Sun Capital Case Rejects Joint Economics And Favors Separate Formalities In Determining Whether A Partnership In Fact Exists
November 27, 2019
by Monte A. Jackel
The recent Sun Capital case in the First Circuit rejected the holding of the District Court below that two separate entities had formed a deemed partnership in fact due to their joint objectives, cooperation and sharing in joint profits and losses. Rather, the First Circuit focused more heavily on the separateness of the two entities in a number of contexts. The First Circuit also seemed to favor a more factor based pro and con analysis under Luna as compared to the District Court which focused heavily on the joint cooperation and sharing of economics without analyzing the pros and Cons of the Luna factors.
If this holding persists, it will become extremely difficult for the IRS to ever find a partnership in fact. This deemed partnership issue is relevant for both substantive tax liability and for partnership audits under the new partnership audit regime.
Pertinent language from the courts’ analysis of the deemed partnership issue is below.
1. United States Court of Appeals For the First Circuit Nos. 16-1376 19-1002
SUN CAPITAL PARTNERS III, LP; SUN CAPITAL PARTNERS III QP, LP; SUN CAPITAL PARTNERS IV, LP,
Plaintiffs, Appellants,
v.
NEW ENGLAND TEAMSTERS & TRUCKING INDUSTRY PENSION FUND,
Defendant, Third Party Plaintiff, Appellee, SCOTT BRASS HOLDING CORP.; SUN SCOTT BRASS, LLC, Third Party Defendants.
APPEALS FROM THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF MASSACHUSETTS
We first consider the Luna factors that favor a finding of de facto partnership. Even before incorporating SSB-LLC, the Sun Funds together “[sought] out potential portfolio companies . . . in need of extensive intervention with respect to their management and operations, to provide such intervention, and then to sell the companies.” Sun Capital II, 724 F.3d at 142 (emphasis added). The Funds, through SCAI, developed restructuring and operating plans for target companies before actually acquiring them through LLCs.13 Id. This behavior is some evidence of the Sun Funds “exercis[ing] mutual control over and assum[ing] mutual responsibilities for the enterprise” of identifying, acquiring, and selling portfolio companies together. Luna, 42 T.C. at 1078. Moreover, if the Sun Funds had in fact formed a partnership through these pre-incorporation activities, the mere creation of SSB-LLC would not, as a matter of law, in and of itself end this already-existing partnership-in-fact. See Wabash Ry., 7 F.2d at 342–44.
The organization of the control of the Sun Funds and of control over SBI also is some evidence of a partnership-in-fact. The two men in control of the Funds’ general partners, Leder and Krouse, essentially ran things for both the Funds and SBI.Together, and at Leder and Krouse’s direction, the Sun Funds placed SCAI employees in two of SBI’s three director positions, allowing SCAI to control SBI. Sun Capital III, 172 F. Supp. 3d at 467. Moreover, this pooling of resources and expertise in SCAI, which the Funds used not only to identify, acquire, and manage portfolio companies, and structure those deals, but to provide management consulting and employees to portfolio companies, including SBI, is evidence tending to show a partnership. See Cahill v. Comm’r, 106 T.C.M. (CCH) 324, 2013 WL 5272677, at *4 (2013) (concluding a party’s desire “to pool his resources and to develop business jointly” evidenced a partnership); Luna, 42 T.C. at 1078 (holding that “mutual control over and . . . mutual responsibilities for [an] enterprise” indicate a partnership-in-fact). Indeed, the record does not show a single disagreement between the Sun Funds over how to operate SSB-LLC. The Funds’ conduct in managing SSB- LLC is further evidence of a partnership-in-fact sitting above. Cf. Luna, 42 T.C. at 1077 (paralleling Luna factor one: “[t]he agreement of the parties and their conduct in executing its terms” (emphasis added)).
We next discuss the Luna factors that counsel against recognizing a partnership-in-fact. The record evidence is clear that the Funds did not “intend[] to join together in the present conduct of the enterprise” (at least beyond their coordination within SSB-LLC). Comm’r v. Culbertson, 337 U.S. 733, 742 (1949); see also Luna, 42 T.C. at 1077 (counting against factor one). The fact that the Funds expressly disclaimed any sort of partnership between the Funds counts against a partnership finding as to several of the Luna factors. See Luna, 42 T.C. at 1077-78 (counting against factor one, the “agreement of the parties”; factor five, “whether business was conducted in the joint names of the parties”; and factor six, “whether the parties… represented to . . . persons with whom they dealt that they were joint venturers”). Most of the 230 entities or persons who were limited partners in Sun Fund IV were limited partners in Sun Fund III. The Funds also filed separate tax returns, kept separate books, and maintained separate bank accounts — facts which tend to rebut partnership formation.15 Id. at 1078 (counting against factors six and seven). The Sun Funds did not operate in parallel, that is, invest in the same companies at a fixed or even variable ratio, which also shows some independence in activity and structure.
The creation of an LLC by the Sun Funds through which to acquire SBI also shows an intent not to form a partnership (although not as categorically as the Funds contend). The formation of an LLC both prevented the Funds from conducting their business in their “joint names” (Luna factor five) and limited the manner in which they could “exercise[] mutual control over and assume[] mutual responsibilities for” managing SBI (Luna factor eight). Id.
Using the Luna factors, we conclude that most of them, on these facts, point away from common control. We credit the district court for its careful and reasoned analysis of the complex facts and law at hand. Nonetheless, the district court (and the Pension Fund and PBGC) too greatly discounted the Luna factors rebutting partnership-in-fact formation. Importantly, although the district court correctly concluded that incorporating SSB-LLC did not in and of itself prevent recognizing a partnership-in-fact between the Funds, SSB- LLC’s incorporation implicates many Luna factors counting against that recognition (an analysis absent from the district court’s opinion).
2. Case 1:10-cv-10921-DPW Document 177 Filed 03/28/16 Page 1 of 44 Doc 2016-6566 (44 pgs)
SUN CAPITAL PARTNERS III, LP, )
SUN CAPITAL PARTNERS III QP, LP, )
and SUN CAPITAL PARTNERS IV, LP, )
Plaintiffs/ ) Counter-Defendants, ) v. ) ) NEW ENGLAND TEAMSTERS AND ) TRUCKING INDUSTRY PENSION FUND, ) ) Defendant/ ) Counter-Plaintiff. )
CIVIL ACTION NO. 10-10921-DPW
UNITED STATES DISTRICT COURT
DISTRICT OF MASSACHUSETTS MEMORANDUM & ORDER
March 28, 2016
Whether a partnership or joint limited partners in Sun Fund III. The Funds also filed separate tax returns, kept separate books, and maintained separate bank accounts — facts which tend to rebut partnership formation.15 Id. at 1078 (counting against factors six and seven). The Sun Funds did not operate in parallel, that is, invest in the same companies at a fixed or even variable ratio, which also shows some independence in activity and structure.
The creation of an LLC by the Sun Funds through which to acquire SBI also shows an intent not to form a partnership (although not as categorically as the Funds contend). The formation of an LLC both prevented the Funds from conducting their business in their “joint names” (Luna factor five) and limited the manner in which they could “exercise[] mutual control over and assume[] mutual responsibilities for” managing SBI (Luna factor eight). Id.
Using the Luna factors, we conclude that most of them, on these facts, point away from common control. We credit the district court for its careful and reasoned analysis of the complex facts and law at hand. Nonetheless, the district court (and the Pension Fund and PBGC) too greatly discounted the Luna factors rebutting partnership-in-fact formation. Importantly, although the district court correctly concluded that incorporating SSB-LLC did not in and of itself prevent recognizing a partnership-in-fact between the Funds, SSB- LLC’s incorporation implicates many Luna factors counting against that recognition (an analysis absent from the district court’s opinion).
2. Case 1:10-cv-10921-DPW Document 177 Filed 03/28/16 Page 1 of 44 Doc 2016-6566 (44 pgs)
SUN CAPITAL PARTNERS III, LP, )
SUN CAPITAL PARTNERS III QP, LP, )
and SUN CAPITAL PARTNERS IV, LP, )
Plaintiffs/ ) Counter-Defendants, ) v. ) ) NEW ENGLAND TEAMSTERS AND ) TRUCKING INDUSTRY PENSION FUND, ) ) Defendant/ ) Counter-Plaintiff. )
CIVIL ACTION NO. 10-10921-DPW
UNITED STATES DISTRICT COURT
DISTRICT OF MASSACHUSETTS MEMORANDUM & ORDER
March 28, 2016
Whether a partnership or joint venture exists in this context between the Sun Funds is a matter of federal law. The Internal Revenue Code provides the relevant definition of a partnership:
The term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term ‘partner’ includes a member in such a syndicate, group, pool, joint venture, or organization. 26 U.S.C. § 7701(a)(2). The Supreme Court has interpreted this provision by providing a guide for how to determine the existence of a partnership for tax (and MPPAA) purposes.venture exists in this context between the Sun Funds is a matter of federal law. The Internal Revenue Code provides the relevant definition of a partnership:
The term “partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation; and the term ‘partner’ includes a member in such a syndicate, group, pool, joint venture, or organization. 26 U.S.C. § 7701(a)(2). The Supreme Court has interpreted this provision by providing a guide for how to determine the existence of a partnership for tax (and MPPAA) purposes.
A partnership is generally said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses. When the existence of an alleged partnership arrangement is challenged by outsiders, the question arises whether the partners really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses or both. And their intention in this respect is a question of fact, to be determined from testimony disclosed by their agreement, considered as a whole, and by their conduct in execution of its provisions.Commissioner v. Tower, 327 U.S. 280, 286-97 (1946).
Subsequent cases have further elaborated the factors to which courts should turn in determining the existence of a partnership. In Commissioner v. Culbertson, the Supreme Court identified whether “the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise” as the ultimate inquiry and required fact finders to look at “the agreement, the conduct of the parties in execution of its provisions, their statements, the testimony of disinterested persons, the relationship of the parties, their respective abilities and capital contributions, the actual control of income and the purposes for which it is used, and any other facts throwing light on their true intent” in determining that intent. Commissioner v. Culbertson, 337 U.S. 733, 742 (1949).
The Tax Court [Luna] has pointed to a long list of factors as relevant in determining whether a partnership exists:
The agreement of the parties and their conduct in executing its terms [factor 1]; the contributions, if any, which each party has made to the venture [factor 2]; the parties’ control over income and capital and the right of each to make withdrawals [factor 3]; whether each party was a principal and coproprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income[factor 4]; whether business was conducted in the joint names of the parties [factor 5]; whether the parties filed Federal partnership returns or otherwise represented to respondent or to persons with whom they dealt that they were joint venturers [factor 6]; whether separate books of account were maintained for the venture [factor 7]; and whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise [factor 8]. Luna v. Commissioner, 42 T.C. 1067, 1077-78 (1964).
A joint venture is similar to a partnership, but is “generally established for a single business venture . . . while a partnership is formed to carry on a business for profit over a long period of time.” Podell v. Commissioner, 55 T.C. 429, 432 (1970). The Luna factors, and the ultimate inquiry into the parties’ intent, is the same for joint ventures as for partnerships. Luna, 42 T.C. at 1077. Whether the Sun Funds formed what might be characterized as a joint venture with respect to Sun Brass or a partnership in which Sun Brass is one of several joint investments by the Funds is not material. I will continue my analysis through the partnership lens for discussion purposes.
Applying the above-mentioned factors, it is clear that no partnership-in-fact exists between the Sun Funds that covers all their activities and investments. The Sun Funds are closely affiliated entities and part of the larger ecosystem of Sun Capital entities created and directed by Marc Leder and Rodger Krouse. Sun Capital, 724 F.3d at 133. Leder and Krouse, acting as the limited partner committees of the general partners of each Fund, retain substantial control over both Funds. Id. at 134-35. The Funds have identical language in their partnership agreements and are operated similarly. Sun Capital, 903 F.Supp.2d at 110.
Of course, individuals may create multiple businesses, using the same strategy, without necessarily putting all their enterprises into partnership with each other. And looking superficially, there is nothing that evidences an intent that Sun Fund III and IV be joined together as a general rule. The Funds filed partnership tax returns and filed them separately. Sun Fund III and Sun Fund IV have separate financial statements, separate reports to their partners, separate bank accounts, largely non-overlapping sets of limited partners, and largely non-overlapping portfolios of companies in which they have invested. When they co-invested, as in Sun Scott Brass, LLC, their agreements disclaimed any intent to form a partnership or joint venture. The conventional theories of a general partnership — those that on the face reflect operational and institutional overlap between the Funds — are not evident here.
A more limited partnership or joint venture, however, is nevertheless to be found, based on the present record. The Sun Funds are not passive investors in Sun Scott Brass, LLC, brought together by happenstance, or coincidence. Rather, the Funds created Sun Scott Brass, LLC in order to invest in Scott Brass, Inc. Between 2005 and 2008, Sun Funds III and Sun Funds IV also coinvested in five other companies, using the same organizational structure. In each case, they expressly disclaimed any intent to form a partnership or joint venture, a fact that remains relevant — but not dispositive — as to whether a partnership-in — fact was created. More importantly, prior to entity formation and purchase, joint activity took place in order for the two Funds to decide to coinvest, and that activity was plainly intended to constitute a partnership-in-fact.
In its opinion in this case, the First Circuit observed that “It is the purpose of the Sun Funds to seek out potential portfolio companies that are in need of extensive intervention with respect to their management and operations,” and that in this connection “[i]n 2006, the Sun Funds began to take steps to invest in SBI.” Sun Capital, 724 F.3d at 142. I do not suggest that the court’s description of the Sun Fund III and Sun Fund IV acting in concert as the “Sun Funds” in itself represents a prior judicial finding that a partnership existed. But the court’s opinion shows how difficult it can be to speak sensibly of the business model of Sun Fund III and Sun Fund IV without describing them as acting together or in concert with respect to specific investments. The period of joint action evident in the First Circuit’s observation covers at least the period before the Funds completed the acquisition of a portfolio company through an LLC and holding company and would appear to extend through the operation of those LLCs and portfolio companies.
Notably, the Funds made a conscious decision to split their ownership stake 70/30 for reasons that demonstrate the existence of a partnership. The Funds assert three motivations for this split: that Sun Fund III was nearing the end of its investment cycle while Sun Fund IV was earlier in its own cycle, a preference for income diversification, and a desire to keep each Fund below 80 percent ownership to avoid withdrawal liability. With the exception of income diversification, which two truly independent entities could also pursue in parallel but on their own, these goals are instinct with coordination and show joint action. The record shows that the 70/30 split does not stem from two independent funds choosing, each for its own reasons, to invest at a certain level. Rather, these goals stem from top-down decisions to allocate responsibilities jointly.
Entities set up with rolling and overlapping lifecycles and coordination during periods of transition offer advantages to the Sun Funds group as a whole, not just to each Fund. And the choice to organize Sun Scott Brass, LLC, so as to permit each of the Sun Funds coinvesting to remain under 80 percent ownership, is likewise a choice that shows an identity of interest and unity of decision-making between the Funds rather than independence and mere incidental contractual coordination. A separate entity
which is perhaps best described as a partnership-in-fact chose to establish this ownership structure and did so to benefit the plaintiff Sun Funds jointly.
The two Funds were organizationally separate – and this remains important under Culbertson and Luna – but the record shows no meaningful evidence of actual independence in their relevant co- investments. The Funds have not indicated, for example, that they sometimes co-invested with each other but sometimes co-invested with other outside entities. Neither has evidence been adduced of disagreement between Sun Fund III and Sun Fund IV over how to operate the LLC, as might be expected from independent members actively managing and restructuring an industrial concern. The smooth coordination is indicative of a partnership-in-fact sitting atop the LLC: a site of joining together and forming a community of interest.