Is a nonresident's gain from selling a partnership interest California-source income?

Two sourcing tracks, and the question that picks between them

California taxes a resident on all income regardless of source, and a nonresident only on gross income from sources within the state (Rev. and Tax. Code section 17951). Section 17954 provides that a nonresident's income from sources within and without the state is allocated and apportioned under rules and regulations prescribed by the Franchise Tax Board, and the statute and the regulations together supply two tracks for the two ways a partner realizes value from a partnership.

The first track is section 17952. Income of a nonresident from stocks, bonds, notes, or other intangible personal property is not income from California sources unless the property has acquired a business situs in the state. The regulation defines a business situs as property employed as capital in California, or property whose possession and control has been localized in connection with a California business, trade, or profession so that its substantial use and value attach to and become an asset of that business (Cal. Code Regs., tit. 18, section 17952(c)). A partnership interest is intangible personal property, and a nonresident's sale of one is, on its face, a section 17952 event.

The second track is Regulation 17951-4(d), which governs a nonresident partner in a partnership carrying on a unitary business within and without California. The total business income of the partnership is apportioned at the partnership level under the Uniform Division of Income for Tax Purposes Act, Revenue and Taxation Code sections 25120 to 25139, and the regulations under it (section 17951-4(d)(1)). The source of a partner's distributive share of items that are not business income is determined under sections 17951 through 17955, as if the income-producing activity were undertaken by the partner individually (section 17951-4(d)(4)). Where a partner holds a 20 percent or greater interest and the partnership's business is unitary with another business activity of the partner, the unitary income is combined and apportioned at the partner level (section 17951-4(d)(5), (d)(6)).

The question that picks between the tracks is where the gain was generated. If it arose in the nonresident's own hands, from a disposition of property the nonresident owned, section 17952 governs. If it arose inside a partnership and reached the nonresident as a distributive share, Regulation 17951-4(d) governs, and the item's character as business or nonbusiness income is fixed at the partnership level before anything flows up.

The direct sale: Ames and the business situs test

In Appeals of Ames, nonresident limited partners in a partnership whose principal business was real property in Los Angeles sold their interests as the project failed. The State Board of Equalization held that the gain was not a result of partnership operations but of the sale of an intangible, and that the interests had not acquired a California business situs because the partners made no attempt to localize them in California or to employ the wealth they represented in business activity here. The assessments were reversed.

Two features of the test deserve emphasis because they are the points the cases turn on. First, the situs inquiry is about the partner's interest, not the partnership's business. A partnership can operate entirely in California while the nonresident partner's interest in it lacks a California business situs. Second, participation in management does not by itself localize the interest. The Office of Tax Appeals applied both points in the mirror-image setting of Appeal of Buehler, 2023-OTA-215P, where California residents sought a credit for Massachusetts tax on gain from selling a membership interest in a Delaware LLC, classified as a partnership, that provided portfolio management services from offices in California, Massachusetts and New York. The panel held that the member's service as a managing member did not alone show that the interest had been localized in Massachusetts, and that the record supported only that the member directly held the interest, not that the member was conducting a unitary business with the LLC. Applied in the other direction, the same reasoning protects a nonresident who holds a California partnership interest directly.

The tiered sale: Smith and the unitary flow-up

Appeal of L. Smith, 2023-OTA-069P, keeps the direct-sale rule from becoming a general rule. The nonresident there held an indirect interest in a holding LLC, classified as a partnership, whose only function was to hold a direct interest in an operating partnership that developed and sold timeshare interests within and without California. The holding partnership sold its entire interest in the operating partnership and sourced none of the gain to California. The nonresident argued that the gain was gain on an intangible sourced to the state of residence under section 17952.

The Office of Tax Appeals rejected that framing because it focused on the gain at the nonresident's level when the gain was generated at the holding partnership's level. Relying on The 2009 Metropoulos Family Trust v. Franchise Tax Board (2022) 79 Cal.App.5th 245, which involved nonresident shareholders of a unitary S corporation and which the Supreme Court declined to review on August 24, 2022, the panel held that income from a pass-through entity is characterized at the entity level as business or nonbusiness income, that business income is apportioned under the Uniform Division of Income for Tax Purposes Act, and that nonbusiness income is sourced under the personal income tax sourcing statutes. Regulation 17951-4 carries the same dignity as a statute and does not yield to section 17952, and the partnership conformity statute, section 17851, adopts the federal pass-through scheme only except as otherwise provided, which the panel read as a signal that federal conduit treatment yields to California's apportionment rules. The S corporation shareholder side of Metropoulos is described in the library's California article on the section 338(h)(10) election; the point for partnerships is that the panel found the court's reasoning equally applicable to a unitary partnership and its nonresident partners.

At the holding partnership's level, the questions become whether the gain is business income and whose factors apportion it. The parties agreed, and the panel accepted, that if the two partnerships were unitary the interest sold was a unitary asset and the gain was apportionable business income under the functional test of section 25120(a) as construed in Hoechst Celanese Corp. v. Franchise Tax Board (2001) 25 Cal.4th 508. The factor question was answered by Regulation 25137-1, which Regulation 17951-4(d)(1) reaches through its reference to the regulations under the Uniform Act. Where the partnership's and the taxpayer's activities constitute a unitary business under established standards, disregarding ownership requirements, the taxpayer's share of the partnership's trade or business is combined with its own as a single trade or business (section 25137-1(a), (f)); where they are not unitary, the partnership's business is treated as another trade or business of the taxpayer (section 25137-1(g)). A 2018 amendment, operative January 1, 2019, added to section 25137-1(a) a statement that the same principle applies when the partnership itself owns interests in other partnerships.

The unitary finding is what makes Smith instructive. The holding partnership had no property, payroll, or sales of its own, so without unity the gain would have been apportioned with factors of zero and no California-source income would have resulted. The panel declined to adopt a special unitary test for pass-through holding companies, relying on Appeals of PBS Building Systems, Inc., 94-SBE-008 (1994), which it read as dispelling the notion that a separate unitary test exists for holding companies, and held that unitary combination does not require that the partner control the partnership or hold a majority interest. An unrelated investor's appointment of most of the operating partnership's board did not defeat unity. On the facts, one individual served as sole manager of the holding partnership and as chief executive and board chair of the operating partnership, the holding partnership adopted resolutions on the operating partnership's loan agreements, and the operating agreement barred the holding partnership from competing. The panel also held that the 20 percent threshold of section 17951-4(d)(5) and (d)(6) did not prevent the holding partnership from being unitary with the operating partnership.

Where a nonresident holds an interest through a partnership, and that partnership sells an interest in a lower-tier partnership with which it is unitary, the gain is apportionable business income at the selling partnership's level, apportioned using the lower-tier partnership's factors, and the nonresident's distributive share of the California-apportioned gain is California-source income.

The hot-asset bifurcation: Legal Ruling 2022-02 and Burch

The Franchise Tax Board's third theory reaches sales that the unitary theory does not. Legal Ruling 2022-02, issued July 14, 2022, considers a nonresident who sells an interest in a partnership holding unrealized receivables, appreciated inventory, and depreciation recapture property, and concludes that the portion of gain attributable to that section 751 property is treated as if the partnership had sold the property and allocated the income to the partner. On that premise the hot-asset gain is California-source under Regulation 17951-4 where the partnership operates only in California, and is apportioned using the partnership's factors where it operates within and without the state; only the remaining section 741 gain is sourced as an intangible under section 17952. The ruling reasons from Appeal of Bense, 79-SBE-055 (1979), which fragmented a partnership interest sale into two sales. The Franchise Tax Board advanced the same theory as an alternative ground in Smith, and the panel there declined to reach it.

The Office of Tax Appeals reached it in Appeals of J. Burch, J. Carden and K. Carden, 2026-OTA-527P. Nonresidents there held interests in a holding partnership that owned a minority interest in an operating partnership selling goods through retail stores and online and holding inventory and unrealized receivables. The holding partnership sold portions of that interest in 2012 and 2013 and reported the gain as nonbusiness income not derived from California. The Franchise Tax Board did not argue that the two partnerships were unitary, so Smith was not in play; it treated the section 751(a) portion as the nonresidents' distributive share of the operating partnership's business income, sourced with the operating partnership's apportionment percentages, and left the remainder to section 17952.

The panel declined to follow Legal Ruling 2022-02 and reversed. It found Rawat v. Commissioner (D.C. Cir. 2024) 108 F.4th 891, decided after the ruling issued, highly persuasive. Rawat held that the operative clause of section 751(a), under which the hot-asset portion of the amount realized "shall be considered as an amount realized from the sale or exchange of property other than a capital asset," means the gain is ordinary income, not that the partner sold the underlying assets. The panel adopted that reading for California: section 751(a) has an anti-abuse function, converting capital gain to ordinary income so that the partnership form cannot launder ordinary income, and does nothing more. Section 751(b), which does treat certain distributions as a sale or exchange of hot assets, shows what Congress wrote when it intended a deemed sale. The panel therefore analyzed the transaction as a sale of a partnership interest in the nonresidents' hands, not a sale of the partnership's assets. Bense was distinguished as a character case that did not involve nonresident sourcing, the taxpayers apparently being residents; Metropoulos as a case about a federal deemed asset sale at the S corporation level; Smith as a unitary case. The panel found that section 17952 makes no mention of bifurcation and that Regulation 17951-4(d) by its plain terms reaches a nonresident partner's distributive share of unitary partnership income, not a sale of a partnership interest, a conclusion consistent with Ames. If the Franchise Tax Board wishes to source such sales by its proposed method, the panel wrote, it is free to approach the Legislature, which had amended section 25125 to overturn Appeal of Holiday Inns, Inc., 86-SBE-074 (1986), for corporate partners. The panel also rejected investee apportionment, sourcing a taxpayer's gain by the in-state activities of the entity invested in regardless of any unitary relationship, as something California's personal income tax law does not provide for.

The status of Burch matters as much as its reasoning. The opinion is posted as pending precedential, and the Office of Tax Appeals invites comments on whether a posted opinion should be designated precedential before it decides the designation (Cal. Code Regs., tit. 18, section 30502). Until then Burch shows how the tribunal reads the statute but is not yet a precedential opinion that later panels follow. Either party had 30 days from the opinion's issuance to petition for rehearing (Rev. and Tax. Code section 19048; Cal. Code Regs., tit. 18, section 30602), a window that closed in August 2026, and nothing posted on the Office of Tax Appeals site shows a petition. Legal Ruling 2022-02 remains on the Franchise Tax Board's legal rulings index without a withdrawal or modification note. A nonresident who sold a partnership interest with hot assets in an open year therefore faces an agency ruling and a tribunal opinion pointing in opposite directions.

What the corporate rule does not do, and what remains open

A corporate partner faces a different statute. After Holiday Inns, the Legislature amended section 25125 to give a corporation a specific allocation rule for nonbusiness gain on the sale of a partnership interest, which the library's article on corporate limited partners in investment funds describes. That rule lives in the Corporation Tax Law and is not among the sourcing rules that Regulation 17951-4(d)(4) applies to a nonresident individual's nonbusiness items; those are sections 17951 through 17955, and section 17952 governs an intangible.

Three questions remain open. The first is the final designation of Burch and what the Franchise Tax Board does with Legal Ruling 2022-02: whether it withdraws the ruling, continues to apply it to other taxpayers and contests the question in a later appeal, or seeks the statutory change the panel pointed to. The second is whether the Franchise Tax Board will meet a sale by a holding partnership with the Smith theory instead of the ruling, arguing that the holding partnership and the operating partnership are unitary. Burch did not foreclose that path, because the Franchise Tax Board did not take it, and Smith's holding that unity under Regulation 25137-1 requires neither control nor a majority interest makes it available against a minority holding partnership. The third is the case where a nonresident individual who sells directly also conducts a business of which the interest is arguably a part: section 17951-4(d)(6) combines at the partner level an individual's unitary sole proprietorship with 20 percent or greater interests in unitary partnerships, and Buehler shows a record that fell short of establishing that. Where none of those facts exists, Ames controls and the gain follows the seller's residence.

Practice notes

The first step in any analysis of this kind is identifying the seller. A gain reported on a nonresident's return as a distributive share from a partnership that sold a lower-tier interest is analyzed under Smith and the unitary standards of Regulation 25137-1, and the record that decides it, overlapping management, intercompany financing, approvals, and restrictive covenants between the tiers, is assembled before the return is filed rather than reconstructed under audit. A gain the nonresident realized by selling an interest held directly is analyzed under section 17952 and the business situs definition in the regulation, with attention to whether the interest was pledged for, or otherwise employed as capital in, a California business of the nonresident. Where the partnership sold holds unrealized receivables or inventory, the return position on the section 751(a) portion is documented against Burch and its pending status, the panel's reading of section 751(a) tracking the D.C. Circuit's reading of the same clause in Rawat, and any prior-year return that followed Legal Ruling 2022-02 is calendared against the refund claim periods of section 19306(a). A holding partnership that exists only to hold an operating interest deserves a hard look before any sale, because Smith was decided on that structure. G&G State Tax Group provides nonresident sourcing analysis and controversy representation on partnership interest dispositions alongside its state and local tax practice.