Nonresident alien partner’s gain on inventory items sourced to US

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The portion of a nonresident alien’s gain on the sale of an interest in a U.S. LLC treated as a partnership that was attributable to inventory items held by the LLC at the time of the sale was sourced to the United States under Sec. 865(b).


Indu Rawat was a nonresident alien individual for federal income tax purposes during 2008 and 2009. She filed U.S. federal income tax returns as a nonresident alien for the 2000 through 2007 tax years but did not file returns for the 2008 and 2009 tax years.

Innovation Ventures LLC (IV LLC), an LLC treated as a partnership for tax purposes, is a U.S. business that manufactures and sells popular consumer products including 5-Hour Energy drinks. Rawat acquired a 30% interest in IV LLC between 2000 and 2007. She sold her interest for $438 million in January 2008.

When Rawat sold her interest in IV LLC, the company had inventory items with a basis of $6.4 million, which it held for future sale in the United States. It later sold those inventory items for a profit of $22.4 million. Rawat and the IRS agreed that of the $438 million sale price paid to Rawat for her interest in IV LLC, $6.5 million was allocable to inventory held in the United States for sale therein (inventory gain).

The IRS conducted an examination of IV LLC for the 2007 and 2008 tax years. As a result of this exam, the IRS determined that Rawat’s income for 2008 should include the $6.5 million of inventory gain. In 2016, the IRS issued a notice of deficiency for 2008 and 2009 that included in the indicated deficiency $2.9 million in tax, interest, and additions to tax for the 2008 tax year related to the inventory gain. Rawat challenged the IRS’s determination in Tax Court.

In Tax Court, Rawat moved for summary judgment, arguing that under the decisions of the Tax Court and the D.C. Circuit in Grecian Magnesite Mining, Industrial & Shipping Co., SA, 149 T.C. 63 (2017), aff ’d, 926 F.3d 819 (D.C. Cir. 2019), a nonresident alien individual is not subject to U.S. income tax on the sale of the individual’s interest in a U.S. partnership because those gains would be sourced outside the United States under the general rule of Sec. 865(a)(2), regardless of whether any portion of the gains would be attributable to inventory items under Sec. 751(a)(2). The IRS countered that the sourcing of the inventory gain should instead be made under the rules of Sec. 865(b).

Applicable law

In general, if the owner of a partnership interest sells that interest, Secs. 741 and 751 determine the income tax treatment of the sale. Sec. 741 provides that the owner’s gain or loss “shall be considered as gain or loss from the sale or exchange of a capital asset.” However, Sec. 741 provides an exception to this rule: “except as otherwise provided in section 751 (relating to … inventory items).” Sec. 751(a)(2) provides an exception for inventory items of the partnership. The amount of any money received by a transferor partner in exchange for all or a part of its interest in the partnership attributable to inventory items of the partnership is considered to be an amount realized from the sale or exchange of property other than a capital asset.

U.S. federal income tax is imposed on nonresident alien individuals by Sec. 871. Under Sec. 871(b)(2), a nonresident alien is only taxable on income that is “effectively connected with the conduct of a trade or business within the United States.” Under Sec. 864(c)(3), “[a]ll income, gain, or loss from sources within the United States … shall be treated as effectively connected,” while under Sec. 864(c)(4)(A), “no income … from sources without the United States shall be treated as effectively connected.”

With regard to the sourcing of the nonresident’s income, under Sec. 865(a) (2), “income from the sale of personal property [such as a partnership interest] … by a nonresident shall be sourced outside the United States.” However, inventory property is excepted from this rule. Under 865(b)(2), in the case of inventory property, “such income shall be sourced under the rules of sections 861(a)(6), 862(a)(6), and 863.” Under Secs. 861(a)(6), 862(a)(6), and 863, income from the sale of inventory property is sourced to the United States if it is sold within the United States.

In Grecian Magnesite, the Tax Court and the D.C. Circuit held that, as a general rule, an entity approach should be taken in the sourcing analysis of gain realized by a foreign partner upon disposing of its interest in a U.S. partnership and that the asset to be considered in the analysis is the partnership interest itself (which is the subject of the sale) and not the underlying partnership assets. The IRS had argued in that case that an aggregate approach should be taken, that the gain should be analyzed asset by asset, and that, to the extent that the assets of the partnership would give rise to effectively connected income if sold by the partnership, the departing partner’s pro rata share of such gain should likewise be treated as effectively connected income.

The Tax Court’s decision

The Tax Court denied Rawat’s motion for summary judgment. It held that because the inventory gain was attributable to inventory items for purposes of Sec. 751(a)(2), it was excepted from the general rule of Sec. 741. Therefore, it was, for purposes of the sourcing rules, “income derived from the sale of inventory property” under the exception of Sec. 865(b); it may therefore be U.S.- source income.

Rawat contended that the inventory gain portion should be treated the same as the noninventory portion because both portions were not “effectively connected” to the energy drink business in the United States. She claimed that this result was dictated by “the most important point in her motion,” which was that she sold a partnership interest and did not sell inventory. The IRS argued, and the Tax Court agreed, that this was not true because the general approach of Sec. 741, which calls for the sold partnership interest to be analyzed not asset by asset but rather as a singular “capital asset,” gives way to the specific provision in Sec. 751(a)(2) that the portion of the sold partnership interest attributable to inventory items must be separately “considered” as pertaining to “other than a capital asset.” Therefore, the inventory gain was subject to Sec. 751.

Rawat argued that the IRS’s argument made unwarranted use of Sec. 751, which she asserted was not a sourcing rule. Rather, where the section applied, its only effect was to assure noncapital treatment to the proceeds of a sale if the proceeds are taxed at all. The court noted that this was correct but that both Secs. 741 and 751 only defined the character of the property sold and the proceeds, and, to determine the source, the sourcing rules in Secs. 861 to 865 must be applied.

The Tax Court explained that this interpretation was supported by the difference in language between Sec. 741 (which refers to the sale or exchange of a capital asset) and Sec. 751 (which refers to the sale or exchange of property other than a capital asset). As it had explained in its analysis in Grecian Magnesite, this difference in language leads to the conclusion that inventory gain is treated as the proceeds of the sale of separate interests in each asset of the partnership under Sec. 751. According to the Tax Court, this conclusion is also supported by Regs. Secs. 1.751-1(a)(1) and (a)(2).

The court then applied the sourcing rules to the inventory gain. Having found that the inventory gain was excepted from Sec. 741 and that, under Sec. 751(a), this portion of the gain was “attributable to … inventory items,” the court determined that Rawat could not follow the general rule of Sec. 865(a) that sales of personal property of nonresidents are sourced outside the United States. Instead, she was required to follow the exception in Sec. 865(b) for “income derived from the sale of inventory property.” Sec. 865(b) directs the taxpayer to the sourcing rules for the inventory gain in the provisions of “sections 861(a)(6), 862(a)(6), and 863.”

After analyzing the rules in those three subsections, the Tax Court found that, similar to Sec. 865(b), they applied to inventory gain as described in Sec. 751(a). As Rawat’s motion for summary judgment was based on her contention that the sourcing rule for the inventory gain is the general rule of Sec. 865(a)(2), the court concluded it must deny Rawat’s motion.


Although Rawat ended up paying some tax, she overall did much better from a U.S. tax standpoint than she would have if she had sold her interest in IV LLC 10 years later. In response to the decisions in Grecian Magnesite, Congress enacted Sec. 864(c)(8), which applies the aggregate theory to sales of partnership interests by foreign taxpayers by making the gain on the sale of an interest effectively connected income to the extent the portion of the partner’s distributive share of the amount of gain would have been effectively connected if the partnership had sold all of its assets at their fair market value as of the date of the sale or exchange of such interest. If this provision had been in effect at the time of the sale, a much larger portion of Rawat’s total gain on her sale of the interest in IV LLC would have been effectively connected income and subject to U.S. tax.

Rawat, T.C. Memo. 2023-14


James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact

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