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Nonresident Alien May Have Ordinary Income on Sale of Interest in U.S. Partnership
(Parker Tax Publishing February 2023)
In rejecting a motion for summary judgment, the Tax Court held that the proceeds received by a nonresident alien from the sale of her interest in a U.S. partnership attributable to inventory items held for future sale in the United States was excepted from the general rule in Code Sec. 741 that the sale of a partnership interest is treated as the sale of a capital asset. The court concluded that, for purposes of the sourcing rules, the proceeds from the inventory was attributable to "inventory derived from the sale of inventory property" under Code Sec. 865(b) and was therefore not, as a matter of law, non-U.S. source income. The court noted, however, that Rawat might ultimately prevail by showing that the source of the inventory gain was "without the United States" under other relevant Code sections. Rawat v. Comm'r, T.C. Memo. 2023-14.
Background
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. She did not file returns for the 2008 and 2009 tax years.
Innovation Ventures, LLC (IV LLC), is a U.S. business that manufactures and sells popular consumer products including drinks sold under the brand "5-hour Energy". IV LLC was treated as a partnership for federal income tax purposes during the years at issue.
Between December 2000 and January 2007, Rawat acquired a 30 percent interest in IV LLC. On January 4, 2008, Rawat executed a note for the sale of her interest in IV LLC to Manoj Bhargava for $438 million. At the time the note was executed, IV LLC had inventory items with a basis of $6.4 million, which it held for future sale in the United States. IV LLC later sold those inventory items for a profit of $22.4 million, and Rawat acknowledged that her share of income "attributable to the inventory" was $6.5 million (an amount agreed to by Rawat and the IRS). Thus, of the $438 million sale price paid to Rawat (by the note from Bhargava) 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. In December 2010 the IRS issued a Form 5701, Notice of Proposed Adjustment, to IV LLC and to Rawat. The Form 5701 proposed to include in Rawat's income for 2008 $6.5 million arising from the inventory gain issue. The IRS and Rawat agreed to the adjustments but disagreed as to the source of the additional income. In June 2016, the IRS issued a notice of deficiency to Rawat for her 2008 and 2009 tax years. Rawat paid $2.9 million in tax, interest and additions attributable to the initial assessments for the 2008 tax year. In July 2016, Rawat petitioned the Tax Court to challenge the items in the notice of deficiency and to invoke the court's overpayment jurisdiction with respect to her $2.9 million payment.
When a partner sells his or her partnership interest, the tax treatment of the sale is determined under Code Sec. 741 and Code Sec. 751. The general rule in Code 741 is that the gain or loss on the sale of a partnership interest is considered gain or loss from the sale of a capital asset, except as otherwise provided in Code Sec. 751. Code Sec. 751(a)(2) provides that the amount of money received by a transferor partner in exchange for the partnership interest attributable to inventory items of the partnership will be considered an amount realized from the sale or exchange of "property other than a capital asset."
Under Code Sec. 865(a)(2), the sale of personal property by a nonresident alien individual is generally sourced outside the United States. Code Sec. 865(b) provides an exception for inventory property under which income from the sale of inventory property is sourced under the rules of Code Secs. 861(a)(6), 862(a)(6), and Code Sec. 863.
In Grecian Magnesite Mining v. Comm'r, 149 T.C. 63 (2017), aff'd 2019 PTC 212 (D.C. Cir. 2019), the Tax Court held that as a general rule, when a foreign entity sells an interest in a U.S. partnership, the asset to be considered in the sourcing analysis is the partnership interest itself rather than the underlying partnership assets. The court found that Code Sec. 751 is a specific exception to Code Sec. 741 that causes unrealized receivables and inventory items to be "addressed separately" from the remainder of the partnership interest when that interest is sold or liquidated. The court explained in Grecian Magnesite that when Code Sec. 751 applies, it requires that the court look through the partnership to the underlying assets and deem such a sale as the sale of separate interests in each asset owned by the partnership.
Observation: The Tax Cuts and Jobs Act enacted Code Sec. 864(c)(8), which effectively overrules the holding of Grecian Magnesite and provides that the sale of a U.S. partnership interest is generally treated as effectively connected to a U.S. trade or business and is therefore subject to U.S. income tax. Code Sec. 864(c)(8) is effective for transactions after November 27, 2017, and did not apply in this case.
In a motion for summary judgment, Rawat argued that under Grecian Magnesite 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 Code Sec. 865(a)(2), irrespective of whether any portion of the gains would be attributable to inventory items under Code Sec. 751(a)(2). Rawat contended that when she sold her interest in IV LLC, she did not sell inventory but instead an interest in a partnership that owned inventory. She argued that under Code Sec. 741, her partnership interest was a singular "capital asset" on the sale of which she was required to recognize gain or loss. As a nonresident alien, Rawat contended that she was taxable under Code Sec. 871(b)(2) only on income that was effectively connected to the conduct of a trade or business in the United States and that under Code Sec. 865(a)(2), income from the sale of personal property (such as a partnership interest) by a nonresident alien is sourced outside the United States. Rawat argued that the issue in this case was the source of the proceeds, and she asserted that Code Sec. 751 is not a sourcing rule. In her view, the effect of Code Sec. 751, where it applies, is to assure that the proceeds of a sale will take on the character (non-capital) of "property other than a capital asset" and will therefore be taxed, if at all, as ordinary income, not as capital gain.
Analysis
The Tax Court denied Rawat's motion for summary judgment. The court found that, given the explicit exception provided in Code Sec. 741 for the items provided in Code Sec. 751 (unrealized receivables and inventory items), Rawat's inventory gain had to be analyzed under Code Sec. 751, and the singular "capital asset" treatment of Code Sec. 741 did not apply to that portion of her sale proceeds. The court further found that, for purposes of the sourcing rules, the inventory gain was "income derived from the sale of inventory property" under the exception provided in Code Sec. 865(b), and may therefore be U.S.-source income.
In the court's view, the reason that the sale of a partnership interest is treated as the sale of a (singular) capital asset, as Rawat contended, is that Code Sec. 741 so provides, imposing (where it applies) the "entity" theory on such sales. Without Code Sec. 741, the court observed, such a sale could be treated as the sale of the partner's proportionate share of the underlying partnership assets - but Code Sec. 741, where it applies, precludes that aggregation approach. However, the court found that Code Sec. 741 contains an explicit exception for the items identified in Code Sec. 751 (unrealized receivables and inventory items) and that under Code Sec. 751, the "inventory items" portion of the proceeds is considered as an amount realized from the sale or exchange of property other than a capital asset. The court said that Code Sec. 741, by its own terms, does not apply to the "inventory items" portion of the proceeds and the singular "capital asset" treatment of Code Sec. 741 is thus partially disaggregated by Code Sec. 751.
According to the Tax Court, Rawat's view - confining the effect of Code Sec. 751(a) to the assuring of non-capital treatment - did not give sufficient attention to the different wording of the two statutes. The court reasoned that the general rule in Code Sec. 741 refers to gain or loss from the sale of a. singular "capital asset" whereas the exception in Code Sec. 751(a) refers to an amount realized from the sale of "property." This difference in wording, the court found, tended against Rawat's assumption that Code Sec. 751 inherits the "entity" approach of Code Sec. 741. The court explained that the term "asset" is necessarily singular, while the word "property" can be singular or plural (one's property can consist of many assets), and the court inferred that these different terms were not chosen at random. The court also noted its finding in Grecian Magnesite that Code Sec. 751 is one exception to Code Sec. 741 that, when it applies, requires "that we look through the partnership to the underlying assets and deem such a sale as the sale of separate interests in each asset owned by the partnership."
Turning to the sourcing issue, the court first noted the general rule of Code Sec. 865(a) that income from the sale of personal property (such as a partnership interest) by nonresident is sourced outside of the United States. The court reasoned that, for the same reason it held that Rawat's inventory gain was excepted from Code Sec. 741, it could not follow the general rule of Code Sec. 865(a) but instead had to follow the exception for inventory property provided in Code Sec. 865(b). Code Sec. 865(b) in turn refers to the sourcing rules for inventory property provided in Code Secs. 861(a)(6), 862(a)(6), and Code Sec. 863. Since Rawat's motion was based on her contention that the sourcing rule for the inventory gain was the general rule of Code Sec. 865(a)(2), the court denied her motion. However, the court noted that Rawat might nonetheless prevail in whole or in part by showing, pursuant to Code Sec. 865(b), that the source of the inventory gain was "without the United States" under Code Secs. 861(a)(6), 862(a)(6), and Code Sec. 863.
For a discussion of the sale or exchange of a partnership interest, see Parker Tax ¶27,510. For a discussion of the sourcing rules for the income of foreign taxpayers, see Parker Tax ¶200,540.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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