511 organization which is carried on for the production of part, “any activity of a section 511 organization which is carried on for the production trade or income and which otherwise possesses the characteristics required to constitute business within the meaning of section 162—and which, in addition, is not substantially related to the performance of exempt functions—presents sufficient likelihood of unfair 513 the competition to be within the policy of the tax. Accordingly, for purposes of section includes term trade or business has the same meaning it has in section 162, and generally of any activity carried on for the production of income from the sale of goods or performance services.” business” for purposes of the labor statute yield a different result from yield a different of the labor statute for purposes business” the tax code? This ques- phrase “trade or business” in a reading of the the courts, or academic addressed by Congress, tion has not been commentators. such as the one “trade or business” raises. I propose two. such as the one “trade or business” or business for purposes of the labor statute. Thus far, Congress and or business for purposes of the to define the phrase “trade or business.” the courts have been reluctant the phrase “trade or business” is war- However, a limited definition of objective of protecting a wide base of ranted in light of Congress’ protective posture of the phrase. Pro- workers’ pensions, and given the phrase “trade or business” is without viding a limited definition of the tax regulations provide that “for precedent. For instance, the income trade or business has the same mean- purposes of section 513 the term includes any activity carried on ing it has in section 162, and generally the sale of goods or performance of for the production of income from services.” tainty raised by the employment of identical terms in these federal tainty raised by the employment statutes. “trade or business” in the labor code from applying the identical phrase applying the labor code from business” in the “trade or code? in the tax 202 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 44 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 105 Side B 09/19/2016 08:25:28 B 09/19/2016 105 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 106 Side A 09/19/2016 08:25:28 203 I propose adding the following definition to clarify definition adding the following I propose 237 A. Administrative Guidance Warranted? “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE It is unlikely that Congress is willing to act and adopt language In the absence of a defined term, establishing a consistent defi- In the absence of a defined term, providing a definition of a Three factors converge to justify For purposes of Section 1301(b)(1), the phrase “trade or business” the phrase of Section 1301(b)(1), For purposes a regu- and operated on activity organized (1) any business includes in a profit motivated basis or substantial lar, continuous, involving another party under common control transaction with con- fair market value, or (2) any undertaking any exchange at significant or person engaging in a regular, ducted by any or policy mak- in the operations, management, meaningful manner person under common control. ing decisions of another M K C Y 237. 29 U.S.C. § 1301(b)(1). ployed by a single employer and all such trades and businesses as a and businesses trades such and all employer single by a ployed single employer.” the meaning of the statute: the meaning defining a trade or business for purposes of Title 29. This is especially defining a trade or business for purposes of Title 29. This is The first definition focuses the inquiry on exchanges at fair market focuses the inquiry on exchanges The first definition individuals seek with the theory that rational value and is consistent focuses the inquiry exchanges. The second definition to optimize their an exchange at fair mar- activities that do not require on “engaging in” of a trade or business indicate the presence ket value but nonetheless approach is that it respects the separate activity. The advantage to this and corporations under state law, entity structure of LLCs, LLPs, event that a higher-tiered individual while providing liability in the and operational control of the portfolio usurps the policy, managerial, company under federal law. nition of the term “trade or business” will continue to be a challenge. nition of the term “trade or business” the present ambiguity, thereby pro- Regulatory guidance will clarify with the statute. When invoking moting enforcement and compliance a fixed definition of the phrase “trade or the labor statute, the need for statutory gap left open by Congress. business” is warranted to fill the of the corporate laws al- trade or business. First, the modernization in the underlying entity must be lowing for investor involvement to earning the traditional dividends recognized. Second, in addition firms now earn something more: they and appreciation, private equity fees, and monitoring fees. Finally, earn management fees, transaction invoking a benefit or imposing a bur- the difference in posture between “trade or business” must be recognized den when invoking the phrase and applied by litigants. 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 45 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 106 Side A 09/19/2016 08:25:28 A 09/19/2016 106 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 106 Side B 09/19/2016 08:25:28 M K C Y What 238 Vol. 11:1:159 deference each Auer Naturally, the debate will 241 If Congress has directly spoken and If Congress has directly spoken deference, and deference, and 239 -type analysis, a reviewing court evaluates infor- -type analysis, a reviewing court Skidmore “If, however, the court determines Congress has “If, however, the court determines -type analysis, a reviewing court evaluates formal -type analysis, 240 FLORIDA AFLORIDA &REVIEW LAW M UNIV. Chevron Skidmore at 843. construction of the statute which at 842-43 (“When a court reviews an agency’s deference, Regulatory guidance can take various forms, ranging from a for- can take various forms, ranging Regulatory guidance In a In a Id. Id. Id. 241. 238. 239. Inc., 467 U.S. 837, 842 (1984). Chevron, U.S.A., Inc. v. Natural Res. Def. Council, 240. remains, therefore, is for the PBGC to issue regulatory guidance defin- issue regulatory the PBGC to therefore, is for remains, the labor statute. for purposes of or business ing a trade administrative regulation to an informal mal interpretive whether such adminis- The following question arises: pronouncement. court. The answer would be binding on a reviewing trative guidance taken. Courts observe level of administrative action depends on the actions doctrines when evaluating administrative three deference – true given that Congress has already authorized the PBGC to “pre- to the PBGC authorized has already that Congress given true be “consistent that they the only limitation regulations with scribe” purposes by for similar prescribed with regulations and coextensive 26.” 414(c) of Title under section of the Treasury the Secretary named after the principal case. named after the often center on what is the meaning of “the precise question at issue.” often center on what is the meaning has “unambiguously expressed” its intention regarding the applicable has “unambiguously expressed” court is bound to follow Congress’ ex- legislation, then the reviewing pressed intention. mal administrative pronouncements such as “rulings, interpretations mal administrative pronouncements not directly addressed the precise question at issue, the court does not not directly addressed the precise on the statute, as would be neces- simply impose its own construction interpretation. Rather, if the sary in the absence of an administrative with respect to the specific issue, the statute is silent or ambiguous the agency’s answer is based on a question for the court is whether statute.” permissible construction of the administrative pronouncements interpreting a particular statute. The administrative pronouncements is almost always a regulation. formal administrative pronouncement Congress has directly spoken to The court must determine “whether the precise question at issue.” it administers, it is confronted with two questions. First, always, is the question whether it administers, it is confronted with two questions. First, always, is the question Congress is Congress has directly spoken to the precise question at issue. If the intent of give effect to clear, that is the end of the matter; for the court, as well as the agency, must Con- the unambiguously expressed intent of Congress. If, however, the court determines not simply gress has not directly addressed the precise question at issue, the court does of an impose its own construction on the statute, as would be necessary in the absence respect to administrative interpretation. Rather, if the statute is silent or ambiguous with based on a the specific issue, the question for the court is whether the agency’s answer is permissible construction of the statute.”). Chevron 204 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 46 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 106 Side B 09/19/2016 08:25:28 B 09/19/2016 106 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 107 Side A 09/19/2016 08:25:28 . - EV 243 205 . L. R HI Skidmore , 80 U. C -type deference. However, the Su- However, the Auer 246 that interpret the application of application the interpret that 247 242 Deference to Agency Statutory Interpretations First Ad- or Imposing a Burden -type deference. However, if the administrative -type deference. However, if -type analysis, a court is reviewing an administrative -type analysis, a One commentator notes, “Skidmore deference is pre- notes, “Skidmore deference One commentator 244 Auer “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE Chevron 245 The second approach to address the uncertainty raised by the The second approach to address In an administrative agency, if any, The course of action taken by the Id. Id. Id. M K C Y B. Business” - Accessing a Benefit The Dual Posture of “Trade or 246. v. Oregon, 546 U.S. 243, 244 (2006). Gonzales 247. 242. v. Swift & Co., 323 U.S. 134, 140 (1944). Skidmore 243. 244. 245. George Hubbard, Bradley 447, 455 (2013). type deference. Finally, if the administrative agency issues informal type deference. Finally, if the or clarifying announcements, then pronouncements such as additional will receive the resulting administrative guidance and opinions of the Administrator” of the opinions and preme Court cautions that “[a]n agency does not acquire special that “[a]n agency does preme Court cautions words when, instead of using its exper- authority to interpret its own a regulation, it has elected merely to tise and experience to formulate paraphrase the statutory language.” a particular statute. The Supreme Court has indicated that “[t]he has indicated Supreme Court statute. The a particular depend upon the case will in a particular of such a judgment weight of its reasoning, the validity its consideration, evident in thoroughness and all those pronouncements, and later with earlier its consistency to control.” if lacking power to persuade, give it power factors which agency pursues informal pronouncements, thereby bypassing applica- agency pursues informal pronouncements, resulting regulations receive ble APA provisions, then the interpretation of an administrative action. For example, “[a]n adminis- an administrative action. For interpretation of own ambiguous the issuing agency’s trative rule interpreting receive substantial deference.” regulation may mised on practicality—a that agencies are institutionally recognition interpretation of their courts with respect to the superior to the statutes.” employment of identical terms in these federal statutes proposes a employment of identical terms will determine the level of judicial deference ultimately given by the will determine the level of judicial pursues formal regulations in ac- courts. If the administrative agency then the resulting regulation cordance with the APA provisions, receives vanced in Litigation? The Chevron Two-Step and the Skidmore Shuffle Nonetheless, a reviewing court “may properly resort [to these items] reviewing court “may properly Nonetheless, a for guidance.” 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 47 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 107 Side A 09/19/2016 08:25:28 A 09/19/2016 107 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 107 Side B 09/19/2016 08:25:28 M K C Y In con- 248 Vol. 11:1:159 Invoking the 250 26 U.S.C. § 882, which . This approach requires . This approach But see Sun Capital Partners Sun Capital As a matter of statutory construction, the Supreme As a matter of statutory construction, 249 FLORIDA AFLORIDA &REVIEW LAW M UNIV. Mayo Found. for Med. Educ. & Research v. United States, 562 U.S. 44, 59-60 When a statute grants a benefit, as in the case of an income tax When a statute grants a benefit, In contrast, when a statute imposes a burden, the statute In contrast, when a statute See 249. 250. Inc. v. Comm’r, 503 U.S. 79, 84 (1992). INDOPCO, 248. 26 U.S.C. § For example, 162 allows taxpayers to deduct expenses incurred in a trast, the policy objective of the phrase “trade or business” in the labor objective of the phrase “trade trast, the policy a statutory burden. seeks to impose on individuals statute at issue within these statutes is distinction in policy objectives Capturing this of the phrase “trade understanding and application central to a proper to interpret the subject litigants and parties are or business.” Next, a benefit or imposes a to whether the statute grants phrase according statutes that grant a benefit are to be burden. This is likely because statutes imposing a burden are to be narrowly construed, whereas broadly construed. benefit and Recognizing the distinction between when interpreting the phrase “trade or burden justifies the difference business.” narrowly construed to promote the Con- statute, the statute should be repeatedly held that income tax gressional objective. Courts have grace and, therefore, must be nar- benefits are matters of legislative rowly construed. imposes an obligation on taxpayers with effectively connected income to report and pay in- imposes an obligation on taxpayers with effectively connected income to report come tax. method of interpretation that unfortunately was not recognized by the by recognized was not unfortunately that of interpretation method nor the court in litigants phrase “trade or business” for purposes of accessing an income tax ben- phrase “trade or business” for purposes a direct link between the efit requires taxpayers to demonstrate tax benefit. activity and the claimed income recognize Congress’ full power to legis- should be broadly construed to that litigants and courts first recognize the fundamental distinction in distinction the fundamental first recognize and courts that litigants the labor statute tax code and the income objectives between the policy Although not in- or business.” phrase “trade the subject when invoking in policy difference exists a fundamental there itially apparent, labor statute, despite the income tax code and the objectives between “trade or business.” The employ the identical phrase the fact that both in the income tax code of the phrase “trade or business” policy objective benefit. to grant to individuals a statutory generally seeks Court iterated “the ‘familiar rule’ that ‘an income tax deduction is a Court iterated “the ‘familiar rule’ that the burden of clearly showing the matter of legislative grace and is on the taxpayer.’”right to the claimed deduction (2011) (saying “exemptions from taxation are to be construed narrowly”). “trade or business.” 26 U.S.C. § in the 469 requires the active participation of the taxpayer deduction trade or business activity before being allowed the benefit of the passive loss whereas, 26 U.S.C. § 162 contains no such requirement. 206 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 48 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 107 Side B 09/19/2016 08:25:28 B 09/19/2016 107 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 108 Side A 09/19/2016 08:25:28 207 In la- that it and an- 253 256 and reme- Other areas 251 254 Sun Capital Partners environmental law, environmental 255 sought to avoid a burden by relying on a narrow sought to avoid a burden by relying examining the applicability of a “trade or business,” the examining the applicability of 257 United States v. Riverside Bayview Homes, 474 U.S. 121, 133 (1985); Leslie “TRADE OR BUSINESS” IN INCOME TAX LAW TAX INCOME IN BUSINESS” OR “TRADE Good Samaritan Hosp. v. Shalala, 508 U.S. 402 (1993). Higgins v. Comm’r, 312 U.S. 212, 212 (1941); Comm’r v. Groetzinger, 480 U.S. A critical distinction must be drawn between the three Supreme A critical distinction must be drawn See See See statutes are broadly construed to give full effect to to give full construed are broadly statutes M K 252 C Y 257. 256. 251. (W.D.N.Y. 1994) (“As general princi- Avila v. A. Sam & Sons, 856 F. Supp. 763, 769 252. Marshall v. Coastal Growers Ass’n, 598 F.2d 521, 525 (9th Cir. 1979) (“The Farm 253. v. Glenshaw Glass Co., 348 U.S. 426, 476 (1955). Comm’r 254. v. John Bommarito Oldsmobile-Cadillac, Inc., 626 F. Supp. 2d 994, 998 (E.D. Bartis 255. late, and to mandate. This means granting the presumption of the presumption granting means This mandate. and to late, requiring chal- Congress, and enacted by to the statute enforceability is invalid. This statute why the particular to demonstrate lengers that protective with the theory is consistent approach bor law, the Supreme Court has likewise recognized this principle of Court has likewise recognized bor law, the Supreme the Supreme when the court stated, “Traditionally, broad construction the FLSA should be circuit courts have noted that Court and the spirit.’” by ‘look[ing] to its animating broadly construed is not engaged in a trade or business. The plaintiff’s reliance on the is not engaged in a trade or business. In each of the three Supreme Supreme Court precedents is misplaced. Court cases titrust law have adopted a similar rationale when imposing burdens of adopted a similar rationale when titrust law have by federal policy broad approach is therefore justified responsibility. A have repeatedly held that legal fictions objectives and by courts that should not frustrate public policy. the question of “trade or business” and Court cases that have examined plaintiff in the argument advanced by the dial of federal law such as healthcare law, of federal law such application of the phrase “trade or business” when, in fact, a broader application of the phrase “trade the distinction in posture interpretation is suitable. Understanding (be it narrowly or broadly) pro- and interpreting the phrase accordingly and provides litigants and motes efficiency, reduces conflicts, of certainty and uniformity. regulators alike with a degree taxpayer sought to access a benefit. In contrast, the equity funds in taxpayer sought to access a benefit. 23, 23 (1987); United States v. Am. Bar Endowment, 477 U.S. 105, 105(1986). Salt Co. v. United States, 55 F.3d 1388, 1388 (9th Cir. 1995). Congressional intent. A broad construction ensures compliance by indi- ensures compliance broad construction intent. A Congressional In tax law, the Supreme by regulators alike. viduals and enforcement construction when the this principle of broad Court has recognized taxing power.” full measure of [Congress’] Court upheld “the ple, the [Migrant and Seasonal Agricultural Worker Protection Act] is to be broadly ple, the [Migrant and Seasonal Agricultural workers.”). construed to protect migrant agricultural Labor Contractor Registration Act is remedial and should be broadly construed.”). Mo. 2009). Sun Capital Partners 2015 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 49 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 108 Side A 09/19/2016 08:25:28 A 09/19/2016 108 Side Sheet No. 37680-fam_11-1 37680-fam_11-1 Sheet No. 108 Side B 09/19/2016 08:25:28 258 M K C Y Vol. 11:1:159 , 480 U.S. at 32 (“We must regard the Frank- ONCLUSION C Groetzinger . Groetzinger FLORIDA AFLORIDA &REVIEW LAW M UNIV. 259 The determination as to whether an activity amounts to a trade amounts whether an activity as to The determination inevitably in- constitutes a trade or business Establishing what Here, indeed, as so often in other branches of the law, the decisive Here, indeed, as so often in other not of kind. One struggles in distinctions are those of degree and will supply a ready touchstone. vain for any verbal formula that is not a rule of law; it is rather a The standard set up by the statute must supply the answer to the way of life. Life in all its fullness riddle. 259. v. Helvering, 290 U.S. 111 (1933) (Cardozo, J.). Welch 258.Frankfurter approach of requiring exclusive goods or services was rejected by The furter gloss merely as a two-Justice pronouncement in a passing moment and, while furter gloss merely as a two-Justice pronouncement in a passing moment entitled to respect, as never having achieved the status of a Court ruling.”). or business is a challenging, daunting, and problematic inquiry. The and problematic daunting, is a challenging, or business that are impre- legal standards working with itself requires analysis have both refused to Congress and the Supreme Court cise and inexact. to leave it to the standard, preferring instead articulate a definitive of each case before de- the facts and circumstances courts to examine course of action when has proven to be a wise ciding. This approach the phrase “trade or differing policy objectives that considering the to promote. business” is intended deemed critical to the and balancing factors volves examining relevant factors may particular activity. For example, operation of a of goods and services, such as the provision include considerations the Supreme Court in the active participation by the proprietor, managerial oversight by the the active participation by the making decisions in the firm, mak- board of directors, instituting policy organization, requiring prior approval ing operational decisions in the marketing plans for the firm, or for capital expenditures, approving In short, engaging in something more hiring and firing firm personnel. involvement in the operations, man- than an occasional or insignificant of the firm is required. The phrase agement, or policy-making decisions standard: an elusive and slippery “trade or business” is an amorphous description and yet elastic and flexible concept incapable of a definitive to promote Congressional policy to provide the necessary coverage circumstance, whenever a search objectives. Whatever the underlying is launched, we must be mind- for the meaning of a “trade or business” who so eloquently captured the ful of the words of Justice Cardozo, he wrote: essence of legal analysis when 208 \\jciprod01\productn\F\FAM\11-1\FAM105.txt unknown Seq: 50 6-SEP-16 15:52 37680-fam_11-1 Sheet No. 108 Side B 09/19/2016 08:25:28 B 09/19/2016 108 Side Sheet No. 37680-fam_11-1