How does a corporate partner source gain from selling a partnership interest in California?

The threshold question is character, not geography

Business income is income arising from transactions and activity in the regular course of the taxpayer's trade or business, and it includes income from tangible and intangible property if the acquisition, management, and disposition of the property constitute integral parts of the taxpayer's regular trade or business operations (RTC section 25120(a)); nonbusiness income is all income other than business income (RTC section 25120(d)). The California Supreme Court reads that definition as two tests, transactional and functional, either of which yields business income; the functional test looks at the relationship between the property and the taxpayer's business operations, not at the transaction (Hoechst Celanese Corp. v. Franchise Tax Bd. (2001) 25 Cal.4th 508, 526 to 527). The regulations treat gain on intangible personal property as business income "if the property while owned by the taxpayer was used in the taxpayer's trade or business" (Cal. Code Regs., tit. 18, section 25120(c)(2)), and the Franchise Tax Board's instructions state that income "is business income unless clearly classifiable as nonbusiness income" (FTB, 2025 Instructions for Schedule R, General Information A).

A partnership interest is intangible personal property. The Court of Appeal applied the functional test to a parent's sale of a subsidiary's stock and held the gain to be business income, because the stock had contributed materially to the taxpayer's production of business income, and property that generates unitary business income generates business income when sold (Jim Beam Brands Co. v. Franchise Tax Bd. (2005) 133 Cal.App.4th 514, 526 to 527). The Office of Tax Appeals has done the same for a partnership interest. In Appeal of Alvaco Trading Company, Inc., 2024-OTA-142 (nonprecedential), an S corporation whose only asset was an interest in an operating limited liability company reported the gain on selling substantially all of it as nonbusiness income under section 25125(d), while filing as unitary with the company. The Office of Tax Appeals held the two unitary and the gain business income under the functional test, calling the interest "a proxy for the business assets" that had produced the partner's business income.

Regulation 25137-1 provides that a corporate partner's distributive share of partnership business income is business income to the partner, and that "the determination of whether the partnership's activities and the activities of the corporate-partner constitutes a single trade or business or more than one trade or business turns on the facts in each case" (Cal. Code Regs., tit. 18, section 25137-1(a)). Where the two "constitute a unitary business under established standards, disregarding ownership requirements," the partner's share of the partnership's trade or business is combined with the partner's own as a single trade or business; where they do not, the partner's share is treated as another trade or business of the partner, apportioned on the partnership's own factors (section 25137-1(a), (g)). "Disregarding ownership requirements" means the corporate control test does not govern: a 20 percent partner can be unitary with the partnership, and a 60 percent partner can fail to be.

The regulation governs the partner's distributive share, which is why the library's article on the corporate limited partner in an investment fund classifies K-1 items at the partnership level. The gain on the sale of the interest is the partner's own item, and its character is decided at the partner level under section 25120(a); the unitary finding under section 25137-1 nonetheless does nearly all of the work. Where the two were one unitary business, the interest was the vehicle through which the partner conducted part of its business, and the functional test is satisfied on the same facts, as Alvaco shows. Where the partnership was a separate trade or business of the partner, the interest looks like an investment, and the question becomes whether it served an operational function in the partner's own business, the constitutional inquiry discussed below.

The nonbusiness route: allocation under section 25125(d)

Nonbusiness gain on intangible personal property is generally allocated to the taxpayer's commercial domicile, but the allocation statute carves out the sale of a partnership interest and gives it a rule of its own (RTC section 25125(c), (d)). As the Franchise Tax Board states that rule, where 50 percent or less of the value of the partnership's assets at the time of sale consists of intangibles, the gain or loss is multiplied by the ratio of the original cost of the partnership's California tangible property at the time of sale to the original cost of all of its tangible property; where more than 50 percent of that value consists of intangibles, the gain or loss is multiplied by the partnership's sales factor for its first full taxable period before the period of sale (RTC section 25125(d); FTB, 2025 Instructions for Schedule R, General Information A).

Three features of the rule matter. First, the partner's domicile is irrelevant: a corporation commercially domiciled in California does not allocate the whole gain here, as it would for any other intangible, and a corporation domiciled elsewhere allocates to California by the same partnership ratio even if the interest is its only connection to the state. Second, the primary measure is tangible property at original cost, not book value or fair market value. Third, the switch to the sales factor is triggered by value, not cost. The rule as the Franchise Tax Board states it does not define value or say whether cash and receivables count as intangibles for the 50 percent test; the sales factor regulation answers both questions for its own purposes, and a taxpayer that borrows those answers for section 25125(d) is making a judgment the allocation rule does not make.

The rule dates from 1988. The Legislature amended section 25125 that year (Stats. 1988, ch. 1170, section 2) to give corporate nonbusiness gain on a partnership interest a specific sourcing rule and to overturn Appeal of Holiday Inns, Inc. (86-SBE-074), in which the State Board of Equalization, applying the general intangibles rule, had reversed the allocation of a Tennessee-domiciled corporation's gain on a partnership interest to California; the Office of Tax Appeals described the amendment that way in Appeals of J. Burch, J. Carden and K. Carden, 2026-OTA-527P (pending precedential).

The business route: apportionment and the sales factor look-through

Under the single sales factor, which applies to every apportioning trade or business other than those described in RTC section 25128(b) (RTC section 25128.7), the seller's California percentage, not the partnership's, multiplies the gain; the partnership's attributes enter only through the numerator.

The receipt is a sale of intangible property, assigned to California to the extent the property is used in California (RTC section 25136(a)(2)); the regulation defines the use of an interest in a pass-through entity sold in a complete transfer as the use of the entity's underlying assets (Cal. Code Regs., tit. 18, section 25136-2(b)(12)). The mechanics depend on the year of sale.

For taxable years beginning before January 1, 2026, the regulation carried a two-branch test. If 50 percent or more of the assets of the entity sold, determined on the date of sale at original cost basis, consisted of real or tangible personal property, the receipt was assigned by averaging the entity's California payroll and property factors for the most recent twelve-month taxable year before the sale; if more than 50 percent consisted of intangible property, by the entity's California sales factor for that year. In either branch the current year's factors applied to a sale more than six months into the current taxable year, and the assignment ran "to the extent indicated by the taxpayer's books and records kept in the normal course of business." Cash and receivables counted in the asset test, and a seller without the entity's factor data fell to reasonable approximation and then the purchaser's billing address (section 25136-2(d)(1)(B), (C); former section 25136-2(d)(1)(A)1.a. and b.).

For taxable years beginning on or after January 1, 2026, the amendments filed August 27, 2025 apply (section 25136-2(j)(3)). The two branches and the six-month rule survive, but cash, cash equivalents, prepaid items, and accounts receivable are now excluded from the asset calculation (section 25136-2(d)(1)(A)1.a., b.). New rules cover missing information: a taxpayer that cannot determine the asset mix uses the payroll and property method, one with only one set of factors uses the set it has, and one with no factor information assigns the receipt to California if the entity sold is commercially domiciled here (section 25136-2(d)(1)(A)1.c. through e.). The entity's factors are computed under the Part 11 rules whether or not it reported them on a California return (section 25136-2(d)(1)(A)1.f.). A partial sale is a complete transfer of the portion sold (section 25136-2(b)(5)).

Two further rules decide whether the receipt reaches the factor at all. Gross receipts include the amount realized on a sale of property in a transaction producing business income, not reduced by basis, and exclude receipts from intangible assets held in a treasury function (RTC section 25120(f)(2)). And the special-rules regulation excludes from the sales factor substantial gross receipts that "arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer's trade or business" (Cal. Code Regs., tit. 18, section 25137(c)(1)(A)). The regulation defines both terms: a sale is substantial "if its exclusion results in a five percent or greater decrease in the sales factor denominator" of the taxpayer or, for a combined reporting group, of the group as a whole, and occasional "if the transaction is outside of the taxpayer's normal course of business and occurs infrequently" (id.; FTB Chief Counsel Ruling 2017-03). A one-time sale of a partnership interest held for years is the paradigm occasional sale, and the proceeds of a large one will usually meet the five percent test. The gain stays in apportionable income while the proceeds leave both numerator and denominator, and the look-through assignment never applies.

The constitutional floor under the business route

The Due Process and Commerce Clauses limit what a state may include in an apportionable base, and the limit bites hardest on a nondomiciliary corporation selling an investment. In Allied-Signal, the Supreme Court held that New Jersey could not include in a nondomiciliary's apportionable income the gain on the sale of stock in a corporation with which the taxpayer was not unitary. The Court said that payor and payee need not be engaged in the same unitary business, and that what is required instead is "that the capital transaction serve an operational rather than an investment function" (504 U.S. at 787); it added that acquiring an asset "pursuant to a long-term corporate strategy of acquisitions and dispositions does not convert an otherwise passive investment into an integral operational one" (504 U.S. at 788). MeadWestvaco then closed the door that language appeared to open: operational function is not a separate ground for apportionment absent a unitary business; it describes an asset that is itself a unitary part of the taxpayer's business even where payor and payee are not unitary with each other (MeadWestvaco Corp. v. Illinois Dept. of Revenue, 553 U.S. 16, 29 to 30 (2008)).

For a corporate partner, that framework lines up with sections 25137-1 and 25120(a). Where the partnership was unitary with the partner, the gain is business income under the functional test and California may apportion it. Where the partnership was a separate business, the state may still apportion the gain if the interest served an operational function in the partner's own unitary business, a working-capital or supply-chain role for example, but a passive holding, however strategic, is an investment, and a nondomiciliary partner's gain on it cannot be put in the apportionable base. The regulatory presumption of business income does not relieve the state of that constitutional showing; it only allocates the burden of proof on the state-law question.

The nonbusiness route raises its own unresolved constitutional question. Section 25125(d) allocates part of a nondomiciliary's nonbusiness gain to California on the strength of the partnership's California tangible property, treating the partner as having sold a share of assets located here. That is the aggregate view of a partnership, the view the regulations take for the distributive share whether or not the partnership is unitary; the statute extends it to the partner's own gain on the interest, which the regulations do not address. No published California decision reviewed for this article tests subdivision (d) against Allied-Signal for a partner domiciled elsewhere, so a corporate partner whose only California presence is the interest holds an argument that has not been adjudicated.

A related question for that partner is which California tax it pays. A nondomiciliary corporation whose only California contact is a passive, non-unitary partnership interest may not be doing business in the state, but as the library's article on the corporate limited partner in an investment fund explains, a corporation not doing business here remains subject to the corporation income tax on its California-source income; the doing-business answer decides which tax applies and whether the minimum franchise tax is owed, not whether a California allocation is taxed. The library's article on when the bright-line nexus thresholds make a passive investor a taxpayer covers that analysis.

Hard cases

Tiered structures. Regulation 25137-1 applies the same principles through lower-tier partnerships (section 25137-1(a)), so the unitary inquiry runs through the tiers to the operating business. Neither look-through rule says whether an upper-tier holding partnership is measured by its own balance sheet, which may be a single intangible, or by the assets below it.

Hot assets. For nonresident individual partners, the Franchise Tax Board ruled that gain attributable to Internal Revenue Code section 751 property is sourced as if that property had been sold, using the partnership's apportionment factors (FTB Legal Ruling 2022-02). The Office of Tax Appeals declined to follow the ruling in Burch, holding that section 751(a) converts capital gain into ordinary income without turning the sale of a partnership interest into a sale of the partnership's assets. Both address individuals, and the personal income tax rule for nonresident individuals is a separate analysis. Neither states a rule for corporate partners under Part 11, although the opinion's premise, that the transaction remains a sale of a partnership interest, points to section 25125(d) or Regulation 25136-2 governing the whole gain, ordinary portion included.

Mismatched measures. A partnership holding appreciated real estate at low original cost can be under 50 percent tangible by cost and over 50 percent by value, so the same partnership can produce a sales-factor assignment under the business route and a tangible-property allocation under the nonbusiness route.

The minority partner without data (2026 and later years). Where neither factor set is available, the regulation assigns the receipt to California if the partnership's commercial domicile is here (section 25136-2(d)(1)(A)1.e.), an all-or-nothing answer for a partnership managed from California. A partner with even one factor set avoids that result and must use it.

Practice notes

The character determination is the whole case, and it is made on the facts of the holding period, not of the sale. A corporate partner that has combined its share of the partnership's income and factors as unitary cannot credibly treat the gain as nonbusiness, which is the position Alvaco rejected; one that has reported the partnership as a separate trade or business for years has a record supporting the investment characterization, provided the interest played no operational role in its own business. The sale-year file holds four things: the unitary analysis as of the sale; the partnership's balance sheet at original cost on the sale date, with cash, receivables, and prepaid items separated, so that both 50 percent tests can be run; the partnership's California factors for the year before the sale and the sale year, obtained from the partnership rather than estimated; and the occasional-sale computation. For a partner domiciled outside California with no other California presence, the which-tax question comes first, and the constitutional position under Allied-Signal is stated in the file whether or not it is asserted on the return, because preserving it later depends on a timely refund claim. G&G State Tax Group provides income characterization and apportionment analysis for corporate partners disposing of partnership interests alongside its state and local tax practice.