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DC Circuit Court rules that partnership gain treated as ordinary income is not a sale of inventory and is not US-source
July 2024
In brief
What happened?
The DC Circuit Court of Appeals in Indu Rawat v. Commissioner IRS reversed the Tax Court by holding, in an opinion decided on July 23, that gain from the sale of a partnership interest treated as ordinary income as a result of it being attributable to inventory of the partnership is not income from the sale of inventory and is not sourced based on the rules for sourcing inventory sales which, in this case, resulted in treating the income as foreign-sourced. The question before the Court was whether Section 751(a) establishes that ordinary income attributable to inventory items of a partnership arising from the sale of a partnership interest is merely taxed as ordinary income rather than as a capital gain, or whether Section 751(a) also deems the gain to be treated as being from an actual sale of inventory.
Why is it relevant?
The DC Circuit Court of Appeals held that gains from the sale of a partnership interest by nonresident aliens, even if attributable to inventory and treated as ordinary income, are not sourced based on the inventory sourcing rules of Section 865(b), but rather under the general principles of Section 865, which, in this case, resulted in the income being foreign-sourced and not subject to tax. The Court cited the statutory definition of ordinary income and the legislative intent behind Section 751(a) in its reasoning. The year in issue pre-dates the enactment of Section 864(c)(8), which employs a look-through approach for dispositions of partnership interests on or after November 27, 2017.
Action to consider
This ruling is particularly relevant to dispositions made before November 27, 2017. Taxpayers should consider whether any positions could be affected by the Court’s decision.
Background
Generally, a partner treats the gain or loss on the sale of a partnership interest as the sale of a capital asset. However, Section 751 recharacterizes a portion of the gain or loss on such a sale from capital to ordinary to the extent that the gain is attributable to unrealized receivables or inventory of the partnership. Sales of partnership interests generally are considered sales of personal property and typically would be treated as foreign-source income in the hands of a foreign partner and therefore commonly not subject to US taxation. However, sales of inventory could be US-source and could be subject to US tax.
Observation: The 2017 tax reform act added Section 864(c)(8), which treats gain recognized by a foreign partner on the sale of a partnership interest as effectively connected income (ECI) to the extent the foreign partner would have had ECI had the partnership sold all of its assets. The transaction in this case was executed prior to the enactment of the 2017 tax act.
Indu Rawat, a nonresident alien, sold her partnership stake in Innovation Ventures, LLC, an entity treated as a partnership for US tax purposes, for $438 million in 2008, with $6.5 million of that amount attributable to unrealized gain on the partnership’s inventory. The IRS claimed the ordinary income attributable to the inventory should be treated as if it was from the sale of inventory, was US-source income, and should be subject to US tax. The taxpayer contended that the ordinary income was still from the sale of a partnership interest, was foreign-source income, and was not subject to US tax. The Tax Court ruled in favor of the IRS, leading to the taxpayer’s appeal.
Section 864(c)(8) was added in apparent response to the holding in Grecian Magnesite Mining, Ind. & Shipping Co. v. Commissioner, 149 T.C. 63 (2017), aff’d, 926 F.3d 819 (D.C. Cir. 2019). The Tax Court applied entity principles to a foreign partner’s sale of an interest in a partnership engaged in the active conduct of a trade or business within the United States and, therefore, did not treat gain as effectively connected to the conduct of that trade or business subject to tax. Grecian Magnesite Mining invalidated Rev. Rul. 91-32, which relied on a look-through approach similar to the approach subsequently taken in Section 864(c)(8). The IRS position in Rev. Rule 91-32 was that any gain from the sale of a partnership interest that was engaged in a US trade or business (USTB) was US-source to the extent of the USTB assets of the partnership. The Grecian Magnesite Mining decision did not address whether a different result might be obtained on Section 751 gain attributable to partnership inventory.
Court’s analysis
The DC Circuit Court of Appeals rejected the IRS's argument that Section 751(a) changes the asset being sold from a partnership interest to a deemed sale of inventory. The DC Circuit Court concluded that while a portion of the gain would be considered ordinary, it still was generated by the sale of a partnership interest, would be considered foreign-source in this instance, and would not be subject to US tax.
Observation: Some practitioners criticized the Tax Court’s opinion for adopting an unwarranted aggregate approach to the sale of partnership interests that appeared at odds with the Tax Court’s own holding in Grecian Magnesite Mining. The DC Circuit Court of Appeals explored the plain language of the statutes at issue and determined that Section 751(a) merely recharacterizes capital gain from the sale of a partnership interest to ordinary income from the sale of a partnership interest. It contrasted the language Congress used in Section 751(a) (equivalent to the Code’s ordinary income definition) to the language used in Section 751(b) (specifically recharacterizing a redemption transaction as a sale of ‘such property’). The DC Circuit Court of Appeals’ in-depth statutory construction preserves the traditional entity treatment on the sale or exchange of partnership interests.
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