Overview
The DC Circuit recently reversed the Tax Court's decision in Rawat v. Commissioner, a case involving a nonresident's sale of an interest in a partnership owning inventory. Although the specific issue in Rawat has subsequently been addressed by legislation (the 2017 enactment of section 864(c)(8), discussed below), the case had attracted significant attention given the Tax Court's analysis and the potential significance for other issues involving the intersection of the partnership and international tax rules.
Specifically, the DC Circuit held that the nonresident's gain from the sale of her partnership interest should not be sourced as if she had sold her share of the underlying inventory.[1] In contrast, the Tax Court had held that section 751(a) deems a sale of the underlying inventory and thus the default sourcing rule of section 865(a) did not apply to the extent of the gain from inventory.[2]
The Basic Issue: Nonresident Taxation, Sourcing, and Sales of Partnership Interests
Nonresidents are generally subject to US federal income tax on two categories of income: (i) income that is effectively connected with the conduct of a US trade or business (ECI), and (ii) US source income that is fixed, determinable, annual, or periodical (FDAP).[3] When a nonresident is considered engaged in a US trade or business, source is a key factor in the determination of whether income is ECI.[4]
Gain from the sale of personal property is generally sourced by residence of the seller, such that the sale of personal property by a nonresident generally generates foreign source income.[5] There are exceptions for inventory property.[6] Gain from the sale of inventory by a nonresident can be either US or foreign-source, depending on the facts.
Prior to the TCJA, there were numerous questions about how the ECI and source rules applied to a nonresident's sale of a partnership interest where the partnership was engaged in a US trade or business.[7] The interpretation of partnership tax rules, namely sections 741 and 751, is central to these questions. Section 741 provides that gain or loss realized from the sale of a partnership interest is generally "considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items)." Under section 751(a), gain from the sale of a partnership interest "attributable to (1) unrealized receivables of the partnership, or (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." Section 751(a) was enacted to prevent US partners from selling a partnership interest to convert the income from these "hot assets" from ordinary income to capital gain.
The Rawat Case
In 2008, Rawat, a nonresident sold her interest in a partnership, a Michigan business that sold the popular 5-Hour Energy drink, realizing a substantial gain. At the time of the sale, the partnership held inventory, a hot asset under section 751(a).
A key question in the case was the interpretation of section 751(a). The IRS argued that it should be interpreted to mean that Rawat should be treated as selling inventory as opposed to a partnership interest (to the extent of the inventory gain). Under the IRS’s interpretation, the sourcing rules governing the sale of inventory would apply, in which case income from the sale could be considered US-source and—assuming Rawat should be considered to be engaged in a US trade or business to which such income was connected—ECI. (The case presents questions about the application of the US trade or business rules in this context, but the decisions do not delve into those issues.) The taxpayer argued that section 751(a) does not operate as argued by the IRS, that Rawat should be treated as selling personal property (her partnership interest), and that income from the sale should be treated as foreign-source income that is not ECI.
The Tax Court held "that the general approach of section 741 … gives way to the specific provision in section 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.'" According to the Tax Court, it did not matter “that [Rawat] actually sold not inventory but a partnership interest.” The Tax Court reasoned that a portion of the sales proceeds was "'attributable to inventory' and is 'considered' to have been 'realized from the sale' of 'inventory items.'" Therefore, the Tax Court held that the general source rule for personal property under section 865(a) did not govern Rawat's inventory gain from the sale. Instead, Rawat's inventory gain must be sourced under the exception for inventory provided in section 865(b).
On appeal, the DC Circuit reversed the Tax Court's holding and held that section 751(a) does not give rise to a deemed sale of inventory. The court reasoned that the pivotal clause in section 751(a)— "shall be considered as an amount realized from the sale or exchange of property other than a capital asset"—was "materially identical" to the Code's definition of ordinary income contained in section 64. The court also reasoned that "[t]he interlocking nature of [sections 741 and 751(a)]" strongly suggest that those sections merely direct whether gain is treated as ordinary income or capital gain. The DC Circuit noted that the legislative history and purpose of section 751(a) is consistent with this conclusion. Therefore, the court concluded that while section 751(a) treats inventory gain as ordinary income, it does not go so far as to deem inventory gain as gain from the actual sale of inventory.
Enactment of Section 864(c)(8) and Continuing Questions
As mentioned above, the issues in Rawat have been addressed in legislation. After the enactment of section 864(c)(8) in the TCJA, gain or loss from the sale of an interest in a partnership that is engaged in a US trade or business generally is treated as effectively connected with such trade or business.[8] Nonetheless, there remain other unresolved questions resulting from the intersection of the partnership and international tax rules, such the interaction of the section 1248 rules with the section 751 rules.
[1] Rawat v. Commissioner, No. 23-1142, 2024 WL 3504510 (DC Cir. July 23, 2024).
[2] Rawat v. Commissioner, T.C.M. (RIA) 2023-014 (T.C. 2023).
[3] I.R.C. §§ 861, 864(c), 871(a)(1)(A). FDAP income generally does not include gains from the sale of personal property.
[4] I.R.C. § 864(c)(2), (c)(3), (c)(4).
[5] I.R.C. § 865(a)(2).
[6] I.R.C. §§ 865(b), 861(a)(6), 862(a)(6), 863(b).
[7] See, e.g., Rev. Rul. 91-32, 1991-1 CB 107 and Grecian Magnesite Mining, Indus. & Shipping Co. v. Commissioner, 149 T.C. 63 (2017), aff’d 926 F.3d 819, 821 (DC Cir. 2019).
[8] Tax Cuts and Jobs Act of 2017 (TCJA), Pub. L. No. 115-97, 131 Stat. 2054, I.R.C. § 864(c)(8).
