California Nonresidents Selling Partnership Interests Beware: Franchise Tax Board Conflates Federal Gain Recharacterization Rules for Hot Assets with State Sourcing Rules

7 min

Nonresidents of California generally are not taxed by California on gain resulting from the sale of partnership interests. Under new guidance issued by the California Franchise Tax Board ("FTB") nonresidents can now expect to be subject to California tax on a portion of such gain with respect to any partnership that has been filing a tax return with California.

In Legal Ruling 2022-02 issued by the FTB's Legal Division FTB, the FTB asserts that the federal rules for recharacterizing a partner's gain on the sale of a partnership interest as ordinary income under Internal Revenue Code ("IRC") section 751, also known as the "hot asset rules," apply to recharacterize gain as business income for California income tax purposes. In brief, the FTB adopts a "look through" approach that treats the portion of a nonresident partner's gain attributable to the partnership's unrealized receivables or appreciated inventory, as business income that can be sourced and taxed in California. The FTB has been experimenting with versions of this position in audit for the last few years but has now formalized its view in a published ruling.

Traditional Rules for Intangible Gain Sourcing

A generally applicable principle of state income tax law is that income from the sale of intangible assets is attributed to the resident state of an individual realizing the income unless the asset has in some way acquired a business situs or connection with another state. CRTC § 17952. Thus, for a Nevada resident selling interests in a partnership (i.e., an intangible asset), the gain from the sale will generally not be subject to tax by another state even though the partnership may hold assets located in another state. Sellers regularly rely on this principle when selling stock in a corporation or ownership interests in partnerships or limited liability companies. They structure and plan the sale with the expectation that the form of the sale as a sale of an intangible asset will be respected for state income tax purposes and the resulting gain will be sourced to and taxed only by their state of residence.

FTB's New and Novel Approach

The FTB's ruling uses a novel interpretation of federal and California income tax law to sidestep traditional sourcing rules for gain from the sale of an intangible asset in the context of a partnership interest sold by a nonresident of California. The FTB's new formal stance is that any ordinary income recognized under IRC section 751 should be treated as business income and thereby apportioned to California based on the partnership's applicable California apportionment formula.

The FTB explains its rationale for this position by characterizing a nonresident partner's sale of a partnership interest separately from the sale of the partnership's hot assets, effectively treating the sale as two distinct transactions: (1) a sale of an intangible partnership interest by a partner, and (2) a sale of the underlying Section 751 property that is treated as having been sold by the partnership immediately before the sale of the partnership interest, resulting in a deemed distribution to the partner. The ruling effectively holds that this deemed sale of hot assets is not treated as a sale of intangible property, nor as an asset sale, but rather, as a distributive share of income from a trade, business or profession to be sourced under FTB Regulation 17951-4.

With this ruling, the FTB departs from the traditional sourcing rules by misapplying IRC Section 751, which only requires partners to recognize ordinary income or loss for federal tax purposes on the portion of the sale attributable to hot assets. While this re-characterization of capital gain to ordinary income under IRC section 751 changes the rate of taxation for federal tax purposes, it does not require a bifurcation of the sale into two separate transactions, nor does it necessitate a recasting of nonbusiness income into business income. Accordingly, an historically consistent application of IRC section 751 to a nonresident partner's sale of a partnership interest with hot assets would not change the application of California's sourcing rules nor would it change California's tax rate.

California's applicable regulations make clear that whether gain is "ordinary income" or "capital gain" is irrelevant to its classification as "business income" or "nonbusiness income" for California tax purposes. CCR section 25120(a) defines "business income" as income arising from transactions and activities occurring in the regular course of business, including income from tangible and intangible property if the acquisition, management and disposition of that property is an integral part of the business operations. "Nonbusiness income" is defined as all income other than business income. California regulations further clarify that the "classification of income by the labels occasionally used, such as . . . gains, operating income, nonoperating income, etc., is of no aid in determining whether income is business or nonbusiness income." Thus, the FTB's own regulations make clear that the classification of the gain resulting from a partner's sale of his partnership interest as "ordinary income" versus "capital gain" under IRC section 751 for federal tax purposes has no bearing on whether such gain meets California's definition of "business income" for California tax purposes.

In the past, the FTB has sought ways to tax a nonresident partner's gain from a sale of a partnership engaged in business in California. However, the FTB has previously failed in its efforts. In Valentino v. FTB, 87 Cal.App.4th 1284 (2001), the California Court of Appeals unequivocally reiterated the long-standing rule that "[p]artnership interests are intangible property. . ." for purposes of applying California's sourcing rules. Likewise, the California State Board of Equalization has consistently held (see Appeal of Venture Communications, Inc., Cal. St. Bd. of Equal. (Feb. 5, 2003)) that income received from the sale of a partnership interest is income from intangible personal property and will only be from sources within California if such interest acquired a business situs in California. A nonresident partner's interest in a partnership does not acquire a business situs in California by virtue of the partnership's business operations in California. Instead, business situs arises from the acts of the owner of the intangible personal property.

In light of its past failures to tax partnership sales by nonresidents, the FTB is attempting to circumvent years of precedent with a creative reading of IRC section 751. In any event, the ruling lacks a clear legal basis for the use of an income characterization rule (ordinary income v. capital gain) under IRC section 751 in contravention to California regulations.

Other Recent Sourcing Guidance for Nonresidents

The FTB continues to take aggressive approaches in seeking to tax income of nonresidents in other contexts. In The 2009 Metropoulos Family Trust v. California Franchise Tax Board ("Metropoulos"), 79 Cal. App. 5th 245 (2022) (see Venable's alert regarding this case), the California Court of Appeal ruled that nonresident shareholders of an S corporation must source gain on the S corporation's sale of its intangible assets using the S corporation's apportionment factor and not based on the shareholders' state of residence. By taking this position, California can get tax revenue from the sale of intangible assets which have nothing to do with California provided the out-of-state business itself has one or more California customers. Similar to the legal issues litigated in Metropoulos, we can expect the FTB's position in Legal Ruling 2022-02 will ultimately be challenged in court. But until then, this ruling will continue to frustrate out-of-state taxpayers who sell their out-of-state businesses.

Sellers Beware

Legal Ruling 2022-02 together with the decision in the Metropoulos case substantially enhances the FTB's tools to attribute income to California in connection with sales by and of pass-through entities, and because both the legal ruling and caselaw are interpretive of existing authority, the FTB is likely to apply their reasoning both prospectively and retroactively to prior years with open statutes of limitations. Thus, sellers of a business with California connections need to be ever more vigilant in the reporting, negotiation and structuring of their transactions if they seek to minimize state taxation on a sale. Even if the FTB comes knocking, Legal Ruling 2022-02 is simply the FTB's administrative pronouncement. Many options are available for taxpayers to challenge this most recent approach by the FTB.