Editor: Mark G. Cook, CPA, CGMA
The California Franchise Tax Board (FTB) issued Legal Ruling 2022-02 on July 14, 2022, to provide its interpretation of the sourcing of Sec. 751(a) gain from the disposition of a nonresident individual’s partnership interest to the extent the Sec. 751 property is located in California, pursuant to Cal. Code Regs. tit. 18, Section 17951-4.
In its ruling, the FTB addresses two situations. In Situation 1, a nonresident individual partner owns a 49% interest in a partnership that carries on business wholly within California that has assets including unrealized receivables, appreciated inventory located in California, and depreciation recapture assets also located in California (also referred to as “hot assets”). The partner sells its partnership interest to an unrelated third party. Situation 2 assumes the same facts, except that the partnership conducts business within and without California.
For Situation 1, the ruling holds that all gain or loss associated with the partnership’s Sec. 751 property is sourced to California. Cal. Code Regs. tit. 18, Section 17951-4(a), provides that net income from a nonresident’s business, trade, or profession carried on wholly within California is California-source income. Because the business is conducted wholly within California and the FTB deems this in part a sale by the partnership (discussed further below), all of the partner’s income attributed to the Sec. 751 gain or loss will be sourced to California. The partner’s Sec. 741 gain is considered the sale of intangible property and sourced pursuant to Cal. Rev. & Tax. Code (RTC) Section 17952. Assuming the intangible asset has not otherwise established a business situs in California, the Sec. 741 gain would not be sourced to California.
For Situation 2, the ruling holds that gain or loss associated with the partnership’s Sec. 751 property is sourced to California, based upon the partnership’s California apportionment factors by operation of Cal. Code Regs. tit. 18, Section 17951-4(d). Since the gain or loss is calculated as if the partnership had sold the Sec. 751 property and distributed it up pro rata to the partner, the income would be treated as income from a trade, business, or profession and sourced according to the Uniform Division of Income for Tax Purposes Act (UDITPA) (RTC Sections 25120 to 25139).
The FTB gets to this result in part by using two competing approaches to partnerships under Secs. 741 and 751: the aggregate approach and the entity approach. Citing Unger, T.C. Memo. 1990-15, the ruling states that the entity theory holds the nature of a partnership to be such that the partnership is a distinct legal entity separate from its partners. The aggregate theory, on the other hand, considers the partners of a partnership as not forming a collective whole. Rather, the partnership is viewed as merely an aggregate of the individual partners of which it is composed.
Sec. 741 applies an entity approach to partnerships when a partner sells or exchanges their partnership interest. Under Sec. 741, the partner generally recognizes a capital gain or loss on the sale only to the extent the partnership holds no unrealized receivables or appreciated inventory. California generally treats the sale of a partnership interest by an individual under the entity theory as a sale of intangible personal property, sourced to the state of domicile of the seller unless the property establishes business situs in California.
In contrast, for the Sec. 751 property, an aggregate approach is used, and the FTB gets to its conclusion in part because it concludes that the operation of Sec. 751 necessitates that the sale of the partnership interest be treated as two distinct transactions: The Sec. 751 assets are first treated as being sold by the partnership (so characterized as a sale by the business) and then, second, as a separate transaction where the intangible partnership interest is sold by the partner. Following this logic, the two separate “transactions” result in a deemed distribution, and the nonresident partner must recognize gain on the sale, even though the general rule for intangibles sources gain to the seller’s individual domicile.
An interesting aspect of the ruling is that it cites to the FTB’s argument from the recent decision of the California Court of Appeal in The 2009 Metropoulos Family Trust v. Franchise Tax Board, No. D078790 (Cal. Ct. App. 5/27/22). In Metropoulos, the court ruled for the FTB, affirming the trial court’s decision that nonresident S corporation shareholders are subject to California income tax on their pro rata shares of the income from the S corporation’s sale of intangible property. As of this writing, the Court of Appeal decision had not been appealed to the California Supreme Court.
In Legal Ruling 2022-02, the FTB’s position is analogous to the extent that once gain from a transaction is treated as apportionable business income at the (passthrough) entity level, this business income character taints the income that is passed through to the nonresident for individual income tax purposes, resulting in the apportionment of at least some of the gain to California, instead of sourcing to the nonresident’s domicile pursuant to California’s individual income tax statutes.
The FTB generally treats the sale of a partnership interest by an individual as a sale of intangible property, sourced to the state of residence of the seller, based in part on Appeals of Ames, 87-SBE-042 (Cal. State Bd. of Equalization 6/17/87). This case is also cited in Section 3350 of the FTB’s Residency and Sourcing Technical Manual. However, the Sec. 751 gain or loss is not specifically addressed in the manual, and the ruling provides the FTB’s approach where Sec. 751 gain or loss is involved.
Tax practitioners should be aware of the FTB’s two-step approach to transactions involving Sec. 751 gain: From the perspective of the selling nonresident taxpayer, this is one transaction involving the sale of an intangible interest. If taxpayers and their practitioners focus solely on the personal income tax rules, they may conclude that none of the gain is attributable to California at the individual level. Both taxpayers and practitioners must include in their transaction analysis considerations of items such as Sec. 751 gain (hot assets) that may lead to a reclassification of an item of income from a straight sale of an intangible to the sale of a business asset. This ruling and the recent Metropoulos decision make clear that the FTB is broadening its view of what constitutes business income for individual nonresidents, the gain from which must be sourced at least in part to California.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif. For additional information about these items, contact Mr. Cook at 949-623-0478 or email@example.com. Contributors are members of or associated with SingerLewak LLP.