Who is taxed on a partner's distribution in excess of basis in a tiered structure, and whose apportionment factors apply?

The federal event decides whose gain it is

The structure is a common one. An operating partnership, a Delaware LLC taxed as a partnership, holds an investment management group's real estate, loans, fund interests and taxable subsidiaries through lower-tier LLCs and LPs. Its partners are the REIT partner (about 90 percent), the management corporation (about 5 percent) and the executive partnership, an upper tier through which senior executives hold the rest. In the prior year the operating partnership distributed cash to all three partners, and the executive partnership passed its share through to the executives.

Two distributions are in that chain, and each is tested against a different basis. Section 731(a)(1) provides that a partner recognizes no gain on a distribution "except to the extent that any money distributed exceeds" the adjusted basis of its interest immediately before the distribution, and any gain so recognized is treated as gain from the sale or exchange of the distributee partner's interest (IRC section 731(a); Treas. Reg. section 1.731-1(a)(1)(i), (a)(3)). Section 741 makes that a capital gain, except as section 751 provides. The operating partnership's distribution is measured against the executive partnership's basis in its operating-partnership interest; the executive partnership's distribution is measured against each executive's basis in the executive partnership. Either tier, or both, can produce gain, and the tier that produces it determines whose gain it is.

Basis moves during the year. It rises by the partner's distributive share of income (IRC section 705(a)) and falls, not below zero, by money distributed (IRC section 733). A decrease in a partner's share of partnership liabilities is treated as a distribution of money (IRC section 752(b)), and an upper tier's share of a lower tier's liabilities is treated as the upper tier's own liability for applying section 752 to the upper tier's partners (Treas. Reg. section 1.752-4(a)). A lower tier that repays debt can therefore make deemed distributions at every tier above it with no cash moving. Advances or drawings of money against a partner's distributive share of income are treated as current distributions made on the last day of the partnership's taxable year (Treas. Reg. section 1.731-1(a)(1)(ii)), so a draw is measured against basis after the year's income is added. Section 751(b), which treats a distribution that shifts a partner's share of unrealized receivables or substantially appreciated inventory as a sale or exchange, is a separate computation outside this article.

California applies these rules through conformity. In Appeal of Shafer, OTA Case No. 18010886 (July 26, 2019), a nonprecedential opinion, the Office of Tax Appeals required a member to recognize gain under sections 731 and 752 on distributions and debt relief that exceeded his basis, although the LLCs that made the distributions had deferred their own gain. The partner-level gain stood on its own.

An example fixes the point. One executive holds an interest in the executive partnership with a basis of $400,000 and receives $1.5 million. If the executive partnership's own basis in the operating partnership exceeded what it received, the executive partnership recognizes nothing, and the executive alone has $1.1 million of gain on the executive's interest in the executive partnership. That gain is not on the executive partnership's return, not in any partner's distributive share, and not in any receipts factor.

Why the operating partnership's apportionment percentage is the wrong measure

A return position seen in tiered structures takes the executives' section 731 gain, multiplies it by the operating partnership's apportionment percentage in each filing state, and computes nonresident withholding or a composite return on the result. The method assumes that the gain is created by the upper tier and that the upper tier looks through to the operating partnership's factors. Neither assumption holds when the gain is the executive's. The gain belongs to the executive partners, and a state that looks through at all would look to the factors of the partnership whose interest they hold, the executive partnership, not to an entity two tiers down.

The operating partnership's apportionment percentage measures where the operating partnership's business income is earned. The executive's gain is income from a different asset, an interest in an upper tier, and its source is fixed by the rules for that asset. Where the upper tier files in a state under a separate-entity rule, or where the lower tier pays an entity-level tax and nothing flows up, the upper tier has no flowed-up factors to borrow even in principle.

The withholding consequence follows. Nonresident withholding and composite regimes are measured by the entity's state-source income, through each partner's distributive share of it or the distributions that carry it out. New York's estimated tax paid by a partnership on behalf of nonresident partners, for example, is computed on "a partner's, member's or shareholder's distributive share or pro rata share of the entity income" derived from New York sources (N.Y. Tax Law section 658(c)(4)(A)). A section 731 gain recognized by the executive is not a distributive share of anything. Tax computed on it is a prepayment against a liability the partner may not have, recovered only through the partner's own return and the true-up that follows. The library's article on withholding when a partnership distributes refinancing proceeds describes how California measures pass-through withholding by the entity's California-source income rather than by the cash distributed, the same distinction from the other side.

Resident partners: taxed in full, and the credit may not follow

A resident is taxed on income from every source. California taxes residents on all income and nonresidents only on income from California sources (Rev. and Tax. Code sections 17041 and 17951, as summarized in Appeals of J. Burch, J. Carden and K. Carden, 2026-OTA-527P). An executive resident in California at the time of the gain reports all of it there.

Double taxation enters through the other-state credit. California's credit for net income taxes paid to another state applies only to tax on "income derived from sources within that state," and whether income is so derived is determined under California's own rules for sourcing a nonresident's income (Rev. and Tax. Code section 18001(a)(1), (c), as stated in Appeal of Buehler, 2023-OTA-215P). In Buehler, California residents were denied a credit for another state's tax on gain from selling a membership interest in an LLC taxed as a partnership, because the interest had not acquired a business situs in that state and the member and the LLC were not shown to be a unitary business. A California executive whose section 731 gain is also taxed by a look-through state described below faces the same mismatch: the other state taxes the gain, and California treats it as sourced to the residence.

Timing matters for an executive who moves. A draw against the year's income is treated as made on the last day of the partnership's taxable year (Treas. Reg. section 1.731-1(a)(1)(ii)); a distribution that is not a draw is recognized when made. The date can decide which state treats the executive as a resident when the gain arises, and New York applies its real property entity rule to a sale in the nonresident portion of a part-year resident's year (TSB-M-18(1)I (April 6, 2018)).

Nonresident partners: three families of rules

Domicile and business situs. California sources a nonresident's income from intangible personal property to the residence unless the property "has acquired a business situs in this state" (Rev. and Tax. Code section 17952). A partnership interest is intangible personal property, and a nonresident's gain on it was not California-source in Appeals of Ames, 87-SBE-042 (1987), because the interests had not been employed as capital in California or "localized in connection with a business, trade or profession in this State" so that their substantial use and value attached to that business, the regulation's business situs test as Ames quotes it (Cal. Code Regs., tit. 18, section 17952(c)). The Office of Tax Appeals has held that Regulation 17951-4(d) reaches a nonresident partner's distributive share of unitary partnership income, not a sale of a partnership interest, and has rejected sourcing a nonresident's gain by the activities of the entity invested in (Burch, posted as pending precedential). On that reading a nonresident executive's section 731 gain on an interest in the executive partnership is California-source only if the interest has a California business situs. The library's article on whether a nonresident's gain from selling a partnership interest is California-source income covers Ames, Burch and the unitary exception in depth.

New York's general rule is the same in substance: income and gain from intangible personal property are New York-source only to the extent the property is employed in a business, trade, profession or occupation carried on in New York (N.Y. Tax Law section 631(b)(2)). The Department has reached the same result for a section 731 gain. A former resident recognized gain under sections 731 and 752 when investment partnerships paid down liabilities, and the Department concluded the gain "does not constitute gain or loss derived from or connected with New York sources" (TSB-A-06(1)I (March 3, 2006)), an opinion limited to its facts and issued before the real property rule below.

Statutory look-through to the distributing partnership. Minnesota allocates gain on the sale of a partnership interest "in the ratio of the original cost of partnership tangible property in this state to the original cost of partnership tangible property everywhere, determined at the time of the sale," and, where more than 50 percent of the value of the partnership's assets consists of intangibles, "in accordance with the sales factor of the partnership for its first full tax period immediately preceding" the period of sale (Minn. Stat. section 290.17, subd. 2(c)). New York treats an interest in a partnership, LLC, S corporation or non-publicly traded C corporation with 100 or fewer shareholders as New York real property where the entity owns New York real property (or cooperative shares) whose fair market value equals or exceeds 50 percent of all its assets, counting only assets owned for at least two years before the sale or exchange, and sources the gain by the ratio of the New York real property's value to the value of all the entity's assets (N.Y. Tax Law section 631(b)(1)(A)(1)). The Department has said the rule applies if any entity in a tiered structure owns New York real property (TSB-M-09(5)I (May 5, 2009); TSB-M-18(1)I), and it has applied the rule to a loss under section 731(a)(2) on a liquidating distribution, finding none of the loss New York-source because the partnership no longer owned the New York building on the date the interests were liquidated (TSB-A-20(3)I (February 10, 2020)). Minnesota's text speaks of a "sale"; no Minnesota authority applying it to a distribution in excess of basis was found, and the federal characterization of the gain as gain from a sale or exchange of the interest is the bridge.

Ownership-threshold look-through. Ohio requires a taxpayer that directly or indirectly owned at least 20 percent of the equity voting rights of a pass-through entity at any time in the three-year period ending on the last day of its taxable year to apportion income and gain "realized from each sale, exchange, or other disposition" of an interest in that entity by the average of the entity's apportionment fractions for the current and two preceding taxable years (Ohio Rev. Code section 5747.212(B), (C)). The rule operates through the nonresident credit (section 5747.212(A); section 5747.05(A)). The Ohio Supreme Court held the statute unconstitutional under the Due Process Clause as applied to a nonresident's capital gain on a 79.29 percent LLC interest, absent any showing that the investor's own activities formed a unitary business with the LLC, while rejecting a facial challenge (Corrigan v. Testa, 149 Ohio St.3d 18, 2016-Ohio-2805). Below the threshold, a nonresident's capital gain on intangible property is allocated to Ohio only if the taxpayer was domiciled in Ohio at the time of the sale or transfer (section 5747.20(B)(2)(c)), unless the gain is business income: Ohio's definition now includes gain from the sale of an equity or ownership interest in a business where the sale is treated as an asset sale for federal purposes or the seller materially participated in the business in the year of sale or any of the five preceding years (section 5747.01(B)). An executive who works in the business may meet the material participation branch on its face, if a section 731 distribution counts as a "sale" of an interest for this purpose. Section 5747.21(B) apportions business income as if the taxpayer's business were a corporation, and section 5747.231 includes in that computation the taxpayer's direct or indirect share of each pass-through entity's property, compensation and sales; no Ohio authority on a section 731 distribution was found.

Whose factors apply when a state looks through

Every look-through above points at the entity whose interest produced the gain. For an executive, that is the executive partnership. Its own balance sheet is chiefly one intangible, its interest in the operating partnership. Under Minnesota's rule that sends the computation to the intangibles branch and the executive partnership's own receipts factor for the preceding full period. Whether that factor contains the executive partnership's share of the operating partnership's receipts depends on whether the state applies a flow-up rule or a separate-entity rule to the upper tier, a question subdivision 2(c) does not answer, although the Department's 2025 Form M3 instructions treat factors passed through from other partnerships as part of a partnership's Schedule M3A factors (line 7). New York reaches through the tiers for the existence of New York real property, but the two memoranda read for this article do not say how the 50 percent test is measured when the real estate sits in a lower tier and the upper tier holds only partnership interests. Ohio uses the apportionment fractions of the "section 5747.212 entity," the entity whose interest was disposed of, and builds them with that entity's direct or indirect share of each lower-tier pass-through entity's property, compensation and sales (Ohio Rev. Code section 5747.231), so the operating partnership's factors reach the executive's gain through the executive partnership.

The operating partnership's factors enter directly in one case: when the upper tier itself recognizes the gain. If the operating partnership's distribution exceeds the executive partnership's basis in its operating-partnership interest, the executive partnership has gain on that interest, and the executives receive it as a distributive share. The character and source of a distributive share are fixed at the partnership level. In California, by analogy to Appeal of L. Smith, 2023-OTA-069P, which involved a holding partnership's sale of its interest in a lower-tier partnership rather than a distribution, the gain is apportionable business income measured by the lower tier's factors if the two partnerships are unitary, judged "disregarding ownership requirements" (Cal. Code Regs., tit. 18, section 25137-1(a)); if they are not, the lower tier's business is "treated as another trade or business of the taxpayer" (section 25137-1(g)), and a nonbusiness gain is sourced "as if the income producing activity were undertaken by the partner in its individual capacity" (Cal. Code Regs., tit. 18, section 17951-4(d)(4)), which returns it to section 17952 and the executive's residence. New York's memoranda state that a partnership in a tiered structure that sells its interest in another entity in the structure determines its New York-source income from the sale as if it were a nonresident individual (TSB-M-09(5)I; TSB-M-18(1)I).

The other partners run the same analysis under different rules. A distribution in excess of the management corporation's basis is corporate gain on a partnership interest, and its California treatment, business or nonbusiness, with a look-through either way, is the subject of the library's article on how a corporate partner sources gain from selling a partnership interest in California.

Practice notes

The analysis starts with basis at each tier, computed at the right date with each tier's share of lower-tier liabilities, because the tier whose basis was exceeded owns the gain. Where an executive's basis was exceeded, the gain is the executive's own item, not a distributive share, and the executive partnership supplies what the look-through states need: the distribution date, the executive partnership's tangible property at original cost and asset values, its receipts factor for the preceding full period, the two-year holding history of any entity owning New York real estate, and, for a holder near 20 percent, three years of Ohio apportionment fractions. Nonresident withholding and composite returns are computed on distributive shares, not on partner-level section 731 gain; where earlier years were computed on the operating partnership's apportionment percentage, the partners' refund periods are the limit on the true-up. A resident executive taxed by a look-through state checks the home state's credit rule before assuming the credit. Where the upper tier itself recognized the gain, the unitary record between the tiers decides California's answer and belongs in the file before the return is filed. G&G State Tax Group provides state sourcing analysis of partner-level gain and withholding review for tiered partnerships alongside its state and local tax practice.