A brassy private equity lawsuit could backfire on the entire industry

The saga of Scott Brass is a sad trombone for private equity firms.
The saga of Scott Brass is a sad trombone for private equity firms.
Image: Reuters/Sean Gardner
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Call it overreach: A US private equity firm’s attempt to shake free of pension obligations might cost its entire industry a beloved tax break.

“Carried interest” is a loophole that allows private equity firms (and hedge funds and venture capitalists) in the US to have their income taxed as a capital gain, at a lower rate than income tax, because they take their pay as a percentage of the profits on the assets under their management. It’s a major perk that costs taxpayers about $11 billion each year. President Barack Obama has made getting rid of it a key goal, but Congress is reluctant to raise taxes on the politically powerful financial sector.

That reluctance may matter less now, according to law professor Steven Davidoff, who says a court decision could give the administration an opportunity to act unilaterally.

Sun Capital, a private equity fund run by former Lehman bankers Marc Leder and Rodger Krouse, used a $7.8 billion leveraged buy-out to purchase metals manufacturer Scott Brass in 2007. When Scott Brass went into bankruptcy shortly thereafter, Sun Capital sued the company’s union pension fund in an effort to escape a $4.5 million liability to its workers. Sun Capital said that, as a passive investor, it wasn’t liable for the pension. The union said that the fund was actively engaged in operating Scott Brass—and a Federal Appeals court ruled that the union was right, and Sun Trust had to pay up.

But this same distinction—between a passive investor and someone engaged in “trade or business”—also animates the carried interest loophole. Passive investors can use the loophole, but an active manager of a business would not. Many private equity firms take an active role in managing their acquisitions, hiring and firing executives, laying out business strategies, and plotting potential mergers. With this new court ruling in hand, the IRS could issue new regulations closing the loophole without Congress doing anything.

Of course, this wouldn’t be frictionless: Private equity funds could be expected to sue, and sympathetic lawmakers would likely be persuaded to figure out a new way to enshrine carried interest in law. And, there’s always the possibilities that funds legally reorganize to protect themselves from tax obligations. But if the Obama administration does move to close the loophole, the tarnished private equity owners of Scott Brass will be accompanied by a sad trombone.