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October 1, 2013
Transcript Available of Tax Analysts' Forum on Implications of Sun Capital

Full Text Published by Tax Analysts®



Washington, D.C.

Friday, September 27, 2013



    President and Publisher, Tax Analysts

    Visiting Fellow, Urban-Brookings Tax Policy Center

    Partner, Akin Gump Strauss Hauer & Feld

    Contributing Editor, Tax Analysts

    Partner, Simpson Thacher & Bartlett LLP

    Professor of Practice, Harvard Law School
* * * * *


MR. BERGIN: OK, everybody we're going to start in five minutes. If there's still people coming up, for the people on the video just a few more minutes. Thank you.

OK, good afternoon everybody. Thank you for coming. Welcome to the latest in the Tax Analyst series of discussions on key issues in tax policy and tax administration.

Today's topic is about the meaning of a recent decision by the First Circuit Court of Appeals, Sun Capital, private equity as a trade or business. I'm Chris Bergin, the president of Tax Analysts, which is the nonprofit publisher of Tax Notes, Tax Notes Today, States Tax Notes, Tax Notes International, and many other fine print and online products on federal, state, and international taxation.

We are in our 11th year of public discussion on tax policy. If you are new to our discussions, let me say it's great to have you here. Let me take just a moment to explain our process today. I will open things up with some brief remarks to introduce our topic. I will then introduce our distinguished panel of speakers. Each of them will address aspects of our topic.

After that, we will open up the discussion to all of you and we encourage all of you to participate. Two of our panelists, Lee Sheppard and Steve Rosenthal, have written articles on today's subject that appeared in this week's Tax Notes. And the editor of Tax Notes, Jeremy Scott, has a blog posting up this week on our topic. They are all available to everyone on our website. The articles are also included inside the folders that you were given as you checked in. I hope everybody got one.

We are streaming live video of this event on our website. That explains the camera in the back of the room. So I want to welcome our virtual audience as well. It's good to have you. We will also post both the webcast and a transcript of today's event next week probably on our websites. That's

For all media purposes we are on the record. For that reason when I recognize you, please tell us who you are. Once I call on you, we will quickly get you one of our handheld mics. We're also live tweeting the event at #privateequity, as we reach more people beyond this room through social media. We invite our listeners to send us questions via Twitter and we hope to hear from you.

I will moderate the discussion and we will end at five. And following that we invite all of you here -- we can't do that to the virtual audience -- to attend a complimentary happy hour with beer and wine that will be held right down the hall to the right.

Before we begin I want to let everyone know that we've recently also released a web series of informational videos on tax that will be featured on our website and YouTube channel. The videos will be available regularly and will include several of our top experts who will discuss various topics. Our goal in creating these videos is to discuss complicated tax issues, demystify them, and provide unique insights into our tax system. The first video's on tax reform and includes myself and Clint Stretch, our senior tax policy counsel. Feel free to check it out as well as a lot of other things available to everyone on including our blogs.

Now on to the subject at hand: private equity as a trade or business in the Sun Capital case. In July, the First Circuit surprised many observers by holding that a Sun Capital fund was in an active trade or business for ERISA purposes. The case involved pension plan termination liabilities that resulted when a brass working company purchased by a fund was forced into bankruptcy.

Two Sun Capital funds owned the company and tried to walk away. The Teamsters Union disagreed and took them to court. The funds, or at least one of them, lost. The court held that one fund was in an active trade or business, not a mere investor. And the First Circuit opinion has been the subject of intense discussions ever since particularly in tax circles.

Now, why should an ERISA case excite such interest from the tax bar, tax policy observers, and the tax community at large? Because of the potential consequences for private equity funds if they are held to be in an active trade or business for tax purposes. And I'm sure we're going to hear more about that in just a few minutes.

Sun Capital could cause Treasury to rethink how it views the trade or business analysis, which an attorney for the Treasury Office of Tax Legislative Counsel alluded to last weekend at the ABA tax section meeting in San Francisco. So it's on their radar.

So today we will discuss the possible tax consequences, if any, resulting from the Sun Capital decision. We'll primarily focus on the trade or business analysis and how it might affect private equity funds in the future. But we'll also explore some of the possible policy implications for both Treasury and Congress and what the future holds for funds and their managers. To do so, we have put together an excellent panel.

I will introduce them in the order in which they will speak, which is not necessarily the order in which they're seated. Lee Sheppard is a contributing editor at Tax Analysts. I think everybody here knows Lee. I would like to take this opportunity to deviate here a little bit and congratulate Lee. Next month Tax Analysts and Lee will be celebrating 30 years of our wonderful relationship together.

I give you the tough act to follow. Steve Rosenthal is a visiting fellow at the Urban-Brookings Tax Policy Center. He'll speak next.

Patrick Fenn is a partner at Akin Gump Strauss Hauer & Feld. John Hart is a partner at Simpson Thacher and Bartlett LLP, and Stephen Shay is professor of practice at Harvard Law School.

That's the order we'll go. Professor Shay is going to react to what a lot of the other panelists have to say. And I've promised Steve that if he needs to address anything that comes up in the discussion we'll give him a few minutes before I turn that over to the audience, the discussion, OK? Here, we go. Lee, would you get us started, please?

MS. SHEPPARD: Yes, one of the things I've learned in 30 years is that tax policy is kind of an intellectual rationale for not taxing people who really ought to be paying tax. And to the extent that we're talking about policy today we're sort of talking about well, do you get to -- do certain groups get to decide their own tax treatment?

And what's interesting about this case and what's sort of shocking to tax people is we get outside the walled garden of tax and we get into courts taking an equitable view of things, courts doing a purpose of reading of legislation and that kind of stuff doesn't happen very often in tax cases. And so, the court here is sort of questioning some of tax thinking if you will that's kind of been accepted.

So if we work back, I'm going to sort of go from the general pension and then work into the tax thinking because really what we have legally, legally it doesn't really have any effect on tax. But it has interesting thinking in it that might inform our thinking about how to tax these funds and their investors.

So when you start with one of these cases, and when I say one of these cases, this isn't a first. I mean, this is like first the tax bar, a lot of them have heard of it; this is not the first time a private equity fund has lost a pension plan termination liability case. And the law that's being applied here is pretty standard. It's been the law for -- the case law that's being applied here has been the law for 10 years in the Seventh Circuit, which has a lot of these cases.

And so, what we're looking at is even though, you know, this is new thinking to the tax bar, this is not new thinking in the area that we're dealing in. So we start with a statute, this ERISA. ERISA has a weird divided responsibility between basically labor lawyers, Labor Department, PBGC, and tax people at the IRS. There is a divided responsibility. There are lots of overlap. There's stuff that we have in the tax code that you maybe think should be in the labor law.

On plan termination liability and we're talking about here in this case, we're talking about a multiemployer plan but the same kind of law applies to single-employer plans. You really, you have termination liability if you walk away from an underfunded plan.

You have in the law a test for what we could call group responsibility or group considered single-employer and that says, well, do you have a sort of controlled group situation? And it can be a controlled group of anything. It doesn't have to be corporations. And it works a lot like what we know as controlled group in the tax law. That is not decided in this case. That's on remand in this case.

And then it says, if we're going to hold anybody in the group responsible, that entity doesn't have to be a real separate legal person has got to be a trade or business. It doesn't have to be in the same trade or business as the obligor, as the responsible entity that's got the underfunded plan liability. So what you have is, you have a broad statute that pulls in responsibility in a group so you can't break your business up into little corporations and say, oh, well, the obligor has no money and have the money over here.

When you go into these cases, you're usually in a bankruptcy situation. What's unusual about this case, this is involuntary bankruptcy. People here know how unusual that is in the United States. The company is in Rhode Island. The private equity management company has $10 billion under management. They have two of their funds: one buys 70 percent of the company, one buys 30 percent of the company. The fund that bought 70 percent of the company has $1.5 billion under management. They paid $8 million for the company. $3 million was equity, the rest was borrowed. The termination liability is $4.5 million and when the company was purchased it was purchased at a discount because of the termination liability.

So you already see folks trying to plan out of 80 percent ownership and understanding that there's termination liability there that they might be responsible for. Then they run the company for a while. You get the impression that there was a bunch of borrowing going on that had something to do with the copper price and that maybe they borrowed on inventory or something because when the copper price went back down after having all kinds of crazy things going on in those years, they violated their loan covenants. So they got shoved into involuntary bankruptcy. They stopped paying the plan and then the Teamsters sent them a bill for termination liability.

The PBGC is also in court there. And the court is looking at, and this is not, I'll get to it in a bit, this is -- how am I doing on time?

MR. BERGIN: You're fine.

MS. SHEPPARD: This is not the first Court that's looked at this. The only thing that's interesting about this situation is the design of the private equity fund is a tiny bit unusual in that in each fund the general partner owns the management company. The investors pay the general partner the management fee but the investors get a full offset for the monitoring fee that the company pays the fund. This full offset thing is not unusual anymore because investors have been kicking up a fuss about paying monitoring fees. And even though it maybe makes tax lawyers nervous, investors are basically asking for hundred percent rebates on monitoring fees.

When we get to court and we've been to -- the unions have been to court on this issue for years. When we get to court we're under that statute. The statute says that the labor people and the tax people, the government lawyers on both sides, have to agree on their interpretations of what is a trade or business and what is a controlled group. So we've got regulations where they basically agree on what's a control group. We have nothing on trade or business because obviously tax people aren't going to make a rule on trade or business because trade or business is idiosyncratic in the tax law.

So what's happened is it's been kicked over to the courts and the Teamsters have been marching into court for years, mostly Seventh Circuit and saying, well, you know, Groetzinger test. Now, people here remember what that case was about. That's the gambler case. A guy goes down to the dog track every day. That is a very minimal test of trade or business. That's did you get out of bed and go to the dog track? Or as the Court phrases it, were you continuously occupied in an activity for profit? Well, pretty much anybody in private equity can satisfy that minimal test, OK?

So that's the test the courts have been applying. And by the time we get to the First Circuit they've been applying that for years. And they applied it in another pension private equity called Palladium which was in the Eastern District of Michigan. That was cross motions for summary judgment. This was also a motion for summary judgment. That's important because you don't want to go in there arguing the facts if you're on the private equity side.

In both bases the courts apply the Groetzinger case in the PBGC memorandum that folks will talk about. The PBGC applies the Groetzinger case but what the PBGC is doing in that -- it's kind of like a letter ruling. It's an appeals opinion. What they're doing in there is they're kind of just taking what's been going on in the Courts and applying it themselves. So it's not really new.

So here we are with all this. And the private equity funds are saying, but no, no, no, no, no, no, we are special creatures of the tax law. We are not in a trade or business because we are investors and we are investors under Higgins and Whipple which are very old investor cases that most people in this room here are familiar with. And the court says, well, you know, you're not going to walk away from this. And you passed the Groetzinger test. You've got substantial activity. You're muddling in these companies. You've got your people all over the board of these companies. You've got your people working in these companies without a paycheck and you are getting returns that are not limited to investor returns.

And this is where the court says, look, you have not, and this is you, not just managers but also fund, the court has to get the responsibility down to the fund because that's where the money is. You, fund, are receiving, you are acting like more than an investor in these companies. You don't have one board seat; you have them all, seven or whatever, something like that. And you are not acting like an investor because you have more than an investor's return and here the court points to the fee sharing.

They're saying effectively the fee for monitoring that the portfolio company is paying through the manager and then the investors get the rebate is fee sharing by the investors. That takes it out of Whipple. So what you've got here is you've got a very minimal trade or business test, which is called investment plus, and you've got the fee sharing, which the court is saying that takes you out of the investor safe harbor that you think you had with the Whipple case. And they also differentiate the Higgins because the Higgins case is just sort of an individual who's babysitting his investments and not meddling in the company.

So the court is -- so what you have here that scares people on the private equity side is that minimal test. But you also have the responsibility over to the investors because in the tax law we usually don't look through the partnership to get to the investors and say they're in that trade or business. But this court is not and this is the objection the funds made. And the court says, well, you know, managers are your agents. This is black letter, yes, partnership law under state's partnership law.

So acting through your agents you were messing around in this business. But they don't say, oh, you're in the copper wire fabrication business. They don't say what business the private equity fund is in. Now, in Palladium, which is the Eastern District of Michigan case, which is almost identical to this case, they said you're in some kind of money management and reorganization business. And the PBGC letter, which this court does not adopt, they say, you're in some kind of money management business.

So where does that leave us for tax? Well, the court is just sort of upsetting a lot of assumptions the tax people have had for years and years and years about what test applies and really the court is also saying, you know, certainly for pension purposes, you don't get to pick your own test. And so, when we go back to the tax law and we ask, well, do you get to pick your own test or have we picked the right test for this group of actors?

MR. BERGIN: Thanks, Lee.

MS. SHEPPARD: Thank you.

MR. BERGIN: Steve?

MR. ROSENTHAL: Thank you, Chris. And thank you for hosting this conference. Let's just start, what is a private equity fund? They make their money by acquiring new or struggling companies. They generally buy a block of stock. They develop or improve the companies and then they resell them at a higher price through some exit strategy.

This has been a phenomenally profitable enterprise. The size of the private equity industry has grown to $2.5 trillion. Exploding exponentially, the Sun Capital observed. And an overarching both tax law and policy question is what are we doing about the private equity industry? And is this growth an explosive development, something that we intend? Or is something that's happenstance and should policymakers think about this?

I've tried my best, first in an article in January and then in an article published by Tax Notes this week, to try to demystify what private equity funds do and explain the legal framework and some of the policy concerns. There are many different views on both the law and the policies that are implicated here. Some of which I find quite credible and others of which I really question.

Today, we're here to talk about, as the invitation suggested, whether private equity funds are engaged in a trade or business under tax law in the wake of Sun Capital. I think the answer to that question is clear, yes. Private equity funds are engaged in a trade or business.

The surprising thing to me is that Sun Capital merely observed the obvious: that private equity funds engage in a trade or business. So at some level the decision is not profound. Well, of course. The Sun Capital decision relied heavily on applying tax law principals in tax cases. It started with the PBGC administrative ruling, 2007 ruling, that articulated a framework of let's look at Groetzinger, the two prong test. And let's think if we're disturbed at all by Higgins and Whipple.

And the First Circuit embraced the PBGC approach, finding it persuasive. They borrowed a lot of the tax interpretations from the leading cases and I think by and large borrowed them and interpreted them correctly. They cautioned that tax interpretations would not always control ERISA.

So the court is reading tax cases, Groetzinger, Higgins, and Whipple, finding their answer that -- the First Circuit answer that private equity funds are a trade or business to be consistent with those cases but just warning people that tax law will not always determine the ERISA consequence. Interestingly, both in the administrative ruling and before the First Circuit, the private equity funds argued the tax law should control. And in the amicus brief filed when the industry association asked for the design to be reconsidered, they observed in reliance on a couple of these cases, Higgins and Whipple cases, they said for decades investors have relied on the fact that making and deriving income from investments and paying professional managers to manage those investments does not constitute a trade or business for purpose of the Internal Revenue Code.

I think this, and then they added when they talked about fee sharing, they said, well, that's consistent with the role of a passive investor and is supported by widespread industry practice. That's not much authority, widespread industry practice. Lee highlights how much are we going to allow the industry to set its own rules and I think she's framed an important question.

The bottom line in my observation is the First Circuit correctly relied on tax precedent to find a trade or business. And to be clear, in my view, private equity funds were in a trade or business before Sun Capital. They're in a trade or business after Sun Capital and just simple application of the tax law would have you find a trade a business.

Now, Lee mentioned in passing that there was something funny about what happened with the attribution of the general partners' activities to these passive investors who are surprised to find that their income could yet be tainted by the attribution of trade or business. Well, that's partnership taxation. It's been with us as long as subchapter K has been with us.

The determination of the character of the income is at the partnership level and the attributes flow through to the partners. It's not a hard thing. And it's the right thing, of course, because remember there's no entity-level tax on this activity. There's no corporate-level tax and our expectation is the attributes pass through and the partners will report the attributes as received.

Now, there is an issue also of the notion of well, what business are the private equity funds in? They don't have any employees. There are no offices. Well, the First Circuit had no problem looking through that question and attributing the activities of the funds' agents and contractors to the fund. Of course, a fund is merely a legal formality. It doesn't have flesh and blood. You've got to look elsewhere to determine its activities.

This is not a hard step for the First Circuit to take. And it wasn't just an ERISA determination. Yes, ERISA allows piercing of corporate veils. And yes, if the court had wanted to they could start looking through a variety of entities. But the court explained, without resolving the issue of the extent to which Congress intended in this area, the ERISA area, to honor corporate formalities, they thought normal agency law, restatement of agency law, and Delaware law established that the private equity fund was in a trade or business. No need for anything special in ERISA. And it's a self-evident proposition that you'll find echoed in loads and loads of case law.

Now, let me just say one thing about the test. Lee suggests that Groetzinger's a minimal test. I don't think it's so minimal. I mean it requires continuity, regularity, substantiality. We apply that test everywhere. Just this week a securities trader was not found to be a trade or business because a thousand trades a year was insufficient to be a trade or business.

There's a threshold there. But the private equity funds exceed that threshold. The level of their activity is just astounding. They tell their investors that they're going to exert all this effort to make money on their behalf and they go out and do it.

So you've got Groetzinger, which is the most recent and comprehensive discussion of the trade or business question. I think it's fairly simple to conclude that private equity funds are a trade or business. When I wrote my first article in January, I thought it was pretty simple. I was surprised there's even a hullabaloo after the Sun Capital case.

The capital gains implications I think are harder. Reasonable people differ from me on the law and the policy on how to think about whether or not this income should be capital or not. Whether the income should be effectively connected income to a U.S. trade or business or not -- I can see both sides of the issue. Trade or business I struggle with. I just don't see it.

This is not a well-established and accepted interpretation of the tax law. To look to Whipple and Higgins, this is the private equities' interpretation and only them. Look at hedge funds. Every hedge fund in the country, there are 10,000 of them, all of which apply Groetzinger to determine whether they have above-the-line deductions or under trade or business or not. Same structure, they run their activities through the general partner and they can apply Groetzinger without much trouble. They understand it.

And the curious part to me is the exultation of Higgins. If you look to Groetzinger, which is actually a thoughtful decision, the most recent one and quite lengthy, they cite Whipple twice. They cite Whipple for a "see also" and they cite Whipple for a quote on the origin of the distinction between trade or business income and production of income. Not an important case in the context of things.

Higgins -- the U.S. Supreme Court in Groetzinger explained that Higgins was devoid of analysis and did not set forth the elements of any besides profit motive and regularity that requires a trade or business. It was only until Groetzinger that the Supreme Court grappled firmly with the notion of trade or business and resolved it, I believe, correctly in a test that's both administered and is often applied and applied effectively.

So let me say, I think it's clear to me that private equity funds are in a trade or business. The level of activity is astounding.

Trying to play a shell game of where's the activity under this shell or this shell or this pea or this one, I don't think makes a difference. And I think if you look to their business, my own view, and I articulated this in the January article, was that the trade or business is one of development, corporate development.

They buy businesses. They repair businesses. They resell businesses and it's all designed as a profit for the efforts that they put into turning around these companies. And that's what Sun Fund planned to do with Scott Brass.

Sun Fund planned to profit from their turnaround efforts at Scott Brass, not from the independent success of the metal business. As one of my former colleagues observed, it is one thing to manage one's investments in business. It's another to manage the business in which one invests.

So I'll stop there with the notion of this is not a tough question. We're here to talk about trade or business and whether a private equity fund is in a trade or business or not. I think Sun Capital's analysis, if you read it, is pretty straightforward and correct. It could be improved as I write in my article. But whether you think Sun Capital influenced the debate or not, private equity was in a trade or business before. Private equity is in a trade or business after. The only question is what do we do about it from a tax policy standpoint and I can discuss that but I'm getting the hook. So with that, I'll stop.

MR. BERGIN: In order to give you time in case you need to respond, it's a very gentle hook but thanks, Steve. Pat?

MR. FENN: Yeah, I think if the Sun Capital decision were a Shakespearean play you would be hard to classify it as a comedy, a tragedy, a history, or a drama. It's got a little bit of the elements of everything and I think Lee's summation of it points that out.

It's also interesting that Sun Capital as you've heard is not an income tax case but it seems like all of the important discussion about it is its implications for the income tax law. What you don't hear about is what seems to me to be very serious concern for sponsors and private equity investors and that's the ERISA liability that the court found that the funds might have.

Of course, the decision is not final in the sense that it's been remanded to determine whether or not there is a control group with respect to the ownership of Scott Brass. And that decision might even be a harder decision to come to. So there's still the end of the story to come.

But getting back to the issue at hand as to the implications of the decision for private equity. I think that that Sun Capital court believed that the fund clearly went beyond being a mere investor based on what it thought were principals of the income tax law that it reviewed in its decision and applied in a way that went to find that this particular private equity fund, in fact, stepped over the line to being a mere investor.

Now, the Whipple and Higgins line of cases that the tax bar traditionally looks to, I think we sum up by saying that an investor that puts capital into a company or an enterprise can spend as much time as it wants to managing that investment and making sure that the investment is performing without being engaged in a trade or business. The court thought that because the private equity fund, by virtue of the activities of the general partner and the affiliates of the general partner, went beyond being a mere investor because it spent a lot of time, as you heard, at the company level figuring out how to position the company to enhance its value.

Now, just stopping with that point, I wouldn't have thought that that type of activity, activities that the investor undertakes to protect, manage, and enhance the value of its investment would go beyond the Whipple or the Higgins investor standard. So that on that principle, I'm not aware of any case that says that the mere promotion to that or development of your investment by undertaking activities to enhance its value is a trade or business no matter how active you are in that regard.

The other aspect that you've heard about is this agency aspect which, again, based on the current law, and I think it's important to keep in mind that there may be valid policy considerations, as tax lawyers advising the private equity firms, we deal with the current law. And I have never seen a downward attribution case like this in the income tax area where the activities of the partner were imputed to the partnership to find the partnership was actually engaging in the activity.

And I think, in fact, the Sun Capital court directly or indirectly recognizes that because it goes on to the second point, which is maybe more to the point that under normal tax principals, if you derive a return that's not consistent with being a mere investor, that is the income off the investment and the potential appreciation, then you might be in a trade or business. The court went on to look to this management fee offset arrangement that the Sun Capital funds had with the manager.

That arrangement is simply that if the manager charges the portfolio company a fee, it will not receive the same amount of fee that it's otherwise entitled to receive from the fund. The notion that that results in economic benefit to the fund and the investors is strange to me because as an economic unit you can pay it out of your left pocket or you can pay it out of your right pocket but you're still paying the fee. So the notion that the fund or the fund investors derived some kind of benefit from that offset that expands the activities that the fund is undertaking I think is surprising.

Now, I think Lee either mentioned in her paper or today that this case to me is result oriented. And it may be that the court felt that the behavior of the sponsor was such that it should be liable for the withdrawal liabilities.

But my point is that applying strictly the stated law as it exists, it is surprising to me as a long term practitioner in this area that the court could find that there's a trade or business by the fund. Not saying that the manager may not be in a trade or business of providing management services, but again, to impute that to the fund might be a first. At least, I'm not aware of any case that has done that.

So but I think the other implication that maybe the first question is why is this important? Why does it matter if Sun Capital is engaged in trade or business from a tax standpoint? You know, we know what the implications are from the ERISA perspective. They can be serious but from a tax perspective what is supposed to happen to the investors if, in fact, the fund is engaged in trade or business. And I think the government might be a loser in that result more than a winner.

And I say that because I think the implication, well what I think Steve and Lee want to believe is that the implication would be that the income of the fund would be ordinary. And therefore, would not be entitled to capital gains treatment and I don't think that that would actually be the result because, and I don't think they do either. I think Steve's point is that policy considerations may dictate that that outcome be re-looked at.

But the point is that the stock is a capital asset to the fund and the fund does not have customers, doesn't hold this property as inventory or for sale to customers and therefore it would still be capital gain on a disposition. Turning it into a trade or business might just permit the domestic taxpayer investors to be able to deduct their share of management fees that are paid by the fund.

So I would think on the basis of the current law, I'm not sure without some change in law that there's much of difference to the fund, the fund sponsors, fund investors from finding that the fund is engaged in a trade or business.

MR. BERGIN: Thank you. John?

MR. HART: Thank you and thanks for organizing this panel including me.

MR. FENN: Especially on Friday afternoon.

MR. HART: When Steve talks about policy in his remarks just now, when Steve mentioned policy, the policy he was talking about was whether private equity is good for America, is good for the economy. He wasn't talking about tax policy.

I think tax policy is about treating everyone the same, applying the same rules to everyone regardless of the nature of their activity. And I think if you apply the same rules to everybody it's clear that none of the bad things that have been mentioned, ordinary income, UBTI for tax-exempt investors, assertion of U.S. tax jurisdiction on foreign people, none of those things can happen under current law under the rules that apply to everybody; as a result of the Sun Capital decision or in light of the other case law about trade or business.

As others have said, Sun Capital is an ERISA case. It's kind of curious that we're all gathered here to talk about an ERISA case and its implications on the income tax law when there's such a huge wealth of case law on the income tax law establishing the rules. But it has generated a lot of interest because it involves private equity and because it reaches a conclusion against private equity, so I understand that.

The case itself focuses on two factors as has been mentioned. One is the extensive, intimate involvement of the fund in operations. The other is this fee offset. I don't think either of those things has anything to do with the tax law treatment of gain on sale. The statute requires that the gain be on property held primarily for sale to customers in the ordinary course of business.

Even if you have a trade or business it doesn't mean that your gain on sale is ordinary. Lots of dealers have identified investments and they get capital gain once they've identified the investments. The mere presence of activity couldn't possibly make a difference. Steve talks about it in his writings; hundreds and thousands of employees and an astounding amount of activity is what he mentioned today.

The exact same thing is true of mutual fund sponsors. You have a Fidelity, a Vanguard. They have hundreds of employees engaged in activities to further the cause of those funds. It's the mere existence of a staff of employees that are involved in raising money, accounting, administering funds. That can't possibly be what makes the difference here.

So I don't think that factors cited in the Sun Capital decision really go to the question of whether you get capital gain. I think it's crystal clear that under current law that if you buy stock of a company, plan to hold it for several years, and then sell it, that you don't have ordinary income. You're not holding that primarily for sale. And that's true even if you have some people that to the portfolio company managers, the portfolio company personnel from time to time. That's true even if you have all the directors on the board because you own a hundred percent of the stock and you exercise your rights as a board member.

There's nothing about that that causes your ownership of the stock to turn into inventory and therefore get you ordinary income treatment. Steve has mentioned on occasion -- I'm sorry, before I move on to that I will point out that what the court said about the extensive intimate involvement of fund personnel in the portfolio company operations is really not, in my experience, typical of what fund sponsors do.

Typically, they have a very lean staff. They have a handful of people who will work on a deal, carry out the deal, and have maybe one or two people with some ongoing involvement to communicate with the company personnel. The idea that these hundreds or thousands of employees that Steve mentioned are involved in running the business is simply not the case. That's now how any private investment fund deal has worked that I've been involved in.

The other thing I'll mention, I don't really buy this idea that the fee offset confers some kind of -- that makes a difference. It puts the fund in a trade or business. There's nothing wrong. It's completely commercial for somebody to enter into a management agreement with an adviser that says, I'm going to pay you one percent of capital under management every year. But if you get income from other sources, I'm going to be able to reduce that amount by some or all of that other income.

I don't think that says anything about the nature of the activity of the fund. It doesn't mean that the fund is doing something different now. That's just a commercial arrangement. We all have health insurance policies where if our spouse's health insurance pays for the doctor visit for the child, our insurance company doesn't have to pay. That sort of coordination of benefits, those sorts of arrangements, there's nothing about that that means that the fund is getting a benefit and should be subject to a completely different tax regime.

The last thing I'll just comment on briefly the idea of this developer theory which you have may read about in some of Steve's writings. I think it's a clever theory and if you don't like private equity and you're looking for ways to change the rules, it's something that's worth talking about perhaps. But honestly, the development that goes on isn't all these hundreds and thousands of people. It's a pretty more limited role and a mutual fund has people and it may have board of directors' seats and it may engage in activism and no one's talking about mutual funds not being able to deliver capital gains to their shareholders.

The fund buys stock. It holds the stock for many years in many cases and sells it. And sure, they're going to try to improve the business at the beginning. They're going to maybe bring in new management. They'll maybe restructure the capital but they're holding it for appreciation. It's quite different from a real estate developer who buys raw land, subdivides, builds houses. The value results from the transformation and is immediately present. And they sell those houses as fast as they can if they're lucky.

Private equity funds, it's a multiyear process. The value isn't there on day one. It's a long-term appreciation. That's what capital gain is all about. So my conclusion is I don't see the Sun Capital analysis really changing any of the important tax issues for private equity. And I do think the government may lose because not only are the deductions ordinary instead of itemized and Patrick mentioned but the losses have become ordinary, too.

If you really think that the gains -- the reason there are all these developer cases involving bad debts is that people wanted to take deductions for them and they usually lose. Well, now they'll be able to take ordinary deductions for their equity losses as well as the debt. There really is no case out there right now under current law, no case, applying this developer theory to treat the gain on the sale of stock as ordinary income. It's just as clear as day that's the law and people may want to talk about changing it but it would be a change.

MR. BERGIN: Thank you, John. Steve Shay, where are we?

MR. ROSENTHAL: Would it make sense for me to answer? I'm sort of outnumbered here three to one so at what point do you want me to respond to these --

MR. BERGIN: We'll let Steve first and then I'm going to come back to you as we agreed.

MR. SHAY: Well, I actually am hearing some greater degree of agreement than maybe some others are hearing. Sun Capital is an ERISA case and it really is quite important on that basis alone. And I think Patrick indicated and others have indicated that. Let's not lose sight of that.

But we're really here, I think, because of what Sun Capital may say about the income tax. And particularly the income tax keeping the focus narrow as it applies to private equity funds. And when you think of private equity funds, you think of at least three categories of potential taxpayers; U.S. taxpayers, U.S. tax-exempt taxpayers and non-U.S. taxpayers. And each of those groups of taxpayers is subject to different sets of rules with some considerable overlap but they're not all the same.

The issue that Sun Capital is raising: Is is a private equity engaged in trade or business in the particular context of the ERISA statute that was before the court? It's the way they did the analysis that is raising the question why we have as many people in the room as we do. They look to income tax cases and principals. They explicitly said what most courts say which is the definition of trade or business can be different for different purposes. That's first. So that's the initial question even though they were looking at income tax cases.

And we also know that trade or business in any of the cases we do see it is intensely factual. I'm quite nervous about making broad statements about private equity funds in general because there is indeed a spectrum of activity. And we've had it characterized differently here. One argument is that Sun Capital's at the end of the spectrum. That may or may not be but there is a spectrum in terms of the degree to which sponsor groups treat as part of their business, mode of doing business, getting involved in the activities and business of the portfolio companies. There are sponsor groups that on their websites make an important point about the extent to which they have on staff operational executives. There are sponsor groups that basically don't do that much with their portfolio companies.

So when we come to trade or business and particularly when we apply the analysis of Sun Capital it matters a lot. We're lawyers here.

We're not doing policy. So how this will play out will depend to some considerable degree on what the next case and what the context is. Where are the dollars?

The dollars are largely in whether or not gains on the sale of the stock would be treated as taxable. As ordinary income to the taxable U.S. investors, whether it's possible they could be UBIT to the tax-exempt investors and whether it's possible they could be effectively connected gains to the non-U.S. investors.

But before you get to the capital gains issue which I think we should get to. That's really where we want to push this discussion more analytically, having a trade or business alone at least in the international side is quite significant particularly if there's a dollar of service income. U.S.-source service income, if for no other reason than it will require your foreign investor to file a U.S. tax return.

So the people in this industry have known for years that there's risk with the management fee offset. There's been pressure from investors that's pushed the management fee offset up to 100 percent offset. I think it matters. Is the offset because you're getting a fee for performing traditional consulting services to a portfolio that served clearly a service? It matters for how you think about potential effectively connected capital gain possibly.

But if you have a dollar -- if the Sun Capital analysis is pushed and it were concluded in an income tax context that a private equity fund management fee offset should be treated as income from services, then that's going to affect the foreign investors. Maybe there is a -- most often there is a representation saying we're not going to cause you to be engaged in trade or business or if we are, we'll give you an alternative, a form of blocker.

Sometimes there's a carveout for the management fee offset. If you have that carveout then no sponsor funds may not be affected so much but the investors. So this affects that side of the equation under any of our discussion I think of Sun Capital if Sun Capital's analysis is pushed over to the income tax side with respect to the management fee offset and you can just interpret it as services income particularly if the services are performed in the United States. That's all an if but that part of it, I think there's a different risk profile today than there was before that case was decided and to say otherwise is not being, I think, objective about it.

Now, we move to capital gains. When we move to capital gains, the statute says, you exclude from capital gain treatment a capital asset as a capital asset property held by the taxpayer primarily for sale to customers in the ordinary course of its trade or business. So in addition to trade or business you have sale to customers and you have a somewhat different line of case and way of thinking about that with respect to sales of stock than we do for some other assets.

We have a traditional notion of is somebody a trader, I'm sorry, is somebody an investor, is somebody a trader? You can have a trader with a trade or business. You still may not have capital gains unless you're selling in the ordinary course of your business to customers.

To me, the most interesting part of the work Steve has done and it was in his first article, going back and looking at earlier history and saying, have we had a concept of customers that isn't quite right and is it possible that in the context of private equity funds, the way they normally carry on business with the amount of sales they do, that they may indeed be treated as selling to customers?

The risk here for the taxpayer side is if a private equity fund is indeed selling to customers such that it would be considered in the nature of a dealer, then the capital gains is affected because that then becomes ordinary. The effectively connected rule is affected because if you're a dealer then almost certainly the gain is attributable to the activity of being a dealer if it's a trade or business in the United States.

And finally, and this is the area I know the least so I want to be the most cautious but I think even unrelated business income tax is affected. Normally, tax-exempt is not going to be taxed on a sale of stock no matter what the trade or business aspect but if it's a dealer, then it's not clear to me that you're protected from UBIT.

I think that's all I would have to say at this point. I'm happy to chip in later.

MR. BERGIN: That's a good summary. Let me interrupt here for a second. We are sensitive to getting the audience engaged as quickly as possible. Everybody here is our guest. However, based on the -- I promised Steve that I would let him not feel as if he was isolated. And based on the amount of scribbling that's going on up here, I think it's only fair that I let the panelists engage each other before I get to the audience.

But we will get to you. I would ask that you please, Steve Shay said we are all lawyers up here. So with trepidation I ask that we try to keep our points brief so everybody can get in. Steve?

MR. ROSENTHAL: Well, thank you. And Chris, I don't think you helped me on the feeling isolated part.

MR. BERGIN: You're not. You're with me.

MR. ROSENTHAL: But you would give me an opportunity to answer some of the assertions that are made here. I've tried really hard to articulate my views in my articles. This topic is simply left unsaid in the private equity community. They don't want the topic generally discussed and there's been very little attention to the issues of how to look at private equity. And I've tried my best to get my views out there in writing.

On a few points, small points in order with respect to Patrick who said that he could think of no situation for attributing activities of a partner, a general partner, to a fund and then on to limited partners, that's just 702(b).

That's the way our partnership tax rules work. We have 10,000 hedge funds, for example, who act through their general partner. I think hedge funds typically don't, the fund itself, don't have employees or offices. The general partner does all the trading and we figure out whether or not that level of trading is sufficient to be a trade or business by attributing the activities of the general partner to the fund. So this happens a lot.

On a related point, John went into Fidelity and mutual funds. And not sure I'm addressing precisely the points he made because I was a little puzzled, confused a little bit, but Fidelity -- the way an open-end mutual fund is organized, the open-end fund itself just issues shares and holds assets, stocks. The activities of the fund are run through an investment adviser, with an investment advisery contract approved by shareholders. All the business and operations are in fact through the Fidelity adviser. You wouldn't find employees or offices in the shell itself.

But here's the trick. Fidelity, the fund, isn't a trade or business. It doesn't have any offices, doesn't have any employees. The way our tax rules work with financial intermediaries is that the activities of the agents or contractors are attributable to the fund itself. That's just the way it works. And it's done through these agents and independent contractors for good business reasons to insulate the exposure of the shareholders or partners who hold assets from some of the liabilities that might arise from the activities of these agents or contractors. That's just how we do it.

Now, with respect to John's point of capital gains on mutual funds, by no means do I question whether mutual funds have capital gains or not. Of course they have capital gains just like lots of investors, they have capital gains.

In my first article I devoted a lot of energy to describing there's a couple of prongs to think about for capital gains or ordinary income.

As Steve Shay described, first you think about a trade or business and next you think about whether or not the "to customers" has been satisfied. And I describe the history from 1924, 1930-1934, the evolution of the definition of capital asset and its exclusions and explain why the "to customers" notion really is designed to distinguish financial intermediaries, taxpayers that develop and sell property from those taxpayers who are not providing any intermediation services.

It's not your corner grocery store. And so, that's why you'll find a securities dealer or a market maker who will know who's on the other side of their electronic database buying and selling their stock. They have customers. You don't have to think or visualize the customers.

And let me just end with one last point. John suggested that I was discussing private equity policy and not tax policy. Let me be clear, these are my tax policy views. The overarching issue in my view with private equity is are we choosing to subsidize private equity deliberately or not. Remember private equity funds are partnerships. There are no taxes paid by partnerships.

The partners are overwhelming tax-exempt institutions and foreigners. We are not collecting any UBIT. We are not collecting any withholding tax on ECI today. This is one of the -- there's only one other circumstance I can think of in which a trade or business is not subject to any level of tax. And that was a circumstance with Congress deliberately intended to create a tax regime to relieve taxation on a particular trade or business.

If we want to subsidize private equity funds, Congress should enact a statute to do so. But until we do so, we should apply the laws that Congress wrote. And it's not an imaginative argument on my part to find a trade or business. I don't think that's a difficult issue. Reasonable people disagree with me as to what you do next. And I certainly can understand capital gains versus ordinary income policy, UBIT versus non-UBIT policy, ECI versus non-ECI policy. Reasonable people take a different view from me on both the law and the policy as to where we go once we have a trade or business.

But our policymakers should focus on this issue and not just watch $100 billion industry go to $2.5 trillion. I think they get the message. Earlier I think it was Lee who said the Treasury staffer said in both BNA and Tax Notes and Bloomberg there's a recognition that the court's decision may give us an opportunity to reassess what trade or business means. I welcome a deliberate reassessment. And I don't think it's so much a reassessment but a waking up and applying present law.

MR. BERGIN: Lee, did I see you wanting to get in here?

MS. SHEPPARD: I'm fine right now. I'm just writing stuff down.

MR. BERGIN: All right. Anybody else?

MR. FENN: Well, when I was referring to the attribution I was referring to the management activity itself of a third party or the fees that that party might derive being attributed to -- it's not -- I have no -- the end result for a hedge fund is that it turns over -- it's engaged in business because the courts have decided that if you turn over your portfolio enough and engineer it enough, you can be in a trade or business. That's also a court-made law for I think the -- because the courts were sympathetic to losses that traders were recognizing expenses of generating that income.

So what I was referring to, Steve, is the notion that the services that are provided by and independently contracted for manager being imputed back to the fund, I don't think that that's the same concept that the end result that the fund trading its portfolio or otherwise requires an imputation of that activity.

I guess I'm also not quite sure what, back to the question of what trade or business you think the funds are in. I know you've called it a developer theory but it's still hard for me to distinguish that from the fact that what has happened is a pool of capital has come together. It's invested in corporations around the United States and other business enterprises. And there is a level of activity to protect, manage, and enhance the value of that. But as John has said, almost inevitably that value rises over a very long period of time.

What is it that disturbs you that has the same capital gain treatment that a passive portfolio investor has when it acquires an investment on say, an exchange, holds it for the requisite period of time, and gets long-term capital gain treatment? I'm still not clear why that is offensive from a tax policy or other policy perspective --

MR. ROSENTHAL: Well, nothing is --

MR. FENN: -- especially based on current law.

MR. ROSENTHAL: Nothing is offensive. It's just a question of what tax rules would we like. And so, what business are they in? I think a private equity fund is in the business of corporate development as I described in my first article. The First Circuit stopped short of that argument. The pension fund lawyer actually found my article in her reply brief, got carried away with some of the arguments, and there was a motion to strike some of the arguments and that was unfortunate. I would have liked to have seen the developer argument addressed as well.

But having said that, look, private equity funds hold themselves out to the investors, the private placement funds then memos, and they tell people they're going to go in, buy companies, turn them around, and then sell them. Steve rightfully admonishes me. You know, I get carried away.

It's not every private equity fund. This is a facts and circumstance. John is correct. There could yet be some funds with fewer rather than more employees and the like. But remember these are employees of the management company or the general partner that are going into the Scott Brasses of portfolio companies. They are not Scott Brass employees.

And the question that you have to ask at the fund level is whether or not the level of activity satisfies the Groetzinger test of continuity, regularity, and substantiality. That test should find across the line for real estate, international, Dagres found it. You make a point, Patrick, on the notion of well what about an independent contractor?

Look, I don't think that's much of an issue. We routinely deal with this in real estate cases where you act through an independent contractor or international tax cases in which you act through an independent contractor. The First Circuit cited a case, Boeing that they, I suspect, got from my article, in which a tax case finding ordinary income, the taxpayer did nothing with respect to the timberland it owned. Contracted out for someone to cut the timber, get the timber to market, sell the timber, practically nothing, the court said. Yet these independent contractors created a trade or business for the taxpayer.

And of course, that's the right answer. I give a housing example in my article. This is really not a hard question, I think. What makes it striking is the private equity world has followed a path that I find unsupported by either the statutory framework or the U.S. Supreme Court cases. And so, as we evaluate this the question is should we go out of our way to grant relief for the private equity funds by statute or administrative fiat or should we continue to watch them grow?

MR. BERGIN: Lee and then Steve Shay. I see John obviously had his hand up. Can I go that way?

MS. SHEPPARD: Yes. I just want to go back to the [indecipherable] point, and I don't think you have to worry really about growth because if the zero interest rate policy ever ends, that is a big dent in the economic equation for private equity.

Getting back to that, I've written a million articles about hedge funds and there a lot of them are in what a lot of people would argue, including me, is a lending trade or business in the United States because they're buying bank loans really fast or they're even negotiating them. And there was never a discussion of, oh gee, if we get found to be in a lending trade or business in the United States that there wouldn't be blowback to the foreigner investors.

Also, when hedge funds are thinking about their, because private equity funds don't have these, but hedge funds do have individual investors who are subject to 2-12 and there's a lot of people who on returns want to and there was a return instruction that sort of allowed you to take a position that well, the limiteds are in the same trade or business as the fund is or the fund management company or somebody. It was a downward attribution even though and we have a little bit of downward attribution in the Dagres case but we're only going down from fund to general partner. We're not going back down the limiteds.

But here's my mundane point about all that. We don't have a rule on that. I mean if we're sticking within subchapter K, subchapter K, we get statutes that measure stuff at the entity level, we've got an aggregate concept of partnership for a lot of purposes but we don't have an all-purpose overarching sort of rule of construction that says, thou shalt not never downward the attribute. We don't usually do it. It happened in the Dagres case and that was a little surprising but that's a result-oriented decision, too.

But I just don't see anything in what we know about subchapter K that stops a court that wants to do that regardless of whether it's a good idea or not. I don't think we've ever thought that through because we've only, you know, in tax years this is kind of like dog years. Thirty years is not a long time in tax policy law development years and we've had hedge funds and private equity. But we've had private equity funds not in partnership form but we've had these things in partnership form for what, 20, 30 years? Something like that? And we haven't really thought through the whole big partnership idea. And how much downward attribution are we going to permit? Or are we going to permit it at all?

But I don't see any prohibition if a court wanted to be creative.

MR. BERGIN: Interesting. Steve Shay?

MR. SHAY: I'd like to try and put a framework around the discussion because I really think there are two major categories of effects potentially. One, the issues that we have in Sun Capital come out of the private equity business model, which is different from the mutual fund business model. And the biggest difference that in light in the context that we're talking about is private equity funds go in and have an active management and also earn a stream of fees that mutual funds do not earn.

And let's just think of it conceptually. Some private equity funds engage in active, what you might even think of as traditional business consulting for the portfolio companies. And some, a larger percentage of funds take out deal fees. And those deal fees are a significant part of the economics of the business model as it exists today.

If the man -- that is not a happy outcome to the investor so they have management fee offsets. If the management fee offset is creating this problem, it is an addressable problem. So I think of one but you have to rejigger the economics of the current business model. But that's completely capable of being done. So that is, I think, the narrow private equity aspect of this.

The bigger issue that I think is being raised -- just want to make sure it wasn't coming in my direction. The bigger issue that Steve is raising is whether the capital versus ordinary distinction that we thought about historically in the sale of stock world is different than we have been thinking about it historically. This was explicitly in a footnote not picked up in the Sun Capital case. And I'd like to see us sort of, I think maybe not today, but in terms of that discussion, I think we need to resolve that just from a point of view of good tax administration because people need to know are these dealers or are they not dealers?

And that just really isn't the Sun Capital case. It was excluded but I think if we could -- I think those are the two major issues.

MR. BERGIN: Thanks, Steve. John?

MR. HART: Well, I -- maybe I'll just be repeating myself so I'll -- but I don't think however much you do at the fund level and you can attribute all the activities of the management, of the sponsors' people, whatever, however much you do, you still have to ask the question is this a deal or activity as Steve Shay said. And the fact is in really all of these cases there's no argument to be made that these are dealer transactions.

They're multiyear investments. It doesn't matter how much fix -- look I own Microsoft stock. My law firm does work for Microsoft. Does that mean if I sell it I can't get capital gain? I mean, just because you're performing services for a company doesn't transform the gain on the sale of the stock into something different. It doesn't matter if the fund is in a trade or business. The question is under current law, under the Internal Revenue Code, is it primarily held for sale to customers in the ordinary course of that business?

And really, you just, if you have a multiyear hold and given the amount of "development activities" that you could find, I just don't think there's any case to be made that it's a dealer transaction.

MR. ROSENTHAL: Well, John, private equity funds in my view are fundamentally different than investors. I wrote a whole piece in January on this point. And as I mentioned before, I had a colleague who framed the issue I thought nicely, that there's between managing your investments in businesses and managing the businesses in which you invest.

MR. HART: But I say there is no difference between those two for capital gain under current law.

MR. ROSENTHAL: OK. I'm happy to address that. I think there are two separate questions --

MR. HART: There's no case --

MR. ROSENTHAL: Actually, it's quite -- I wrote a whole article on this piece. The question is whether or not there is financial intermediation or not. And the case law, actually the legislative issue, the statute itself describes how Congress added the words "to customer" because that's what we're arguing about now. We're not arguing about trade or business.

MR. HART: It's primarily held for sale to customers.

MR. ROSENTHAL: To customers, OK. Would you agree that we --

MR. HART: And there's no case --

MR. ROSENTHAL: Would you agree that we have a trade or business here? See, I once debated --

MR. HART: No one -- no --

MR. ROSENTHAL: -- Andy Needham. I tried to talk about the trade or business issue which I think has implications across the tax law Steve Shay has discussed. And we kept shifting back to whether the second half of the capital asset definition was satisfied. I can address that it will just take some time.

The words "to customer" primarily held for sale to customer was added in 1934 because Andrew Mellon and a few rich Wall Street types were selectively taking their losses. And they were selecting them, they were creating them as ordinary. And as a consequence Congress said, no. We want them to be capital. Let's add the words "to customers" for transactions that are anonymously through the exchange and are not in the nature of any kind of intermediation activity or development.

You can find there's -- I've cited I think [indecipherable] describes this point. There's a case contemporaneous to the legislative history I cited in my first article describes the statutory framework correctly. There's a case, Katz, that describes the notion of promotion and turning development activities into ordinary income. And real estate which is at the heart of a lot of the congressional thinking in the '20s and '30s, you subdivide property, you improve it, and you sell it, it doesn't make a difference whether you know who's going to wander into your business or not. You have customers.

The subdividing of the property, you don't need to know whether you're ever going to see the newlywed or who the newlywed is going to be. This is not -- look -- I will acknowledge you have a perfectly sensible view that you might not think there are "to customers". Some of my most respected friends and colleagues will take that view. It's a reasonable view.

I think the better view is the other side of a law. I refer you to my original article because we could have a separate debate on capital gains or not. But today the topic was are private equity funds in a trade or business? If they are in a trade or business we have big questions to address. Effectively connected income, there's no "to customers" there. Is a trading safe harbor available for lending activities? No, according to IRS.

Should it be available for private equity activities? We don't know. But in any event, there are many, many questions once we decide that there's a trade or business. And I'll acknowledge, yes, there's a good view, a different view on whether "to customers" exist. I frankly have a hard time finding a solid view as to whether or not a trade or business exists. I think it exists and I struggle to find a sensible argument otherwise.

MR. SHAY: Can I just make one point of law?

MR. BERGIN: One, two.

MR. SHAY: So if we're effectively connected, if you already have a trade or business then you don't get the benefit of the stock and security safe harbor because that is only a protection against trade or business. Then you have to analyze whether or not your gain on sale is taxable to a nonresident foreigner based on whether the activity that's conducted in the trade or business give rises to that gain or is connected to that gain.

So that's just the context in which that comes up. I just wanted to observe that.

MR. BERGIN: Good. Lee.

MS. SHEPPARD: On the dealer discussion, I'm kind of wondering if we aren't getting messed around by the fact that our capital gains holding period is so short. Because if I'm a car dealer, OK, or I'm a home builder, I'm hoping to get rid of my inventory within the taxable year but if I'm stuck with it beyond the taxable year, we're not going to say oh, that's capital gains because you held it longer.

You're still in dealer status because you're hoping to get rid of the thing. And, you know, if we want to call private equity funds dealers for whatever then how we do divorce that from the fact that our capital gains holding period is so short?

MR. FENN: It's, you know, the argument you're making is that because real estate developers are dealers that anyone who develops is a dealer. I don't think that's true.

MS. SHEPPARD: Well, developers have ordinary income, too.

MR. FENN: Real estate developers can develop projects, hold them for a period of time, sell them, get capital gain treatment. You know, you can build an apartment building. You can build an office building, you can lease it up. You can hold it and you can sell it after an end of a term. That's capital gain.

MS. SHEPPARD: I was thinking of dealers as the ones that have inventory.

MR. FENN: A real estate developer that -- yes, but that's the difference. That's the point. Private equity firms don't have a sense of selling immediately after they acquire. What real estate developers will, if they have inventory will develop a project like a condominium development, pre-sell the units and continue to market whatever units they have.

So there's something else going on than pure development. I don't think pure development in and of itself answers the trade or business question. There has to be something more.

MR. BERGIN: OK. There's interest in the audience to get in here and I'll think go first to I think we have a Twitter question? So my understanding is we have a large audience viewing this and since we can't buy them a beer, we can at least give them the first question, I think.

Who has it?

QUESTIONER: I have. Sorry, can you hear me? Hello?

MR. BERGIN: Uh-huh.

QUESTIONER: The first question is why isn't the company, not the fund, the principal if it pays the full value measurement to the manager?

MR. HART: Well, I think the question relates to a fee of the kind that gives rise to the offset where the company is paying the manager for providing investment banking services or monitoring or Treasury functions, whatever. And typical management agreements between the fund investors and the management company, the management company's receipt of those kinds of fees give rise to the reduction.

I think the attribution analysis is -- the question implies that the principal for that piece of the relationship is really the company and not the investor. And I agree with that completely. I think that's part of the analysis.

MR. ROSENTHAL: So here's the issue in my view. The way private equity is structured, these employees whether we count them as dozens, hundreds, whatever, they are employees of the management company which I believe are operating under the direction of the general partner on behalf of the fund. This is sort of weird. Why can't the portfolio companies like Scott Brass hire their own employees and consultants and the like?

Why do they have private equity fund employees and consultants wandering around? The fee offset that, you know, to some extent the portfolio company paid a small amount in consulting fees to hire some workers: $186,000. It paled compared to the fees and the value of the services that were being rendered by the private equity funds through the management company. And there's a good question here which is are we talking about transfer pricing issues, Steve, here?

Or are we just talking about a way for private equity funds to exploit sweat equity? To contribute labor services rather than have the portfolio company itself pay for the services? Because the short answer to the question is, no, the portfolio company's not paying full, fair market consideration.

And the longer answer is well, what happens if they pay full, fair market valuation or what happens if we start to think about repricing the arrangement to have the portfolio companies actually pay for the services they receive? I think that goes to the heart of undercutting private equity funds' model of improving the companies on behalf of the investors. But it's a good question and there's a varieties of scenarios.

You know, the IRS is thinking about a variety of these scenarios. What happens when the management company is not owned by the principals? What happens if it's unrelated like McKinsey? What happens if the dollars are actually paid from the portfolio company?

We can work through each of those scenarios but the case presented in Sun Capital was an easy one. The private equity fund promised to turn around the companies. They paid for the turnaround of the companies. The portfolio companies did not.

MR. SHAY: Would it help to frame that question if the private equity funds received no fee, so we had no management fee offset, but they did exactly the same thing. I think, Steve, you're arguing that they would be a dealer. They would be engaged in business and selling to customers. And I think the argument that's really the question and I think my colleagues on the left would say, no. If that's all you're doing and you earn no fees, then it's capital gain.

And it seems to me, that is the big, from an economic "where are the dollars" point of view, that's the most important issue that's in front of us.

MR. HART: But Steve, I would say it doesn't matter whether you're paying fees for those -- you know, the shareholders can do whatever they want. They owned stock before, during, and after these activities take place. It's the exact same property. Maybe there are transfer pricing issues. Maybe there are other things going on but it doesn't make it inventory.

It's a multiyear holding period.

MR. ROSENTHAL: Well, we're lapsing back into capital gains or not. I can have that discussion of whether we have "to customers" and development there. On the trade or business issue, the question whenever you have a shareholder is can you identify a separate trade or business of the shareholder separate from the portfolio companies?

Scott Brass was in the metal fabrication business. The shareholders, the private equity funds was in the private firm management turnaround business. They did it with 37 companies, the two of them combined. They earned a great deal of fees in continuity and regularity. The question is that the Whipple gloss that you might find is can we identify a separate trade or business by a shareholder and one company for one shareholder sitting on the board or offering his services?

As a matter of fact, the factual finding in Whipple was not enough. He was not engaged in a distinct trade or business from his company. But my proposition for the trade or business is there is a separate trade or business by the private equity fund. There's the level of activity, the continuity, regularity, and substantiality establishes it.

Now, what that trade or business is will determine whether or not we have capital versus ordinary. And my view is this is a development business, an intermediation business and that when a private equity fund buys companies to repair them and sell them just like a real estate developer buys property to improve it and sell it, that's ordinary income.

I disagree with Patrick's observation about the tax rules. This is an administration problem because I think in the real estate people feel entitled to capital gains whenever they hold property beyond a year and a day. But Malat v. Riddell makes quite clear the distinction of buying property in order to develop it, subdivide it, and sell it as ordinary. And buying property in order to lease it or intending to lease it, even if your plans changed, capital. That's what Malat v. Riddell is all about.

And so, I'd have to talk about this --

MR. FENN: How is that disagreeing, though, with me? That's the point I'm making.

MR. ROSENTHAL: You disagree with the notion that real estate developers who subdivide property, improve the property with the intent of selling the property after they improve it are subject to ordinary income versus capital gains?

MR. FENN: I didn't disagree with that.

MR. ROSENTHAL: OK, that's the proposition that's established --

MR. FENN: I was making -- you're drawing a distinction between someone who is a dealer and someone who is not a dealer by pointing to dealers as -- real estate dealers as an example. So --

MR. ROSENTHAL: I think, Pat -- I'm sorry, go ahead.


MR. FENN: I'm just saying that even within real estate there is the distinction. And you just, as you just said the Malat case confirms that. You can be a real estate developer if your intention is to resale immediately and that's ordinary. But you can also have the intent to hold for a long -- to improve for -- you, first of all develop it. You improve it. You do everything you can to make it beautiful and then you go out and you lease it up and you hold it and when you sell it you'll get capital gain.

I think what I'm saying is, that strikes me as being what private equity is. So, in the real estate world, private equity firms are like the real estate developer that builds a nice building, holds it, and sells it when the time is right. And not like the real estate developer that subdivides property, markets it for presale, or markets it continually with respect to what it continues to hold.

MR. BERGIN: But isn't that a different argument than whether it is a trade or business, Lee?

MS. SHEPPARD: I was going to address a different point.

MR. BERGIN: OK, go ahead.

MS. SHEPPARD: Which is if you look at this from the investor perspective, what is dragging in this Sun Capital case, what is dragging investors into the trade or business of the managers if we just all sort of agree for a second that they are at least managers in the Dagres sense, OK? So let's just leave them there for a second. They do something for a living, right?

On the one hand, you have this sort of ironic point that Steve Shay made which is the less they do to the portfolio company, the better it is for preserving capital gain treatment for the investors.

MR. FENN: Which sounds like a ridiculous notion.

MS. SHEPPARD: Which is crazy because, yes, why would you buy the thing just --

MR. FENN: Let it rot on the vine and you'll get capital gain.

MS. SHEPPARD: Yes. OK, but so nobody's going to do that. But when they're in there organizing and stuff or reorganizing they're taking fees and those are being attributed to the investors in this case and that's a common arrangement and that does matter. The other thing they're doing is they're not taking salaries. So they're in there messing around in the business as agents under state law of the investors. And shouldn't they be taking salaries?

MR. FENN: See, that's the confusion.

MS. SHEPPARD: You know, if you wanted to really separate them from the investors, why wouldn't you put them on the payroll of this company, this portfolio company and say, look, we put them over there on the payroll. My investors just hold stock and there's the portfolio company and there's the guy on the payroll.

MR. FENN: It gets back to Steve Shay's point that if you had no fees and then the shareholders --

MS. SHEPPARD: Well, you may have no fees in the future.

MR. FENN: And then the shareholder says, well, go hire McKinsey because we want you to find a new CEO. We want you to look at your financial costs, how you save costs, what are the strategy --

MS. SHEPPARD: But don't you --

MR. FENN: Then all of sudden you're passive. But yet, if the experts within the private equity firms have better or the same expertise and get paid for that by the portfolio company, that makes a difference. I think we're having trouble with that. That's the attribution that I'm having trouble with.

MS. SHEPPARD: The court's looking at this form by which they take their compensation, the compensation piece of what they're doing. Leaving aside everybody's capital --

MR. FENN: The managers, Lee?

MS. SHEPPARD: The managers. They're looking at the form by which the managers take their compensation. So in the future after this case, why wouldn't you clean up that form? Why wouldn't you make that form as clean as possible so that there would be no agency kind of arguments?

MR. FENN: Yes, I guess we're arguing over whether the agency argument is the right argument. I mean, if I enter into a contract with a manager like John was saying, I'll pay you a fee but I'm not going to let you double dip me if you're going to go to my portfolio company and get paid, I'm not going to pay you also. Look, the whole point of management fees initially was to cover the costs that the manager had incurred to create the opportunity for the investors.

The separate fees that it charges the portfolio company are for real things that the portfolio company needs that it would otherwise go to third parties for. That I don't find objectionable. I don't think -- I think that's --

MS. SHEPPARD: (inaudible) from investors even before this case because the investors were arguing that they were too much in --

MR. BERGIN: All right. I'm going to call an official timeout so I can get to the audience 'cause I think there's a lot of people out there who want to comment. Please, tell us who you are and I am not a rude human being. But if I sense a statement because we're running out of time, I'm going to ask you where a question is. So I'll apologize before if I do that to anybody. Who's got a question? Gentleman right over here.

MR. SULLIVAN: I'm Marty Sullivan, chief economist with Tax Analysts and I'm going to make a statement.

MR. BERGIN: Grab that mic. And he works for us.

MR. SULLIVAN: Let me just say as an economist the part I like best is when Steve said where's the --

MR. SHAY: Which Steve? We have two Steves.

MR. SULLIVAN: Oh, I'm sorry. When

Steve Shay said, "Where are the dollars?" And then he said we were looking at domestic investors who are concerned about capital gains versus ordinary. We're looking at domestic tax-exempts who are concerned about UBIT or non-UBIT and then we're looking at international investors who are concerned about filing a U.S. tax return.

Am I correct in that's sort of the implications? Let me just say that all of these things should be fixable, that we should not have a capital gains differential, that it should not make a difference if I'm an active or passive investor for UBIT and it should not make a difference whether I file a tax return for foreign purposes.

Now, you could disagree with that and I'm not just saying that to be facetious because as an economist and I think you all were alluding to this, that we don't want there to be a huge tax difference if a private equity fund or any investor is more active or more passive. In fact,

I think we want to encourage them to be active. If real estate investors for mortgage-backed securities had been a little more active in 2007 maybe we wouldn't be where we are now.

MR. BERGIN: Good point.

MR. SULLIVAN: So I think there is a neutrality concern. I know you're all lawyers and you're having fun on this part but I think there is a larger picture to look back at. And I'm sorry I don't have a question.

MR. BERGIN: That was short. That was good, Marty. Anybody else? David, did you have something?

MR. BRUNORI: I do. David Brunori, I'm with Tax Analysts. I have a question for Professor Shay?

MR. BERGIN: OK, just -- if you want to get in here anybody here, just raise your hand and I'll get to you. OK, go ahead.

MR. BRUNORI: And mine's actually a question. Steve Rosenthal before said, oh, we keep coming back to capital gains and we can have that debate. To me it seems this is all about capital gains. This is the only thing we really care about ultimately how we're going to treat these things is ultimately, how it's going to affect the capital gains debate that we've been having for the last couple of years because -- and my question for Professor Shay is, do you see the Sun Capital decision having any meaningful, long term effect on the capital gains debate in the United States? Or is, we're going to talk about it for a couple of more months and then wait for the next case somewhere down the line and maybe do this again someday?

MR. SHAY: Well, that question could be answered in a number of different ways. I'm going to not take the political side of that question. Oh, you wanted the political side.

I think just to be sure we're clear about one thing, you can have a trade or business and still have capital gain. And so, the issue that Steve is I think correctly saying isn't in the title of the program and that has been -- we've been touching on is whether or not the private equity fund is holding primarily for sale to customers; what is a customer? Is that tripwire tripped so that they don't get capital gain?

So in a sense, Sun Capital has almost nothing to do with capital gain other than to get private equity funds potentially, if you follow its logic, into the box of having a trade or business. I think that part of Sun Capital, if you did change the business model, you could avoid a lot of that.

I don't mean, I haven't always been a professor, even a professor of practice, so I don't mean to trivialize how difficult it would be for this industry to change that business model. So I'm not saying that's a practical short term answer or necessarily a practical answer. But I do think it's correct.

But having said all that, so, Sun Capital really doesn't affect capital gains at some level. It is affecting the debate on capital gains just because of the intersection with the industry that is the highest-profile industry as a beneficiary of the capital gains differential rate. I happen to personally agree with Marty Sullivan. I don't think we should have a differential rate.

I had nothing to do with the issue but did serve in the Treasury when it was eliminated in 1986 Tax Reform Act. I thought that was a good change. I was very sorry to see it traded away in a deal in the early '90s to get something else that that particular administration thought was important because I think it's brought back into the law a tremendous amount of complexity that is unnecessary and I don't think it's economically justified as long as we have a realization system to the extent we do.

MR. BERGIN: We've got a question over here.

MR. ROSENBLOOM: Just to have a question from somebody who's not from Tax Analysts, I'm David Rosenbloom. I'm David Rosenbloom. I'm not from Tax Analysts.

This panel was inappropriately named, right? Because Sun Capital, I read that case. I don't remember it saying anything about capital gains versus ordinary income. I mean it is tremendously relevant on trade or business, which by the way affects lots of people besides the private equity industry, and you get to a debate about how much is too much. I would basically think I'm with Steve Rosenthal whether these guys are engaged in a trade or business. There is a how much is too much.

I've seen people a lot closer to the law and not be in a trade or business but we could spend the rest of eternity talking about where to draw that line. It's going to be a case by case decision. Capital gain is a completely different question.


MR. ROSENBLOOM: So we're using Sun Capital as an excuse to talk about private equity funds. That's what's going on here. Now, on that one, I'm many steps behind the curve because and I've been paying attention to this out of the corner of my eye. But why isn't it ordinary income when folks receive these interests as opposed to when they dispose of them?

It seems to me, it seems to me, people pay good money for interests in these funds, don't they? That was my impression. So I would have thought for starters that you have ordinary income upfront independently of the point system where by the way, I think I'm probably not on the side of Steve Rosenthal. I think I'm on the side of the proposition that is a capital transaction.


MR. ROSENBLOOM: Let me finish, please. I let you talk. Because I don't think you're looking at this from the standpoint of the customers. Who are the people who are buying these interests from the private equity funds? They're customers? I don't think so. These are people who happen to be there when the private equity funds go out and market whatever they've developed. I don't see that in the normal -- to me that's not a normal definition of customers.

I think you could strain to put it in there. I see the argument but I think I'm on the side that that's capital. But I'm not on the side of the idea that the receipt of these things is completely free of any taxation.

MR. ROSENTHAL: So I liked where you started and I dislike where you ended. Look, the title was to debate trade or business. David, that matters outside of capital gains. Funds have expenses that are either above the line or below the line and get flowed through.

Funds have questions of effectively connected income. Are private equity funds to be treated like the lending hedge funds that Lee mentioned? None of which has anything to do with customers.

So we could talk about the capital gains. I've tried to stifle that and I think I could persuade you that this argument is reasonable. And I wrote my last paper in January.

Shay is right, Professor Shay is right that half of the paper was not picked up by the First Circuit that the customers "to customers" is not part of the ERISA liability standard; trade or business versus 80 percent.

I'm happy to come back and have a discussion of "to customers" or not. I thought we were talking about trade or business which implicates hundreds of code sections. I grant you if we're in the world of second-best and trying to think what do we do with the carried interest that are granted to Mitt Romney and others and the courts and the Treasury will not buy my argument on the fact that in my view it's ordinary income to start. If we're in the second-best should we introduce legislation to change that?

That's a separate argument. And it's not that I'm disagreeing with you in terms of where you end up, although we might. It's just there's only so many arguments we can have here on one panel and trade or business matters a lot. And Sun Capital was really important for the tax interpretation for trade or business not just for the ERISA.

MR. BERGIN: Thank you, Steve. We had a question over here.

MR. McCORMICK: Thank you, Ryan McCormick, the Real Estate Roundtable. I've heard a lot of discussion about private equity funds and how they're different from mutual funds and some interesting discussion about real estate activity and when that's capital and when that's ordinary. But I'm still not sure I fully understand the relevance of the trade or business debate in Sun Capital and how it might apply to real estate funds which, in some respects are very similar to private equity funds and in other respects are quite different. So I'd appreciate any thoughts or guidance or views on the applicability of the trade or business debate to the real estate fund world.

MS. SHEPPARD: I think what's going on in this case and this was the point I was trying to make about cleaning up your fee structure, is the managers are doing stuff that makes them agents, you know, they are agents. Legally they're agents for the investors. But they're also taking their compensation in ways that allows the court, and that was the fees but it's also the lack of salaries in my view, that gives the court sort of a license to attribute the manager's activity to the investors.

Whereas, if you had organized it differently, let's say you put your -- you had your real estate developer guy who's running around. He's trying to get tenants for the see-through building, right? What if you put your building in a defined entity? You could even put it in a corporation. You make this guy an employee. All his compensation comes as salary. If you tell him if he leases up the building in a certain amount of time you give him a bonus and it's still treated as salary.

Instead of giving him a partnership cut and instead of giving him the magic beans of the profit's interest which, because years and years ago courts didn't really understand that that was a derivative and it's an ordinary income strip from the partnership, they didn't understand that they should be treating that as compensation on the receiving end. And that's what David Rosenbloom was talking about.

But because the management group is taking their compensation in a certain way, and they're taking that compensation in that way for good tax treatment for themselves because they don't want to be paying ordinary rates and employment taxes and what you have on salary, OK? Because they're getting compensated in a particular way and what that's doing in this case is blowing back to the investors.

And we've had, and people like me have griped about this for years, the whole profits interest thing and how we sort of have a class of people whose employers in the broader sense happen to be partnerships, being treated differently than your salaried corporate manager who might be doing the same kind of job. This is causing this kind of blowback and that's your implications with this case. Because we know from even before this case that investors were griping about those private equity fees. That's why you have the fee offset. That's why certain kinds of fees are going to go the way of the buggy whip even if this case never got decided, right?

I think that the broader thing that this says to both groups of people operating through these big partnerships is you're going to have to rethink your whole compensation agreements with your managerial class -- lest this blowback to your investors.

MR. ROSENTHAL: Ryan, can I -- let me answer you as a lawyer. In order to have capital gains there needs to be the disposition of a capital asset. Capital asset is defined in 1221(a)(1). It includes all property but excludes among other categories of exclusions property primarily held for sale to customers in the ordinary course of a trade or business. You can divide that phrase into two halves as Mr. Shay has said, primarily held for sale to customers and then in the ordinary course of a trade or business.

When I wrote my article in January, I evaluated both halves of that phrase. I evaluated the trade or business half and I said because of the level of activity and the continuity and the regularity of the private equity funds I thought they were easily in a trade or business. I looked at the "to customer" point, traced that through the capital asset definition and I thought, in my view, the better view is they have customers. I know it's hard, counterintuitive to accept. Read my article, I try my best to explain it there.

It's a little bit technical. If you think the rest of the stuff is technical, read the nuance in the article. But I agree reasonable people will differ with me. I suggested in that article and I suggested this week in this article that on the "to customer" point we ought to look to Treasury to write regulations to clarify the scope of when you have customers or not.

The trade or business point, I don't think that's a tough one. And that's why I tried to refocus us. It matters for so many different code sections. It matters at the big picture whether we're going to collect a tax or not on a trade or business. We almost always do but not here.

So it matters by itself. And to simplify the discussion and not lapse into these private equity managers like Mr. Romney are collecting 15 percent profits on their consulting income. That's not right. To try to isolate the issue of what are the private equity funds doing? Are they in a trade or business? Does that implicate all these other code sections? I've tried to stick to trade or business.

Happy to come back, Chris, and talk about capital gains or not. I debated that before the Sun Capital decision because that's all that was out there. Now, Sun Capital, in my view informs how we want to think about trade or business in an important fashion and I'd like to stop by asking people, read the article. Read the cases. It's one thing to assume what the law says. It's another thing to actually read the cases and the statutes and interpret the law.

MR. BERGIN: Thanks, Steve. OK, we have a question here.

MR. SOWELL: Thank you very much. My name is Jim Sowell with KPMG. As I read the cases they distinguish trade or business from investor based not just on the level of activity but also based on the fact that the party is receiving some sort of compensation other than in the nature of an investor compensation.

MS. SHEPPARD: That's Whipple.

MR. SOWELL: As I look at the scenario we're talking about, we're looking at whether the fund is in a trade or business. So the fact that the sponsor is receiving management fees, that's not management fees that are being received by the sponsor.

So it seems to me that the management fee waiver piece of the puzzle here is really a crucial part of the analysis. It's not and I realize there's a distinction of views on the people, but having read the case law and having looked hard at the case law, that's the way I read the trade or business analyses coming down.

So I tend to think, as John said, if I am a sponsor going to my front investors, I'm going to tell them I am going to do this level of investment for you. And I am going to charge you this much for investment. Now, I'm going to provide those services to a number of entities all over the structure. And I don't know where they're properly going to be attributable on day one. But as time moves on these entities are going to appear and it may be more proper that I am charging these fees to another entity which I think the fee offset roughly gets to. It kind of goes to John's point about the health insurance or just left pocket, right pocket.

So I'm just interested in the thoughts on that. Lee?

MR. BERGIN: Steve first.

MR. ROSENTHAL: Yes, Jim Whipple said that a taxpayer who promotes corporations for a fee or a commission or profit on their sale may engage in a trade or business citing Giblin.

MR. SOWELL: But there are a number of cases of Whipple that revise the Whipple analysis. I'm sorry, there are a number of cases post-Whipple that I think elaborate on the Whipple analysis and limit the Whipple holding.

MR. ROSENTHAL: I don't think so in the sense that there's certainly no U.S. Supreme Court case. I can tell you definitively all of the cases and all of the courts that might have interpreted Whipple in somewhat of a different fashion and perhaps mistakenly.

However, Whipple clearly, in my view, stands for one proposition. Is the shareholder in a distinct trade or business from the portfolio company? And the way you determine that, you look at a variety of things. Is the shareholder engaged in the same type of management activity and engagement with multiple numbers of corporations? Is the shareholder receiving a fee different than the normal investor fee? Now, here you say, wait a second. This shareholder's receiving profits from sale of stock. That's normal investors.

That turns out not to be correct. There really is, if you look closely at the decision, I've described in footnote 59; I went and listened to the oral arguments. I read the article which I suggest, the Dillingham, who argued the case on behalf of Whipple, the notion that the U.S. Supreme Court had in Whipple was that the investor-type profits were profits that came through the corporation from dividend distributions, from appreciation just having inherent gains. Not from buying the stock with the intent to sell it. That was not the dividing line in a trade or business.

And of course, that makes sense. Well, what do hedge funds do? Why do you think hedge funds -- how do you think they make their money? They buy stock when the price is low hoping to sell stock when the price goes up. If you simply viewed that as an investor-like return and said that was not a trade or business, we would lose the 10,000 hedge funds that are engaged in a trade or business.

So I think that if you read the case, I've described in my article my articulation of the principals. And one thing I suggest: Write an article. You know, the First Circuit relied heavily on my first article, cited it half a dozen times for various propositions. Am I a genius? Am I insightful? No, I write. There's nothing out there. Write it up and let it see the light of day and let the policy decisionmakers look at the analysis and make a determination.

MR. BERGIN: Write it up and send it to us.

MR. SOWELL: I was just making the point I think even by Lee's earlier standard, Whipple is a very old case even for tax law and there has been a lot of development of the law in this area. And having looked at this hard in light of the Sun Capital cases, because it's very important to many of our clients, I see the courts as having put a gloss on Whipple that does alter the analysis.


MS. SHEPPARD: Don't the deal documents say to the foreign investors and the tax-exempt, the managers, or whoever, the general partner, will use their best efforts to keep them out of a trade or business, right? Yes, OK.

So doesn't that, and I'm just reiterating my previous point, doesn't that say that if some of this case law comes down and says you have to rejigger your fee arrangements, that you maybe have to think about doing that? That maybe the managers should be in there only for capital gain and that management fees should only cover documented office expenses instead of being a huge chunk of committed capital. I mean that may be where you have to go to keep the investors out of the trade or business soup on this.

MR. BERGIN: One more question. I think this is going to be the last question.

MR. WALSH: I have a question kind of based on Steve Rosenthal's analysis so far.

MR. BERGIN: Tell us who you are, please.

MR. WALSH: I'm Kevin Walsh from Groom. It seems like the management fee is one potential line for determining if something is a trade or business. But it appears that you've rejected that position to a degree. And the position so far seems to be that it's facts and circumstances, specific test and that generally you believe private equity funds are over the line.

So just as far as line drawing goes, I'd like to throw out an oversimplified line and ask that you explain how the bright-line test that I'm throwing out differs from your position. And that bright line would be that in general, all partnerships where the general partner works to deliver a profit to limited partners is engaged in a trade or business.

MS. SHEPPARD: That's interesting.

MR. ROSENTHAL: My own view is I think that would be a fine line but I think what you try to do is measure the level of activity. Is it continuous, regular, and substantial? And by and large we are in a line-drawing area. This is facts and circumstance. One of the criticisms I got with my first article on capital gains, people said, Steve, people are going to have to think through what the facts and circumstances are to determine whether you have capital or ordinary. We want all stock to be capital.

Well, that's a line and that's easy to administer but the question is whether it gives you a sensible tax policy result. I don't think so. Others can disagree. That's fine. But in terms of line drawing I think you're approaching this in the right way. You're in effect attributing the general partners' activity to the fund which I think is correct. But I still think there's value to measuring the level of activity.

And Groetzinger 1987 case, I agree Whipple is old, 1963. Groetzinger's a very well-reasoned decision. It happened to apply to gambling. Now, whether or not gambling and stock picking is much different as a structural matter I'm not quite so sure. But it's easy to adapt. So the only reason why Whipple is exalted so is because it's a U.S. Supreme Court case that at times has some sloppy dicta in it.

But I think it's fairly straightforward as to where Whipple stands and how to interpret it. So I'm not too sure we need many lines or presumptions or safe harbors. But you're going about it in the right direction.

MR. BERGIN: Anybody else on the panel?

MR. FENN: So if I understood the bright-line any profitmaking activity is a business? Any promise to produce profits from your own efforts whether it be an agent or your own efforts is suddenly a business?

MR. WALSH: But only in a partnership.

MR. FENN: Well, let's take just Carl Icahn. Is he in a trade or business when he -- and takes a large position in a public company, shows up at the board and pounds the table and demands spinoff this, change this, reorganize that. And he's in it for a profit. There's no doubt about that. Is he in a trade or business?

MR. ROSENTHAL: Can I just point --

MR. FENN: Is that the line you're now developing, Steve? Is any entrepreneur, take any entrepreneur, lots of capital, Zuckerberg, if he does 16, which company is he? Sorry. He does 20 of those, is he in a trade or business? His personal efforts give rise to the value of the stock of that company. Where are you going to -- where does it stop and what additional factors stop that from being a trade or business based on your bright-line test?

MR. ROSENTHAL: Look, I'm all for apple pie and entrepreneurship and making America great. And I would say the thought that's actually interesting with respect to the entity, the partnership, Sun Capital drops an interesting observation in the decision which I didn't know what to make of. It's in the footnote of my article. They say it would be highly unlikely that a for-profit entity was not engaged in a trade or business within the Groetzinger standard.

Now, that to me proves perhaps too much. However, look at every corporation. I cite Bittker and Eustice. They are deemed, it's presumed to be in a trade or business. No code section says that. No reg says that. The reason why we get there is that the entity is organized under state law for a business purpose and it would be sort of surprising that this entity was not in effect a trade or business.

So extending that the next step to a partnership which is organized under state law for some business purpose I don't think is so big. I didn't play that too hard in this article because that would drive people even more crazy. But I think the level of activity, but there is a difference between an entity and individual.

MR. BERGIN: All right. I am going to stop it here. There's a lot of benefits to being -- excuse me? It was just getting fun, I know, I know but it's five o'clock and I always try to end on time. There's several benefits to being the moderator. I get to listen to really smart people for a couple of hours and I get the last word.

But I'm actually -- Steve, I'm going to give you the last word by proxy. The question was private equity as a trade or business, and it's complicated as you can tell. Did we answer it? I think Steve gave me the best answer. Whatever it is it matters. It matters a lot. So thank you to this excellent panel. It was fantastic conversation. Thank you to the Tax Analysts staff. They are the best in the business and thanks to you. So are you. Good night. The drinks are next door.

(Whereupon, the PROCEEDINGS were adjourned.)

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