Nonresident Alien's Inventory Gain on the Sale of Her Partnership Interest Is Not Taxable

(Parker Tax Publishing August 2024)

The D.C. Circuit reversed the Tax Court and held that inventory gain from the sale of a partnership interest by a nonresident alien was not U.S-source income and thus was not taxable by the United States. The court's decision was based on pre-2017 Tax Cuts and Jobs Act (TCJA) law and the court noted that, had the transaction at issue occurred after enactment of the TCJA, the result would have been different. Rawat v. Comm'r, 2024 PTC 261 (D.C. Cir. 2024).

Background

Indu Rawat is a nonresident alien. During the early 2000s, she made several investments in Innovation Ventures, LLC (IV LLC), a Michigan business (and a partnership for tax purposes), accumulating a 29.2 percent stake. In 2008, IV LLC bought back Rawat's share of the company in exchange for a promissory note worth approximately $438 million. At the time of the transaction, IV LLC held inventory valued at $6.4 million, which it later sold for a profit of $22.4 million. As a 29.2 percent owner of that inventory at the time she sold her interest in IV LLC, Rawat was entitled to $6.5 million of the inventory gain. Thus, of the $438 million Rawat received for her stake in IV LLC, $6.5 million was attributable to a gain on IV LLC's sale of inventory.

Rawat recognized ordinary income of $6.5 million resulting from the inventory gain. The IRS took the position that the inventory gain was U.S.-source, taxable income and notified Rawat that she owed approximately $2.3 million in taxes on that gain. While Rawat eventually paid that amount (plus penalties, interest, and other adjustments), she petitioned the Tax Court for a refund, contending that the inventory gain was foreign-source income and therefore nontaxable.

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 a partnership interest attributable to inventory items is considered an amount realized from the sale or exchange of property other than a capital asset.

The dispute between Rawat and the IRS turned on whether the inventory gain should be treated as income Rawat earned from selling inventory. If so, the sourcing rules governing the sale of inventory would apply, under which income from the sale could be considered U.S.-source (and taxable) depending on the particulars. While the IRS and Rawat agreed that Code Sec. 751(a) requires inventory gain to be taxed as ordinary income, the IRS argued that it also deems gain on the sale of a partnership interest attributable to inventory to be gain on the sale of inventory, such that it is taxable as U.S.-source income.

Rawat argued that Code Sec. 751(a) has a more limited scope and does not give rise to a deemed sale of inventory and thus does not render taxable what would otherwise be nontaxable income. Rather, according to Rawat, Code Sec. 751(a) merely subjects inventory gain to ordinary-income taxation if the gain is otherwise taxable. And Rawat considered the inventory gain she realized to be nontaxable, as it arose from the sale of a partnership interest, not from the actual sale of inventory. According to Rawat, her gain constitutes proceeds from the sale of general personal property (as opposed to inventory) and is foreign-source income because she is a nonresident alien.

In Rawat v. Comm'r, T.C. Memo. 2023-14, the Tax Court sided with the IRS and held that proceeds received by a nonresident alien from the sale of an interest in a U.S. partnership attributable to inventory items held for future sale in the United States are 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 were attributable to "inventory derived from the sale of inventory property" and were therefore not, as a matter of law, non-U.S. source income. Thus, the Tax Court said, under Code Sec. 751(a), Rawat must be taxed as though she sold the inventory that gave rise to the inventory gain. Rawat appealed to the D.C. Circuit.

Analysis

The D.C. Circuit reversed the Tax Court and held that Code Sec. 751(a) does not of its own force render Rawat's inventory gain taxable because it does not change the fact that she sold a partnership interest, not inventory. As a result, the court said, the inventory gain is foreign-source income on which Rawat owes no U.S. taxes.

The court noted that, when a nonresident alien sells an interest in a U.S. partnership, a straightforward sourcing rule in Code Sec. 864(c)(8) has governed since the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA): income from the sale is U.S.-source and thus taxable. However, the court observed, the events in Rawat's case predated the TCJA's enactment and prior to the TCJA, no specific sourcing provision governed income derived from the disposition of a partnership interest. Instead, the Code provisions governing the sale of personal property controlled and, under those rules, income from the sale of most personal property by a nonresident alien is treated as foreign-source income and thus nontaxable. However, the court noted some exceptions including for inventory: income derived from the sale of inventory might be U.S.-source or foreign-source, depending on various context-specific considerations related to the sale. Such income thus may be taxable even if the seller is a nonresident alien.

The question to be resolved, the court said, is whether Code Sec. 751(a) merely establishes that inventory gain arising from the sale of a partnership interest is taxed as ordinary income rather than as a capital gain, or whether Code Sec. 751(a) also deems inventory gain from a partnership-interest sale to be income from a sale of inventory. According to the court, if the inventory gain is understood to be income from the sale of inventory, then the income can be taxable as U.S.-source income. But if the inventory gain is treated as income from the sale of a partnership interest rather than income from the sale of inventory, then the income is foreign-source and nontaxable.

The court found the final clause of Code Sec. 751(a) to be pivotal. That clause dictates that 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 (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." Thus, the court rejected the IRS's argument that Code Sec. 751(a) deems the gain Rawat realized on the sale of her partnership interest that is attributable to the partnership's inventory to be income from a sale of that inventory.

For a discussion of the sourcing of income rules for nonresident aliens, 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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