Court finds foreign partner not liable for ‘hot asset’ gain

The Court of Appeals for the D.C. Circuit has held in Rawat v. Commissioner (Case No. 2023-1142) that a foreign partner was not liable for U.S. tax on gain attributable to her share of a partnership’s inventory as a result of Section 751(a). Rawat involved the taxpayer’s 2008 tax year and thus may have limited direct impact due to the subsequent enactment of Section 864(c)(8) as part of the Tax Cuts and Jobs Act (TCJA). However, the opinion still provides valuable insight into the aggregate versus entity concept that underlies much of partnership taxation.

The taxpayer in Rawat was a Canadian individual who sold an interest in a U.S. partnership. A portion of the gain recognized was attributable to the partnership’s inventory and the IRS asserted that the taxpayer was subject to U.S. tax with respect this portion of the gain. Thus, the issue under consideration was whether the taxpayer should be viewed as selling inventory for purposes of the sourcing rules, notwithstanding that the actual asset sold was a partnership interest.

In Revenue Ruling 91-32, the IRS previously asserted that gain from a foreign taxpayer’s sale of its U.S. partnership interest was income effectively connected (ECI) with a U.S. trade or business to the extent the taxpayer would have been allocated ECI if the partnership had sold all its assets. This approach was previously rejected in Grecian Magnesite Mining, Indus. & Shipping Co. v. Commissioner 149 T.C. 63 (2017), aff’d, 926 F.3d 819 (D.C. Cir. 2019) which held that, in the absence of specific sourcing rules, gain from the sale of a partnership interest was ECI only to the extent provided by generally applicable rules for sales of personal property (which generally source such gain outside the U.S.). In Grecian Magnesite, the Tax Court noted that the IRS had not argued that gain from the sale of a partnership interest could be sourced to the U.S. through the operation of Section 751; Section 751 became the core of the IRS argument in Rawat.

Sections 741 and 751 govern the character of gain or loss recognized from the sale of a partnership interest. Section 741 provides that such gain or loss is generally capital gain/loss, except as otherwise provided in section 751. Section 751(a) provides that the amount of money or fair market value of property received by a transferor partner in a sale or exchange of a partnership interest that is attributable to the partnership’s unrealized receivables and inventory is treated as from the sale or exchange of property other than a capital asset (i.e., from an asset that generates ordinary income or loss).

While the parties agreed that Section 751 caused the taxpayer to recognize some amount of ordinary income with respect to the partnership’s inventory from the sale of her partnership interest, the IRS argued that, by virtue of Section 751, the taxpayer recognized gain from the sale of inventory, which could be sourced to the U.S. and thus constituted ECI.

Although the Tax Court agreed with the IRS, the Court of Appeals for the D.C. Circuit reversed and held that the taxpayer solely recognized gain from the sale of a partnership interest, not the sale of the partnership’s inventory. The appellate court determined that while the legislative history indicated that Section 751 was intended to cause a partner who sold her interest to recognize ordinary income in the same manner as would have been recognized if they had separately disposed of the partnership’s inventory and unrealized receivables, such ordinary income was still income from the sale of a partnership interest (and not the partnership’s assets). Under the sourcing rules in effect at the time, the taxpayer was not subject to U.S. tax on her gain from the sale of her partnership interest.

Subsequent to the opinion in Grecian Magnesite, Congress added Section 864(c)(8) to the Code as part of the TCJA, effectively codifying the IRS position set forth in Revenue Ruling 91-32. As a result of the addition of specific sourcing rules for sales of partnership interests, the holding in Rawat likely has limited impact for post-TCJA years. Still, the court’s opinion highlights that while Section 751 prevents taxpayers from avoiding ordinary income by selling a partnership interest instead of partnership assets, its effects stop short of causing the partner to be treated as actually selling those assets. Rawat’s logic could influence a variety of partnership transactions in which the tax consequences from the sale of a partnership interest might differ from those which would flow from the sale of the partnership’s assets.

Contacts: