Just How Hot Should Section 751 Be - 05-01-25

Tax rules are generally designed with a purpose in mind. Most rules serve to define the tax base and tax rates. Many others serve to serve a behavioral purpose to encourage or discourage certain activities. The focus of this podcast stems from tax rules that are a combination of favoring certain activity such as generation of capital gains, and a limitation on such gains for certain taxpayers, such as the so-called “hot assets” rule for partners under IRC Section 751, Unrealized Receivables and Inventory Items. While Section 751 has been in the tax law for decades, a new application of it was raised by both the IRS and California FTB. This podcast summarizes Rawat, TC Memo 2023-14, rev’d, No. 23-1142 (DC Cir., 2024), and FTB Legal Ruling 2022-02, and offers observations on their relevance to tax research and practice.

This podcast is meant for entertainment purposes only. For the more thorough, complete, and accurately written version of this article which includes citations, visit us at http://www.tottb.tax

Transcript

Welcome to this deep dive. Today, we're tackling a piece of the tax code, section 751 that's maybe been a bit sleepy, but is definitely waking up. That's a good way to put it. We're talking about hot assets in partnerships, those unrealized receivables inventory items. Right.

The rule itself isn't new. It's been around for decades, mainly to stop folks converting ordinary income into capital gains when they sell a partnership interest. Pretty standard stuff usually. Usually. Yeah.

But, what's bringing it back into focus is how the IRS and, significantly, the California Franchise Tax Board, EFTB, are looking at it again. Ah, okay. So new interpretations or applications. Exactly. Which makes understanding it, like, really critical right now for anyone advising partnerships or partners, especially with nonresident partners, which is where things get tricky.

Got it. And I hear there's a specific case and a ruling that really highlight this. Yes. That's what we wanna unpack today. We're gonna look closely at the Rauch tax court case and its appeal, importantly, and also FTB legal ruling 2022 a two.

Okay. So the mission today is clear. Understand these different takes on section seven fifty one, especially the sourcing rules for nonresidents, and figure out what it all means for tax practice. Couldn't have said it better. Let's dive in.

Alright. Let's start with Rawat. Give us the background there. Okay. So this case involved a missus Rawat.

She was a nonresident alien. Back in 02/2008, she sold her 30% interest in a US partnership. And this wasn't just any partnership. Right? No.

It was the maker of five Hour Energy. So a pretty significant business. The sale resulted in a huge gain for her, something like $438,000,000. Wow. Okay.

And the section seven fifty one part. Right. Of that total gain, about $6,500,000 was agreed to be her share of the partnership's inventory gain, the hot asset piece. So that $6,500,000 is where the fight was? Precisely.

The IRS argued, and the tax court initially agreed that section seven fifty one kicks in here. It says you treat that inventory related portion of the gain not as capital gain from selling the interest, but as if it were from selling a noncapital asset. Meaning ordinary income? Ordinary income. Yes.

And, crucially, they said it was US source ordinary income taxable to Misrawat even as a nonresident alien. The tax court really bought into this idea of looking through the partnership interest to the underlying assets, an aggregate view for that piece. Okay. That makes sense from the IRS perspective. What was miss Rawat's counterargument in tax court?

I mean, she agreed it was ordinary income. Right? She did. Yeah. She wasn't disputing the character of that $6,500,000.

She conceded section seven fifty one made it ordinary. Her point was different. Which was? She argued that, okay, it's ordinary income, but where's The US source? She didn't personally sell any inventory in The US.

She sold her partnership interest, which is generally sourced based on the seller's residence outside The US for her. I see. So section seven fifty one changes the character, she argued, but not the fundamental sourcing rule for the sale of a partnership interest itself. Exactly. Character, not source.

That was her core argument. But the tax court didn't buy it. No. They went with the IRS view. But then it went to appeal.

What happened there? Big reversal. The court of appeals overturned the tax court. Really? On what grounds?

They agreed with missus Rawat fundamentally. They said, yes. Section seven fifty one deals with the character of the gain ordinary versus capital, but they decided it doesn't transform the sale of the partnership interest into a deemed sale of the underlying inventory, not for sourcing purposes anyway. So the character rule doesn't automatically create a US source for that ordinary income portion. That was the appellate court's conclusion.

They looked really closely at the words in the statute. The specific language. That's always key in tax, isn't it? Absolutely. They pointed out a difference between section seven fifty fifty one a, the part dealing with sales of interest, and section seven fifty one b, which deals with certain distributions.

Okay. What's the difference? Well, section seven fifty one a says the amount linked to hot assets is considered as an amount realized from the sale or exchange of property other than a capital asset. Just changes the character. Right.

But section seven fifty one b for distributions treated as sales says the partner is considered as having sold or exchanged such property. It points directly to the underlying hot assets. Such property. That little phrase makes a difference. The court thought so.

They inferred that because congress used that such property language in b, but not in a, they didn't intend for a to be treated as a direct sale of the underlying assets for all purposes, including sourcing. It's a classic example of statutory interpretation. That's fascinating. So the structure in word choice really drove the decision. It seems so.

It highlights how important careful reading of the code is for us practitioners. And didn't the court also mention the Tax Cuts and Jobs Act, the TCJA? They did. They noted that congress in 2017 added section eight sixty four c eight. This new rule specifically says that gain or loss for a nonresident alien selling an interest in a partnership engaged in a US trade or business is effectively connected income and thus US source.

So the TCJA basically adopted the IRS's position from Rawat, but only going forward. Essentially, yes. It fixed the sourcing issue prospectively. It showed congress knew how to explicitly source this kind of gain to The US when it wanted to. But, crucially, that law wasn't in effect for missus Rawat's two thousand eight sale.

So a win for her for that year, but the federal rule changed later anyway. Correct. On the federal side. But that's not the end of the story because then California weighed in. The FTB legal ruling twenty twenty two zero two, you mentioned?

What's California's take? Well, California's FTB looked at this whole situation and basically said, we agree with the IRS and the tax court's original interpretation. So they're sticking with the idea that the section seven fifty one ordinary income portion is sourced to California if the partnership operates there, even for a nonresident? That's exactly their position. They view that part of the gain as California source business income taxable by the state regardless of the federal appellate decision in Rawat or the seller's residency.

Okay. That's a major divergence. What's their justification for essentially ignoring the federal appellate court on this? Their rationale leans heavily on the aggregate theory of partnerships. They see section seven fifty one as forcing a sort of two step view of the transaction.

Hot the hot assets by the partnership, happening immediately before the partner sells their interest. Then there's a deemed distribution of those proceeds. A deemed sale inside the partnership first. That's their interpretation. And that deemed sale of assets located or used in California, they argue, generates California source business income.

That's quite a construct. So that deemed sale connects the income directly to California operations. That's the idea. It allows them to sidestep the usual rule about sourcing the sale of an intangible based on seller's residence, at least for the section seven fifty one portion. So how do they actually apply their sourcing rules to this deemed sale amount?

They point to their standard business income sourcing regulation, section one two nine five one four. So if the partnership operates solely within California, then a % of that deemed hot asset gain is California source. And if it operates in multiple states? Then it gets apportioned using California's regular apportionment factors, property, payroll, sales, the standard drill. So for us advising Don resident partners selling interest in California partnerships, this FTB ruling is a huge deal.

It creates a state tax liability that the federal courts, at least the raw water appellate court, suggested shouldn't exist federally for that year. It's a very significant state level issue now. Absolutely. Even with section eight sixty four handling the federal side going forward, this California position remains. This really shows how complex things get.

You know, you think about the purpose of tax rules. Section seven fifty one exists for a reason. Right? To prevent that ordinary income escape. Exactly.

It's meant to protect the character of the income, make sure operational profits, taxes, ordinary income, don't magically become capital gain just by selling the partnership interest instead of the assets. The appellate court even noted that purpose. But then you get these situations like Rawat and the FTB ruling where interpretations diverge, especially when there's maybe some ambiguity in how a rule applies across different context, like character versus source. Right. And you often see interpretations evolving when, you know, maybe a tax agency sees an opportunity to clarify or expand the base or a taxpayer sees an advantage in a particular reading.

Semitatory ambiguity is often the battle ground. And we absolutely have to remember as practitioners that the TCJA's section 864 c eight fixed the federal sourcing problem for nonresident selling interests in US businesses, but clearly not the state one as California shows. That state piece is wide open potentially, which brings us back something really fundamental for tax professionals, understanding how laws get interpreted, the rules of statutory construction. Definitely. Especially with courts playing such a key role.

Didn't the Supreme Court recently weigh in on the role of agencies versus courts in interpreting laws? Yes. The Loperbreit Enterprises case. The Supreme Court really emphasized that interpreting ambiguous statutes is primarily the job of the judiciary using traditional tools of interpretation, sort of pushed back on the idea of automatically deferring to an agency's interpretation like the IRS's under the old Chevron doctrine. So understanding those judicial tools is more important than ever for us.

It really is. Courts look at text, context, structure, purpose, all those things. And you mentioned the Rouotte appellate court used a specific tool, negative inference. That's right. They used the rule of negative inference.

By comparing the language in seven fifty one a and seven fifty one b and noting that the phrase such property was in b but not in a, they inferred congress intended a different meaning. The absence of the words was as significant as the presence of words elsewhere. It shows how detailed the analysis can get. Are there good resources for tax pros who wanna get sharper on these interpretation rules? Oh, absolutely.

Besides reading court decisions themselves, the Congressional Research Service, CRS, puts out fantastic reports on statutory interpretation. Highly recommend those. And sometimes state legislative services offices have good guides too. It's worth building that skill set. Good tip.

So looking ahead, what's the big question mark hanging over all this for practitioners? I think the crucial question is, will other states jump on the bandwagon with California? Will they adopt the FTB's view that section seven fifty one game is sourced based on the partnership's activity, overriding the general rule for intangibles. And if they do, how will those interpretations hold up in state courts, especially considering the federal raw water appellate decision went the other way on the underlying logic? Exactly.

That's the area of uncertainty. It's something we absolutely need to monitor for our clients with multi state partnership interests, especially nonresident clients. So wrapping this up, we've really seen this tension play out between sections seven fifty one's role in characterizing gain as ordinary and the separate complex question of sourcing that gain, particularly for nonresident partners. And the practical takeaway for tax professionals is crystal clear. You have to be aware of these differing views.

The federal rules under 864 c eight are one thing, but state interpretations like California's can create significant and perhaps unexpected tax liabilities. It means advising on partnership interest sales, especially cross border or multistate ones, requires careful attention to both federal and state specifics around section seven fifty one. Absolutely. Diligence is key. You can't assume the federal outcome dictates the state outcome here.

It's a perfect reminder for all of us in practice. Tax law is dynamic. Even established sections like seven fifty one can generate new challenges and require us to stay constantly informed to serve our clients effectively. Definitely something to keep an eye on.