A nonresident's gain from selling a partnership interest generally is not taxable in California simply because the partnership conducts business in the state. But that has not stopped the California Franchise Tax Board (FTB) from trying to limit this general rule.
Since issuing Legal Ruling 2022-02 in July of 2022, the FTB has argued that certain gains from the sale of partnership interests should be sourced to California and taxed based on the partnership's California business activities. However, in a recent opinion, Appeals of Burch and Carden,[1] the California Office of Tax Appeals (OTA) rejected that approach. The opinion, issued July 24, 2026, and published in October 2026, is currently designated "pending precedential" and may support refund claims by nonresident taxpayers who previously paid California income tax on gains attributable to hot assets from sales of partnership interests.
Background: The FTB's Hot Asset Sourcing Rule
Under California Revenue and Taxation Code (R&TC) section 17952, gain realized by nonresident individuals and nonresident nongrantor trusts from the sale of intangible property, including partnership interests, generally is sourced to the resident state of the taxpayer and thus is not subject to California income tax unless the property has acquired a business situs in California. Other sourcing rules will apply, however, when such gain arises from the conduct of a business operating in California.
For federal income tax purposes, Internal Revenue Code (IRC) section 741 generally treats gain from the sale of a partnership interest as capital gain. IRC section 751(a), however, requires the portion attributable to certain unrealized receivables and inventory (among other categories), commonly known as "hot assets," to be treated as ordinary income. This rule prevents partners from converting ordinary income into capital gain simply by selling their partnership interests rather than the underlying assets.
The FTB took this characterization rule regarding what tax rate applies to taxable income for federal income tax purposes and transformed it into a sourcing rule for state income tax purposes. In Legal Ruling 2022-02, issued July 14, 2022, the FTB gave notice of its position that the ordinary income attributable to hot assets should be sourced as though the partnership had sold those assets immediately before the partner sold its interest. Under this approach, California could tax a portion of a nonresident's gain based on the partnership's California business activities, even if the partnership interest as held by the nonresident taxpayer itself had no California business situs.
As we explained in our August 2022 alert, the FTB's approach fails to distinguish between how gain is characterized for federal income tax purposes and how that gain is sourced for California income tax purposes.
The OTA Rejects the FTB's Position
In Burch and Carden, the taxpayers were California nonresidents who owned interests in JCB Investments, LLC (JCB), an investment company treated as a partnership for tax purposes that held approximately 28% of Tory Burch LLC, which conducted business within and outside California. In 2012 and 2013, JCB sold portions of its interests in Tory Burch, generating both capital gain and ordinary income attributable to hot assets. Although JCB executed the sales, the parties agreed to analyze the sourcing of the resulting gain from the perspective of the nonresident individual taxpayers as if they had directly realized the gain from the sale of the partnership interests.
The FTB agreed that the capital gain was not California-source income. It argued, however, that the ordinary income attributable to hot assets should be apportioned to California using Tory Burch's California apportionment factors.
The OTA disagreed. Relying on the decision by the U.S. Court of Appeals for the D.C. Circuit in Rawat v. Commissioner,[2] which it found highly persuasive, the OTA concluded that IRC section 751(a) changes the character of gain from capital to ordinary income but does not turn a partnership interest sale into a sale of the partnership's underlying assets. In other words, treating part of the gain as ordinary income does not change what the taxpayer actually sold.
Applying that reasoning, the OTA held that the disputed gain remained subject to California's sourcing rule for intangible property under R&TC section 17952 applicable to nonresident individuals and nonresident nongrantor trusts. Because the FTB conceded that the partnership interests had not acquired a California business situs, the gain was not California-source income. More significantly, the OTA also found that neither California law nor its regulations supported the FTB's proposed sourcing approach and expressly declined to follow Legal Ruling 2022-02.
The decision does have important limits, however. It does not mean that California can never tax a nonresident's gain from selling a partnership interest. The OTA distinguished earlier decisions, including Appeal of Smith[3] and The 2009 Metropoulos Family Trust v. California Franchise Tax Board,[4] in which income recognized by pass-through entities was treated as apportionable business income attributable to their unitary business activities. In Burch and Carden, by contrast, the FTB did not argue that JCB and Tory Burch were unitary or that the gain was apportionable business income at JCB's level. Instead, the FTB sought to source the disputed gain based on a deemed sale of Tory Burch's hot assets, an approach the OTA rejected. Whether California can tax gain from the sale of a partnership interest therefore continues to depend on the particular facts and structure of the transaction.
Potential Refund Opportunities
Burch and Carden may provide an opportunity to seek a refund for nonresident taxpayers who, in connection with the sale of partnership interests, previously paid California income tax on gains attributable to hot assets under the FTB's approach. Taxpayers should consider reviewing prior partnership sales to determine whether their circumstances are consistent with the OTA's decision and whether a refund claim is available for open tax years.
Timing is important. Under R&TC section 19306(a), a refund claim generally must be filed within the later of (1) four years from the original due date of the return, (2) four years from the date the return was filed, if filed in a timely manner (including within an applicable extension period), or (3) one year from the date of overpayment. Taxpayers should review these deadlines promptly and consider whether protective refund claims are appropriate while the opinion's precedential status and the FTB's response remain unresolved.
Although the OTA's opinion provides support for taxpayers challenging the FTB's hot asset sourcing approach, it has not yet been designated precedential, and Legal Ruling 2022-02 has not been withdrawn. The opinion's ultimate precedential status and any subsequent action by the FTB or California legislature could affect its practical implications for taxpayers.
How We Can Help
Our Transactional Tax team is closely monitoring Burch and Carden and its implications for nonresident taxpayers. We can help evaluate potential refund claims, review the California tax consequences of past or proposed partnership sales, and assess how the opinion may affect state tax reporting positions.
[1] 2026-OTA-527P (Cal. Off. Tax Appeals July 24, 2026).
[2] 108 F.4th 891 (D.C. Cir. 2024).
[3] 2023-OTA-069P (Cal. Off. Tax Appeals Dec. 7, 2022).
[4] 79 Cal. App. 5th 245 (2022).