Under the Patient Protection and Affordable Care Act (the “Affordable Care Act”), employers with 50 or more full-time or full-time equivalent (“FTE”) employees may be subject to a penalty if the employer fails to offer a certain percentage of its full-time employees and their dependent children health coverage that meets the minimum essential coverage requirements of the Act (the “No Coverage Penalty”) or the employer offers coverage that is unaffordable or that does not provide minimum value (the “Insufficient Coverage Penalty”). The penalties will apply to employers with 100 or more FTE employees starting in 2015, and to employers with 50 or more FTE employees starting in 2016.

To determine whether an employer has 50 or more FTEs, the number of employees is determined on a “controlled group” basis as defined under Section 414 of the Internal Revenue Code. Under the controlled group rules, all employees of commonly-controlled corporations, trades or businesses are treated as employees of a single corporation, trade or business. There are three basic types of controlled groups under the Code:  (i) a parent-subsidiary controlled group, which generally exists where one entity owns at least 80% of a second entity (e.g., a holding company that is the principal owner of a portfolio company constitutes a parent-subsidiary controlled group); (ii) a brother-sister controlled group, which exists where the same five or fewer individuals, estates or trusts own at least 80% of two or more entities and own more than 50% of those entities when considering each individual’s, estate’s or trust’s ownership to the extent that it is identical with respect to each entity; and (iii) a “combined” controlled group, which exists where the group includes both parent-subsidiary and brother-sister members.

Private equity funds have historically relied on Whipple v. Commissioner, 373 U.S. 193 (1963) and Higgins v. Commissioner, 312 U.S. 212 (1941) for the proposition that private equity funds, as passive investors in portfolio companies, are not engaged in a trade or business (and therefore the funds are not part of a controlled group with their portfolio companies).^[1]  Thus, in the case of a private equity fund with fewer than 50 FTEs that owns multiple, unrelated portfolio companies each employing fewer than 50 FTEs:

• The fund and its portfolio companies would not constitute a controlled group and would not be subject to the employer mandates of the Affordable Care Act based solely on the fund’s ownership of the companies.

• None of the portfolio companies would be in a “portfolio company” controlled group with each other, and would not be subject to the employer mandates of the Affordable Care Act based solely on the fund’s ownership of the companies.

However, traps for the unwary exist and a careful analysis of the proposed ownership structure of a portfolio company should be undertaken to determine if a controlled group would be created.  For example, where private equity funds engage in “add on acquisitions” under a holding company that is itself wholly-owned by the private equity funds, the acquired companies would likely be considered part of a controlled group with the holding company, thereby subjecting the holding company and its portfolio companies to the employer mandates of the Affordable Care Act.

Moreover, in a July 2013 decision of the First Circuit involving private equity fund Sun Capital Partners IV, the Court concluded that the fund was engaged in a “trade or business” under the controlled group rules of ERISA for purposes of a portfolio company’s unfunded pension liabilities. For a detailed discussion of the Sun Capital Partners IV case, please see our Client Alert dated September 13, 2013, which can be found here.

While the Sun Capital Partners IV case is not a tax case under the Internal Revenue Code, it raises the possibility that a private equity fund could be considered a trade or business and part of a controlled group with its portfolio companies for tax purposes, depending on the facts of the particular situation. The potential implications for private equity funds under the Affordable Care Act include the following:

1. Portfolio companies with less than 50 FTEs who believe that they are not subject to the Affordable Care Act may actually be subject to the requirements of the Affordable Care Act, which could result in the imposition of substantial penalties for noncompliance.

2. Private equity funds that have employees (as opposed to private equity funds without employees that are managed by the fund’s sponsor or by an investment manager that does not have an ownership interest in the portfolio company) may be subject to the requirements of the Affordable Care Act.

It is worth noting that Craig Gerson, an attorney-advisor in the tax policy section of Treasury, stated at a September 2013 meeting of the American Bar Association tax section that Treasury recognizes the Sun Capital Partners IV decision could provide it with an opportunity to reassess what a “trade or business” means, but the administration would not be in a rush to issue guidance relating to the decision.

_{[1] In order for a partnership or limited liability company, such as a fund, to be part of a controlled group with another entity, the partnership or limited liability company must be a trade or business and under common control with the other entity.}