On July 24, 2024, the D.C. Circuit Court of Appeals sided with the taxpayer and reversed the Tax Court decision in Rawat v. Commissioner, No. 23-1142. The taxpayer in Rawat was a nonresident alien who, in 2008, sold her interest in a partnership that operated its business in the U.S. for $438M, with approximately $6.5M of her gain attributable to her share of the inventory held by the partnership. The relevant question presented in the case for purposes of this email is whether §751(a) deems the “inventory gain” to be from the sale of inventory or simply recharacterizes as ordinary income the portion of the overall gain on the sale of the partnership interest that relates to the inventory.

When a partner sells a partnership interest, §741 provides that the gain or loss recognized by the transferor partner is “from the sale or exchange of a capital asset, except as provided in section 751.” Code §751(a) requires the gain attributable to the transferor partner’s share of the partnership’s inventory to be taxed as ordinary income, and the Tax Court in Rawat agreed with the IRS and held that the taxpayer must be taxed as if she had actually sold the §751(a) asset (inventory in this case) that gave rise to the ordinary income from the sale of her partnership interest.

The taxpayer disagreed with the Tax Court’s ruling and appealed to the D.C. Circuit Court, where the Court reversed the holding of the Tax Court and held that §751(a) does not go further than recharacterizing as ordinary income the portion of gain from the sale of a partnership interest attributable to the §751(a) assets (inventory in this case), but should not be considered to be a sale of the §751(a) asset itself.

For the taxpayer in Rawat, the distinction is significant because of the rules that determine whether the income is U.S. or foreign source income. Had Rawat been affirmed, the taxpayer would have been responsible for paying tax on $6.5M of ordinary income sourced to the U.S.

(1) treating a transferor partner’s holding period as long-term for stock received in an “interests-over” partnership incorporation transaction, rather than following Rev. Rul. 84-111, 1984-2 C.B. 88 (Situation 3) and bifurcating the holding period of the stock received between the portion attributable to the transferor’s share of the partnership’s §751 assets (new holding period) and the other assets (tacked holding period) of the partnership;

(2) the ability to sell a partnership interest on the installment method and not accelerate gain associated with §751(a) property, which is in conflict with the generally applied principles of Rev. Rul. 89-108, 1989-2 C.B. 100, which does not permit income from the sale of a partnership interest to be reported on the installment method to the extent it represents income attributable to §751(d) inventory items; and

(3) allowing a partner to report all the gain generated by the sale of the partner’s partnership interest (an intangible asset) to the partner’s state of domicile, where the different state in which the partnership does business has a statute that attributes the portion of the gain attributable to §751(a) assets to the state in which the business is conducted.

For example, A, B, and C own a partnership equally. During the year, A sells her 1/3rd interest to D on the installment method and the parties determine that A has $1,000,000 of gain attributable to the partnership's inventory under §751(a). Prior to Rawat, it was clear that A must recognize the full $1,000,000 of gain attributable to the inventory at the time of closing (because gain on the sale of inventory is not eligible for installment reporting, and one looks through the partnership to the underlying §751(a) assets). The decision in Rawat creates an argument that the $1,000,000 of gain attributable to the inventory is not subject to the immediate recognition rule of Rev. Rul. 89-108, but instead, eligible for the installment method associated with the partnership interest being sold.