Those of you who attend our annual Tax Planning Forum® or Fundamentals of Flow-Through® programs are well aware that we do not practice in the state and local tax arena (“SALT”), and it is rare that we cover SALT developments. However, this article is an exception, as there is a lot of business conducted in California for which there are non-resident owners. Moreover, there are a lot of states that may take their cues from California tax decisions. In this email blast, we want to bring to your attention the Office of Tax Appeals (“OTA”) decision in Burch et al., OTA Case Nos. 230112266 & 2330112267 (July 26, 2026).

In this case, the OTA held that California could not tax the portion of the gain on the sale of a partnership interest by a non-resident that is characterized as ordinary income under §751(a). As noted by the OTA, California generally conforms to federal partnership tax law, including §741 and §751. In its decision for the taxpayer, the OTA principally relied on Rawat v. Commissioner 108 F.4th 891 (DC Cir. 2024), rev’g TC Memo 2023-13 (2023), which we discussed at our 2024 Tax Planning Forum. In Rawat, a non-resident alien sold a partnership interest where there was ordinary income recognition under §751(a), and the IRS attempted to source such portion of the taxpayer’s gain to the United States. The IRS was unsuccessful, holding that §751(a) merely recharacterizes gain as ordinary income and is not a provision that considers the taxpayer to be selling the underlying §751 asset (which, in Rawat, would have resulted in US source income, if such “piercing” were permitted). The DC Circuit contrasted this result with what would have happened with a redemption of a partnership interest where the §751(b) deemed distribution out of a §751 asset to a redeemed partner followed by its deemed sale of the asset back to the partnership would have resulted in US source income. The OTA relied on the Rawat reasoning to reach its decision in favor of the taxpayer.

In many circumstances, a partnership having partners residing in a state having no income tax (e.g., Florida) or residing in a state that has a lower income tax rate than the state in which the partnership conducts its business will structure the sale of the business as a sale of partnership interests, rather than a sale of assets. This technique takes advantage of state sourcing rules that treat the gain on the sale of an intangible asset (e.g., a partnership interest) as sourced to the state of residence of the selling partner. Burch could be an important decision that might be cited in a different state proceeding where a state might try to pierce the sale of a partnership interest by a non-resident in order to tax §751(a) income. Note, however, that Burch made the following observation:

If FTB [California Franchise Board] wishes to source such sales [of partnership interests] based on its proposed method, it is free, for example, to approach the Legislature to seek a statutory change.

It is our understanding that there are a few states that have enacted statutes to do just that. Whether such a statute will withstand a constitutional challenge is an issue for another day and for SALT experts.

New developments always are covered at our flow-through programs, and we hope that you will consider attending either or both of the Tax Planning Forum or Fundamentals of Flow-Through virtual or in-person programs. The beginning of our season is rapidly approaching, and we encourage you to register soon, especially if you are interested in either of our in-person programs in Las Vegas or Orlando where space is limited.