In a recent decision, the California Office of Tax Appeals (OTA) held that nonresident partners were not subject to California income tax on gains from the sale of partnership interests merely because a portion of the gain was characterized as ordinary income under Internal Revenue Code (IRC) section 751(a). In Appeals of J. Burch, J. Carden and K. Carden, 2026-OTA-527P, the OTA rejected the Franchise Tax Board’s (FTB) sourcing approach under FTB Legal Ruling 2022-02 and concluded that section 751(a) changes the character of gain but does not, by itself, determine the gain’s sourcing for California income tax purposes.
Background
The taxpayers, California nonresidents, held interests in JCB Investments, LLC (JCB), which owned approximately 28% of Tory Burch LLC. In 2012 and 2013, JCB sold portions of its interests in Tory Burch LLC, recognizing gains attributable in part to unrealized receivables and inventory items, commonly referred to as “hot assets” under IRC section 751(a).
Pursuant to FTB Legal Ruling 2022-02, the FTB asserted that the section 751(a) gains should be treated as income from a deemed sale of the partnership’s underlying assets and apportioned to California using Tory Burch’s California apportionment percentages.
The OTA’s Decision
The OTA rejected the FTB’s position, concluding that section 751(a) changes the gain from capital to ordinary income but does not transform the transaction into a sale of the partnership’s underlying assets for sourcing purposes.
The OTA found the reasoning in Rawat v. Commissioner, 108 F.4th 891 (D.C. Cir. 2024), highly persuasive. In Rawat, the court concluded that IRC section 751(a) changes the character of partnership interest gain without creating a deemed sale of the underlying partnership assets. Applying that reasoning, the OTA determined that the section 751(a) gains did not constitute distributive shares of partnership operating income for California purposes.
The OTA distinguished Appeal of Bense, 79-SBE-055 (1979), which the FTB cited in support of its position. Although Bense described partnership-interest sales as fragmented into separate transactions, the OTA explained that this treatment addressed the characterization of gain rather than establishing a deemed sale of the partnership’s underlying assets. The OTA further noted that Bense did not address nonresident income sourcing at issue in Burch.
Additionally, the OTA distinguished Appeal of Smith, 2023-OTA-069P, where a unitary relationship between the holding and operating partnerships supported treating the gain as apportionable business income. Unlike in Smith, the FTB did not assert that JCB and Tory Burch were unitary or that the gains constituted apportionable business income at JCB’s level.
Accordingly, the OTA concluded that the section 751(a) gains remained attributable to the sale of intangible partnership interests and were subject to California Revenue and Taxation Code section 17952, under which a nonresident’s income from intangible property generally is not treated as California-source income unless the property has otherwise acquired a California business situs.
Taxpayer Implications
The decision expressly declines to follow FTB Legal Ruling 2022-02 and may provide support for nonresident taxpayers recognizing section 751(a) gains from partnership-interest sales involving California businesses. However, the ruling does not preclude California taxation where a partnership interest has acquired a California business situs or where a unitary relationship or another applicable sourcing provision supports taxation.
Taxpayers with similar transactions should consider reviewing their California reporting positions, pending examinations, and potential refund opportunities, including whether protective refund claims should be filed to preserve their rights pending further developments, subject to applicable statutes of limitations.
If you have questions regarding partnership interests or another tax matter, contact a CBIZ tax professional. contact a CBIZ tax professional.
Frequently Asked Questions
The OTA held that IRC section 751(a) changes the character of partnership interest gain from capital to ordinary income but does not, by itself, determine how that gain is sourced for California income tax purposes.
The decision may support nonresident taxpayers recognizing section 751(a) gains from sales involving a California partnership interest without changing the sourcing to California. However, California taxation may still apply when unrelated California sourcing rules supports taxation.
Taxpayers may want to review their California reporting positions, pending examinations, and potential refund opportunities. They should also consider whether a protective refund claim may be appropriate, subject to applicable statutes of limitations.
The OTA expressly declined to follow the sourcing approach in FTB Legal Ruling 2022-02, rejecting the view that section 751(a) gain should be sourced based on a deemed sale of the partnership’s underlying assets.
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