Aug 15 California Nonresidents: Beware if Selling Partnership Interests
On July 14, 2022, California released Legal Ruling 2022-02 that now recharacterizes the gain resulting from the sale of partnership interest as ordinary income and therefore taxable by the state.
Generally, California law, like most states, prescribes that the sale of an intangible asset (such as an interest in a partnership, corporate stock, or a dividend) is sourced to a taxpayer’s state of residence.
Under this new guidance, California affirms that a sale of partnership interest that includes the sale of “hot assets” (ordinary income producing assets) is considered to be realized from the sale or exchange of property other than a capital asset. That portion of the sale to the partners is ordinary gain.
In simple terms, a nonresident of California that is selling, or anticipating the sale of, a partnership interest, must be cognizant of the federal classification of the gain. A portion of the gain is apportionable income (i.e., does not follow the Mobilia doctrine), to the extent that any portion of the gain on the sale is deemed to be “hot assets” or ordinary income at the federal level. In this scenario, it would be a mistake to consider any and all partnership interest sales to be the sale of an intangible asset sourced to the taxpayer’s state of residency.
In coming to this conclusion, California discusses the very important application of the aggregate or entity theory of partnership taxation; however, for brevity and purposes of this writing, we will not delve into this portion of tax history – although this is a fascinating area of partnership taxation, both on a federal and state level.
California’s guidance in this ruling applies to all nonresidents of California that hold a partnership interest in a partnership that operates in California. Even more so, this ruling should be very carefully reviewed by any former residents of California that have maintained their interest in a California operating partnership and anticipate a future liquidity event.
This ruling is positionally in line with the California Franchise Tax Board’s previous ruling related to the sale of corporate stock wherein an election is made under either Internal Revenue Code (hereinafter “IRC”) section 338(h)(10) or 338(g). For federal tax purposes, IRC section 338 allows taxpayers to elect to treat certain stock sales as a sale of the underlying assets of the corporation whose stock was sold. The key item to note here is that the deemed sale of assets under an IRC section 338 election will be treated as an actual sale of assets for apportionment purposes. Suppose the gain from the sale constitutes apportionable business income under section 25120 et seq. In that case, the gain must be apportioned to the state(s) where Old Target did business before the sale.
Although the current legal ruling concerns the California personal income tax code, the latter relates to the California corporation tax law; the underlying message is identical. Whether a portion of the gain from the sale of an intangible asset is apportionable income, or income subject to non-business allocation, or the Mobilia doctrine, rests heavily on the federal classification of that gain.
The Sax State & Local Tax (SALT) team works heavily in residency and domiciliary law, corporate income tax, and various other state and local tax areas (e.g., the California Personal Income Tax law and the California Corporation Tax Law).
We are dedicated to, and thrive on, being the leading advisors in this area of taxation for our current and prospective clients. If these issues apply to you, please feel free to contact your SAX LLP Tax Advisor, or the SAX LLP State & Local Tax Practice specialists.
Reach out to:
Edvin Givargis, SALT Partner at [email protected]
Jenie Khimthang, SALT Manager at [email protected]
John Nunes, SALT Manager at [email protected]
 This law, adopted by almost all states, follows the doctrine of Mobilia Sequuntur Personam (which translates to “movables follow the person”). It is the doctrine whereby the gain from the sale of an intangible asset is assigned to a taxpayer’s state of residence i.e., gain on intangibles (e.g., corporate stock, dividends, gain from the sale of a trademark or partnership interest) follow you to your home… for better or for worse – mostly for the better if you have changed residency (and in some cases domicile) in anticipation of a liquidity event.
 See California Legal Ruling 2006-03.