Match Made in Heaven

There is no denying that many parts of the Code are complex and, in some cases, too obscure for many “laypersons” to comprehend.[ii] Over time, this reality spawned the need for advisers who are both knowledgeable and experienced in the ways of the Code.[iii]

Yet, even within this group of learned individuals,[iv] there are many for whom certain chapters and subchapters of the Code recall the opening of Dante’s Inferno: “I found myself within a forest dark, For the straightforward pathway had been lost.”[v]

Among these sometimes seemingly inscrutable parts of the Code are the provisions dealing, respectively, with the taxation of partnerships and of non-U.S. persons.

On occasion, these two sets of rules overlap, as they did recently in a matter before the Federal Court of Appeals for the D.C. Circuit.[vi]

Before delving into the particulars of the Court’s decision, a brief review of the Code’s relevant partnership and foreign tax rules may be in order.

Taxation of Partners

In general, a partnership is not treated as a taxable entity. Instead, the partnership’s income passes through to its partners – whether or not it is actually distributed to them – and each partner reports their distributive share of such income on their return to determine their income tax liability.[vii]

The character of an item of partnership income that passes through to the partners – either as capital gain or ordinary income – is determined as if the item were realized by the partners directly from the source from which it was realized by the partnership.[viii] In other words, the income retains the character it had in the hands of the partnership; for example, a partnership’s gain from the sale of a capital asset, or of “property used in the trade or business”[ix] of the partnership, will retain its character as capital gain when it is allocated to the partners.

Distributions

A partner’s basis in their partnership interest is increased by the amount of income or gain thus included by the partner.[x] This basis adjustment prevents double taxation of partnership income when such income is distributed to the partner.[xi] Simply stated, a distribution of money to a partner in an amount equal to the partner’s adjusted basis for their interest represents a nontaxable return of the partner’s basis; i.e., the return of the partner’s unreturned capital plus their share of partnership income already included on the partner’s tax return.[xii]

Sales

However, if the amount of money distributed to a partner exceeds the partner’s adjusted basis in their partnership interest, the amount of such excess is treated as gain from the sale of the distributee-partner’s partnership interest.[xiii]

The gain from this deemed sale of the distributee-partner’s partnership interest is treated as gain from the sale of a capital asset,[xiv] except to the extent it represents the distributee-partner’s share of certain ordinary income-producing assets of the partnership, in which case it gives rise to ordinary income rather than capital gain.[xv]

But what if the distributee-partner is not a U.S. person?

Non-U.S. Partner

As a general matter, a nonresident alien (“NRA”)[xvi] must pay U.S. tax on income “received from sources within the United States,” but not on income received from sources outside the U.S.[xvii]

An NRA who is engaged in a trade or business within the U.S. is taxed on that portion of their taxable income that is “effectively connected” with the conduct of that trade or business.[xviii] In determining such taxable income, deductions for business expenses generally are allowed against effectively connected income.[xix]

If an NRA is a member of a partnership that is engaged in the conduct of a U.S. trade or business, the NRA is considered as being engaged in such business.[xx]

Any gross income derived by this NRA that is not effectively connected with the partnership’s U.S. business is not taken into account in determining the U.S. taxable income from such business.[xxi]

Effectively Connected

Whether an NRA, or the partnership of which the NRA is a member, is engaged in a trade or business in the U.S. depends on the nature of their activities. Some kind of continuous business contacts with the U.S. are usually required in order for an NRA to be engaged in a U.S. trade or business. Generally, the activities conducted by the NRA directly or through agents, have to be regular, substantial and continuous in order to be engaged in a trade or business. All income from U.S. sources that is connected with the conduct of that U.S. trade or business is considered effectively connected income.[xxii]

Assuming the presence of a U.S. trade or business, certain kinds of income that may be described as “investment income” – including, for example, gain from the sale of a capital asset – may nevertheless be treated as effectively connected income. Among the factors taken into account in determining whether such investment income or gain is effectively connected to a U.S. business are the extent to which the income or gain is derived from assets used in or held for use in the conduct of the U.S. business, and whether the activities of the business were a material factor in the realization of the income or gain (the ‘‘asset-use’’ and ‘‘business-activities’’ tests, respectively).[xxiii]

Thus, notwithstanding the general rule that the source of any gain from the sale of personal property is generally determined by the residence of the seller,[xxiv] an NRA partner who is deemed to be engaged in the business of the partnership, and who sells their partnership interest, may have effectively connected income by reason of the asset-use or business-activities of the partnership in which they are an investor.[xxv]

Foreign Person’s Sale of Partnership Interest

As stated earlier, the gain realized by a partner on the sale of their partnership interest is generally treated as gain from the sale “of a capital asset.”

However, under an important exception to the foregoing rule, to the extent the amount received by the selling partner is “attributable” either to “unrealized receivables of the partnership,”[xxvi] or to “inventory items of the partnership,” that gain “shall be considered as an amount realized from the sale . . . of property other than a capital asset.”

In other words, that portion of the gain from the sale of a partnership interest that is attributable to inventory items or unrealized receivables is taxable as ordinary income to the selling partner rather than as a capital gain.[xxvii]

Rev. Rul. 91-32

Years ago, the IRS ruled that the asset-use and business-activities tests (described above) should be applied to partnership assets to determine the extent to which the income derived from the sale of a partnership interest by a foreign person was effectively connected with the partnership’s U.S. trade or business.[xxviii]

Under the ruling, gain from the sale of a partnership interest would be treated as effectively connected with the conduct of the partnership’s U.S. trade or business to the extent such gain is attributable to the unrealized gain in partnership assets, which gain would be treated as effectively connected if those assets were sold by the partnership.

In other words, the ruling treated the sale of a partnership interest by an NRA as a sale of the separate assets of the partnership rather than as a sale of an interest in the partnership as a whole.[xxix]

Grecian Magnesite

However, in 2017 the U.S. Tax Court rejected the aggregate approach adopted by the IRS.[xxx]

Instead, the Tax Court held that a foreign person’s sale of a partnership interest should be treated as the sale of an interest in the entity as a whole,[xxxi] rather than as the sale of the foreign partner’s share of the underlying partnership property.

Because income from the sale of personal property by an NRA is generally sourced outside the U.S.,[xxxii] the Tax Court concluded that the gain from the foreign person’s sale of its partnership interest was income from sources outside the U.S.

And because foreign-source income is generally not treated as effectively connected income, the Court determined that the income was not effectively connected with the conduct of the partnership’s trade or business in the U.S. and, therefore, not taxable to the NRA.

Tax Cuts and Jobs Act

Shortly after this decision, Congress overturned the Tax Court’s conclusion by enacting a provision that treats a foreign partner’s gain from the sale of their partnership interest as effectively connected with a U.S. trade or business to the extent that such foreign partner’s share of the partnership’s gain would have been effectively connected gain had the partnership sold all of its assets at fair market value.[xxxiii]

Thus, Congress applied the aggregate theory of partnership taxation

The foregoing amendment to the Code is effective for sales of partnership interests occurring on or after November 27, 2017.[xxxiv]

However, the transaction considered by the Circuit Court – referred to earlier and described below – occurred almost a decade earlier.[xxxv]

Disposition of Foreigner’s LLC Interest

Taxpayer was an NRA who made several investments – accumulating an almost thirty percent interest – in an LLC that was treated as a partnership for U.S. tax purposes.

A few years later, Taxpayer disposed of her entire membership interest in exchange for a promissory note worth approximately $438 million. At the time of this transaction, LLC held inventory valued at $6.4 million, which it later sold for a profit of $22.4 million.

As an indirect owner of that inventory at the time she sold her interest in LLC, Taxpayer would have been entitled to $6.5 million of the gain from the sale of the inventory. Thus, of the $438 million Taxpayer received in exchange for her interest in LLC, $6.5 million was attributable to what would have been Taxpayer’s share of the gain on LLC’s sale of its inventory.[xxxvi]

Hot Assets

The IRS took the position that this inventory gain was U.S.-source taxable income and notified Taxpayer that she owed taxes with respect to such income. After Taxpayer paid the tax, she petitioned for a refund, contending that the inventory gain was foreign-source income and, therefore, nontaxable.

The IRS’s and Taxpayer’s differing positions revolved around competing understandings of the Code’s partnership “hot asset” rule,[xxxvii] under which gain from the sale of a partnership interest that is “attributable to . . . inventory items of the partnership, shall be considered as an amount realized from the sale or exchange of property other than a capital asset.”

While the parties agreed that the hot asset rule requires inventory gain to be taxed as ordinary income, the IRS argued that the rule also deemed that portion of the gain from the sale of a partnership interest attributable to inventory to be gain on the sale of inventory – as if such inventory had actually been sold – such that it can be taxable as U.S.-source income.[xxxviii]

Taxpayer, however, contended that the hot asset rule had a more limited scope, and insisted that it does not give rise to a deemed sale of inventory and, thus, does not render taxable to an NRA what would otherwise be nontaxable, foreign-source income – i.e., the gain from the NRA’s sale of personal property (Taxpayer’s membership interest in LLC).

Rather, according to Taxpayer, the hot asset rule merely subjects inventory gain to ordinary-income taxation if the gain is otherwise taxable. Because the inventory gain in question was attributable to the sale of a partnership interest (a capital asset), and did not arise from the actual sale of inventory, Taxpayer considered the inventory gain realized to be nontaxable.

Specifically, Taxpayer maintained that the gain constituted proceeds from the sale of personal property other than inventory and was foreign-source income because Taxpayer was an NRA.

The Court’s Analysis

The Tax Court agreed with the IRS, holding that Taxpayer must be taxed as though she actually sold the inventory that gave rise to the inventory gain, thereby causing the gain to be U.S. source income.

Taxpayer appealed to the D.C. Circuit Court.

The Issue

The question before the Circuit Court was (i) whether the hot asset rule merely establishes that inventory gain arising from the sale of a partnership interest is taxed as ordinary income rather than as capital gain – the character of the income – or (ii) whether it also deems inventory gain from the sale of a partnership interest to be income from a sale of inventory – the character of the transaction.

The Court acknowledged that if the inventory gain is understood to be income from the sale of inventory, as asserted by the IRS, then the income may be taxable as U.S.-source income.

It also agreed that, if the inventory gain is treated as income from the sale of a partnership interest, as Taxpayer contended, rather than as income from the sale of inventory, then the gain is foreign-source (based upon Taxpayer’s non-U.S. status) and not subject to U.S. tax.

“Treated As” or “Arising From”?

The Court explained that, under the hot asset rule, inventory gain realized on the sale of a partnership interest is treated as ordinary income for tax purposes.

The hot asset rule, the Court stated, does not treat the inventory gain from the sale of a partnership interest – i.e., the gain attributable to the partnership’s inventory – as income arising from the sale of the inventory. As a result, the gain Taxpayer realized when she sold her interest in LLC was foreign-source income as to which she owed no taxes.

The Court quoted the relevant part of the hot asset rule:

“The amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to . . . (2) inventory items of the partnership, shall be considered as an amount realized from the sale or exchange of property other than a capital asset.[xxxix]

According to the Court, for purposes of its analysis, the “pivotal clause” in the hot asset rule is the last one: “shall be considered as an amount realized from the sale or exchange of property other than a capital asset.”

In construing that language, the Court considered the Code’s definition of ordinary income; i.e., “any gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b).”[xl] The Court noted that this language and the key clause of the hot asset rule are materially identical – both describe an amount realized from the sale or exchange of property other than a capital asset.

When considered in light of the statutory definition of “ordinary income,” the Court continued, the words in the hot asset rule – i.e., “shall be considered as an amount realized from the sale or exchange of property other than a capital asset” – effectively mean the same thing as the phrase “shall be considered as ordinary income.”

The Court observed that a “mandate” that inventory gain be considered ordinary income differs from a mandate that inventory gain be considered income “from the sale of inventory.” If Congress had wanted to convey something other than “ordinary income,” the Court stated, it presumably would have said so expressly. Instead, Congress used terminology that directly corresponds to the definition of ordinary income.

After some additional statutory interpretation and a review of the legislative history of the hot asset rule, the Court concluded as follows:

“The short of it is that [the hot asset rule] does not of its own force render [Taxpayer’s] inventory gain taxable because it does not change the fact that she sold a partnership interest, not inventory. Once we reach that conclusion, the parties agree that the inventory gain from the sale is foreign-source income as to which [Taxpayer] owes no U.S. taxes.”

What Have We Learned?

Some of you may be thinking that Taxpayer’s story was interesting but only from a historical perspective in light of the changes wrought by the 2017 legislation, described earlier, under which an NRA’s gain from the sale of an interest in a partnership engaged in a U.S. business is treated as effectively connected with the conduct of such business.[xli]

Though this is a mostly accurate assessment of the Court’s decision, it overlooks the important distinction made by the Court between the character of an item of income as opposed to the “source” of such income.

Specifically, the Court emphasized the difference between a rule that “converts” the character of the gain arising from a transaction and one that, in effect, changes or recharacterizes the object or form of the transaction itself.

Query the implications of this reasoning.

For example, the IRS has long denied installment reporting for the gain realized on the sale of a partner’s interest in a partnership that is attributable to the partnership’s hot assets on the grounds that, if such assets were sold directly by the partner, the gain could not be reported under the installment method.[xlii] It appears the Court’s decision would support installment reporting in those circumstances, contrary to the IRS’s position.

Stay tuned.

The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] The quotation attributed to Yogi Berra is actually, “it’s like déjà vu all over again.” Did you know that Yogi won 10 World Series as a player with the Yankees? (Plus three as a coach: 2 with the Yankees and one with the Mets.)

[ii] I will remind you that taxpayers have themselves to blame. It is the overwhelming desire of many taxpayers to pay as little tax as they possibly can. This is a reflection of humanity’s natural tendency toward selfish behavior. In the case of some individuals, this aversion to paying tax – i.e., to contributing to the common good (as articulated by political leaders, Heaven help us) – is manifested in the implementation of plans or schemes that seek to take advantage of ambiguities in the written law, that utilize complex or multi-step structures to dissemble the true nature of a transaction, or that knowingly break the law. Because of humanity’s creativity, lawmakers often find themselves reacting to some newly hatched tax-saving arrangement by amending the law. At the same time, lawmakers must be careful not to suppress or dissuade behaviors they have determined will benefit society as a whole. As a result, over the course of many years, we have ended up with a voluminous and complex set of tax laws, along with an equally complex and even more voluminous set of administrative interpretations that have derived from and been influenced by ever-changing economic and social environments and the selfish reactions thereto of many so-called “sophisticated” taxpayers.

[iii] Yes, I am channeling Star Wars – “I want to learn the ways of the Force,” Luke says to Yoda, “and become a” . . . tax lawyer. Of course, this last part was inexplicably written out of the final cut and replaced with some nonsense about becoming a Jedi.

[iv] “I will die as one of them,” as Aragorn said to Legolas at Helm’s Deep.

[v] Canto I.

[vi] Rawatt v. Comm’r, No. 23-1142 (D.C. Cir. July 23, 2024).

[vii] IRC Sec. 701, 702, 704.

[viii] IRC Sec. 702.

[ix] Within the meaning of IRC Sec. 1231(b).

[x] IRC Sec. 705.

[xi] For a discussion of when a distributee-partner’s basis is determined, please see: https://www.taxslaw.com/2022/04/current-partnership-distributions-when-do-you-figure-your-basis/.

[xii] For purposes of this post, we’ll ignore partnership liabilities described in IRC Sec. 752.

[xiii] IRC Sec. 731(a)(1). In the case of “payment” made in liquidation of the payee-partner’s interest, one must first consider IRC Sec. 736 to determine whether such payment should be treated as a distribution (which would be covered by IRC Sec. 731) or as something else.

[xiv] IRC Sec. 741.

[xv] IRC Sec. 751(a), (c), (d).

The distinction matters especially in the case of an individual partner because the tax rate applicable to an individual’s long-term capital gains is lower than the rate applicable to ordinary income. IRC Sec. 1.

[xvi] IRC Sec. 7701(b)(1)(B). Yes, the Code refers to “aliens,” as in non-citizens. And if an alien individual is in the country illegally, they are an illegal alien. As such, a biological male alien could not represent the U.S. in a women’s athletic competition sanctioned by the International Olympic Committee. Or could they? Anyway, they couldn’t vote in a federal election. Right?

[xvii] IRC Sec. 871(a), (b); Sec. 861, 862. This taxable income is subject to federal income tax at the same graduated rates that apply to U.S. persons.

U.S. source income includes, for example, dividend income received from U.S. corporations, interest on bonds of U.S. residents, wages for services performed in the U.S., rents from property located in the U.S., and royalties for the use of intangibles in the U.S.

[xviii] IRC Sec. 871(b) and Sec. 864(c).

For example, an NRA will generally be engaged in a U.S. trade or business if they own and operate a business that sells services, products, or merchandise in the U.S. Thus, the profit from the sale in the U.S. of inventory that was purchased either in the U.S. or abroad is effectively connected business income. IRC Sec. 861(a)(6), Sec. 863, Sec. 865(b).

Another example: gain from an NRA’s sale or exchange of U.S. real property is taxed as if the NRA were engaged in a U.S. trade or business; this gain is also effectively connected business income. IRC Sec. 897 (FIRPTA).

[xix] IRC Sec. 873, Sec. 874.

[xx] IRC Sec. 875.

[xxi] IRC Sec. 871(b)(2). In general, the nonresident alien would still be subject to U.S. tax for other U.S. source investment income, the gross amount of which may be subject to tax at the rate of 30% (collected by withholding) or at a lower treaty rate, if applicable. IRC Sec. 871(a); Sec. 1441. See IRS Form 8833, Treaty-Based Return Position Disclosure.

[xxii] IRC Sec. 864(c)(3). There are circumstances in which some kinds of foreign source income may be treated as effectively connected with a U.S. trade or business. IRC Sec. 864(c)(4).

[xxiii] IRC Sec. 864(c). In determining whether the asset-use or business-activities tests are met, “due regard” is given to whether such assets or such income or gain were accounted for through the trade or business.

[xxiv] IRC Sec. 865(a).

[xxv] Special rules apply to treat gain or loss from disposition of U.S. real property interests as effectively connected with the conduct of a U.S. trade or business. IRC Sec. 897. To the extent that consideration received by the nonresident alien or foreign corporation for all or part of its interest in a partnership is attributable to a U.S. real property interest, that consideration is considered to be received from the sale or exchange in the U.S. of such property. IRC Sec. 897(g).

[xxvi] Defined expansively in IRC Sec. 751(c).

[xxvii] IRC Sec. 751(a).

[xxviii] Rev. Rul. 91–32.

[xxix] An aggregate approach to taxation of the sale of a partnership interest. Under the aggregate approach, a partner is treated as having an undivided interest in the partnership’s assets.

[xxx] Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (July 13, 2017). The D.C. Circuit Court of Appeals affirmed the Tax Court’s decision. 926 F.3d 819 (2019).

[xxxi] The “entity approach” to partnership taxation, which views the partnership as a separate entity, distinct from its partners.

[xxxii] IRC Sec. 865(a)(2).

[xxxiii] Sec. 864(c)(8)(B). Pub. L. 115-97.

[xxxiv] The law was enacted on December 22, 2017.

[xxxv] So why bother? Patience.

[xxxvi] IRC Sec. 736, Sec. 731, Sec. 741, Sec. 751, Sec. 761(d).

[xxxvii] IRC Sec. 751(a).

[xxxviii] See Rev. Rul. 89-108, in which the taxpayer sold a partnership interest in exchange for an installment obligation. The partnership held inventory; thus, the gain realized on the sale was, in part, attributable to the partnership inventory. The IRS explained that, in general, the sale is treated as the sale of a single capital asset without regard to the nature of the underlying partnership property. However, to the extent the partnership interest represents inventory or unrealized receivables (hot assets), the tax consequences to the seller are “the same tax consequences that would be accorded to an individual entrepreneur.” In effect, the selling partner is treated as disposing of the hot assets “independently of the rest of his partnership interest.” Because the gain realized on the sale of the interest attributable to the hot assets would not be eligible for installment reporting if such assets were sold directly, the gain could not be reported under the installment method. The balance of the gain from the sale of the partnership interest would be reportable under the installment method.

[xxxix] IRC Sec. 751(a).

[xl] IRC Sec. 64. The Court omitted the rest of the definition: “Any gain from the sale or exchange of property which is treated or considered, under other provisions of this subtitle, as ‘ordinary income’ shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b).”

[xli] Specifically, IRC Sec. 864(c)(8).

[xlii] Rev. Rul. 89-108.