Out of State Partners Beware: Welcome to Taxifornia

Based on the Franchise Tax Board’s (“FTB”) recently issued legal ruling, nonresident partners who previously thought the sale of their partnership interests were treated as the sale of intangible property and excluded from California taxation under Cal. Rev. and Tax. Code section 17952 will have to reconsider their tax situation.

On July 14, 2022, the FTB issued Legal Ruling 2022-02, which provides guidance on the sourcing of Internal Revenue Code (“IRC”) section 751(a) gain from the disposition of a nonresident individual’s partnership interest to the extent IRC section 751 property is located in California. 

IRC section 751 property includes items such as unrealized receivables, substantially appreciated inventory, and depreciation recapture on assets under IRC section 1245.  Typically, if IRC section 751 property were sold or collected by a partnership, it would result in an ordinary gain.  Therefore, IRC section 751 acts to prevent a partnership from converting ordinary gain into capital gain through the sale of partnership interests.

The ruling describes two situations.  The first involves a nonresident individual partner who owns a 49 percent interest in ABC Partnership, which is carried on wholly within California.  The partnership’s assets include “unrealized receivables, appreciated inventory located in California, and depreciation recapture on assets located in California.”  The nonresident partner sells her partnership interest to an unrelated third party.

The second situation is the same as the first, except that the ABC Partnership conducts business “within and without California.”

The legal ruling walks through the federal tax law, IRC sections 741 and 751, and the two different approaches found within federal tax law regarding the treatment of a partnership, the entity theory and the aggregate theory.

The entity theory provides that the partnership is “a distinct legal entity separate from its partners.”  The aggregate theory, on the other hand, views the partnership as “merely an aggregate of the individual partners of which it is comprised.”

As described in the ruling, “IRC section 741 applies an entity approach to partnerships,” and when a partner sells their partnership interest, in general, the partner recognizes “a capital gain or loss on the sale only to the extent the partnership holds no unrealized receivables or appreciated inventory.”

California generally conforms with IRC section 741 and treats the sale of a partnership interest as the sale of intangible personal property and sources that sale to the seller’s residence unless it has acquired a business situs within the state.

The ruling then describes the treatment of IRC section 751 property, which follows the aggregate theory.  Under IRC 751, gain or loss associated with the sale of the partnership interest “attributable to unrealized receivables or inventory items of the partnership” is treated as ordinary income or loss.

The FTB reasons that the sale of a partnership interest is treated as two separate transactions, “one in which the intangible partnership interest is sold by the partner, and one in which the underlying IRC 751 property is treated as sold by the partnership immediately before the partner disposes of its interest, leading to a deemed distribution to the partner.”

Therefore, a partner’s deemed sale of IRC section 751 property is not sourced as income from the sale of an intangible under Cal. Rev. and Tax. Code section 17952, but as income from a nonresident’s business, trade, or profession under Regulation section 17951-4.

For the first fact pattern, the FTB splits the sale of partnership interest into two transactions.  The first transaction is the sale of the intangible partnership interest under IRC section 741, which is sourced to the seller’s residence unless it has acquired a business situs in California.  The second transaction is the sale of the ABC partnership’s IRC section 751 property, the unrealized receivables, appreciated inventory located in California, and depreciation recapture on assets located in California.  The FTB’s ruling concludes that all the gain or loss associated with the ABC partnership’s IRC section 751 property is California source income and accordingly sourced to California. 

The ruling’s conclusion for the second fact pattern largely mirrors the first, except that the gain or loss from the ABC partnership’s sale of IRC section 751 property is apportioned to California based on the partnerships’ apportionment factors under Regulation section 17951-4(d).  The ruling also states that “each item of IRC 751 property, not the partnership interest, must be sourced under the sourcing rule appropriate to that item.”

Nonresident partners should be aware of the FTB’s new views on sourcing income from the sale of partnership interests and analyze whether they have California source income when selling partnership interests if the partnership has IRC section 751 property.