Nonresident Partners May Face Triple Taxation on Partnership Interest Sales

When selling your partnership interest, accurately completing tax forms and understanding state-specific tax laws can help you avoid penalties or audits due to noncompliance. Learn more about state tax legislation and rulings to help you make informed decisions and plan your tax obligations accordingly.

Partnership interest sales: resident vs. nonresident states

When a partnership (or limited liability company) interest is sold, the gain (or loss) recognized by a partner is not a partnership flow-through item reported to the partner or tax authority on a Schedule K-1.

Rather the gain is computed and incurred at the partner’s level and is recognized outside of the partnership operations. For income tax purposes, selling a partnership interest will generally be characterized as capital gain, but under certain situations, all or part of the gain may be recharacterized as ordinary income.

Although the partner will report the gain on their federal and state resident income tax returns, they might not report any part of the gain to the partner’s nonresident states where the partnership has business operations. This is because most partners believe gain recognized from selling their partnership interest, as an investment asset, should only be taxed in their resident state.

The common rule partners rely on is most states will tax a nonresident on the gain recognized from the sale of a partnership interest only if the partnership interest itself acquires a business situs in the state or is employed in a business, trade, profession, or occupation carried on in the state.

When do states impose tax on a nonresident’s gain from their partnership interest sale?

Although most states will tax a nonresident’s gain from selling an intangible asset, such as a partnership interest, when the intangible asset has acquired a business situs or is connected to a business carried on in the state (e.g., a nonresident pledges their partnership interest as security for payment of a debt incurred in connection with their business in the state), this situation is rare.

Realizing this, states have enacted tax legislation to tax nonresident partners on the gain recognized from selling their partnership interests when the gain is attributable to the partners’ share of the increase in the in-state value of the underlying partnership.

Real estate partnerships

Some states specifically focus on partnerships owning a significant amount of real estate in their state (e.g., real estate partnerships and operating companies with significant real estate value).

Under their state tax laws, nonresidents pay state income tax on gains from selling a partnership interest of a partnership owning real property in their state, with a fair market value that equals or exceeds a certain percentage (typically 50%) of all the entity’s assets on the date of sale.

In essence, these states deem selling a partnership interest to be the sale of the underlying real estate, with the gain sourced to their state, as if the appreciated real property was sold.

Operating partnerships

States may not only tax the gain generated by a nonresident from selling an interest in a partnership holding real estate but may also tax the gain if the partnership has business operations within the state contributing to the gain.

The state looks at the underlying partnership to determine the taxability of the gain connected to their state. For example, assume an individual who is a resident of State X and a nonresident of State Y owns a partnership interest in a partnership operating a business in State Y. If the partner sells their interest in the partnership and recognizes gain, the partner is subject to three taxes:

1. Federal income tax;
2. State income tax in the partner’s resident state (State X) based on the full amount of the gain; and
3. State income tax in the partner’s nonresident state (State Y) to the extent that the gain is deemed connected to State Y.

The gain from the sale of a partnership interest could result in triple taxation.

Selling a partnership interest at a gain could result in triple taxation unless the partner’s resident state allows reducing the partner’s resident tax for part or all the tax paid to the nonresident state. Not all states will allow the resident partner a credit, either full or partial, for the state taxes paid on the gain taxed in another state.

Hot asset ordinary gain

Although, under their tax laws, states, such as California, may not tax the gain derived by nonresident partners selling their partnership interests in a state under the general sourcing rule, state tax authorities are finding creative ways to work around that law.

California recently issued Legal Ruling 2022-02, which provides that any part of the gain recognized by a nonresident from the sale of an interest in a partnership doing business in California, which is attributable to “Section 751 property” (a.k.a. “hot assets,” such as accounts receivable, inventory, and depreciable property owned by the partnership), that would otherwise generate ordinary income gain upon its sale, is subject to taxation.

Under the ruling’s analysis, since federal and California income tax law bifurcates the gain from the sale of a partnership interest into capital gain and Section 751 ordinary income gain, the California Franchise Tax Board takes the position that although they are prohibited from taxing the capital gain portion under their law, California can tax the portion of the gain that is recharacterized as ordinary income gain to the extent it is attributable to California.

Taxability occurs at the entity level

In most states, who sells the partnership interest can have an impact on its state taxability. If a nonresident partner sells their direct interest in a partnership, the gain may not be taxed under the state’s general sourcing rule.

However, if the nonresident holds the partnership interest indirectly through an entity holding the partnership interest, and the entity sells the partnership interest, the gain could become taxable to the nonresident owners of the entity and/or the entity itself if certain criteria are met (e.g., if the gain is considered “unitary business income”).

In other words, by “filtering” the gain through an underlying entity, the gain may be taxable — whereas if the gain is realized directly by the partner, it would not be taxable.

What are states doing now?

States are increasingly looking for ways to tax gains realized by nonresident partners when selling their partnership interests in partnerships with some nexus to their state. States are taking novel approaches to tax these gains, either through legislation, regulations, or rulings. The Multistate Tax Commission, an intergovernmental state tax agency working on behalf of states, has also recently begun studying the multistate taxation of partnerships and their partners.

In addition, state tax authorities are increasing inclined to audit and scrutinize partnership-related transactions to capture prior year taxes due. These audits have risen to judicial challenge by taxpayers, some of which have sided with the states.

How we can help

Without proper state and local tax advice and planning prior to the time of a sale, partners selling their partnership interest may be caught off guard when they must pay state taxes to a state they have no connection to, other than as a partner.

CLA’s state and local tax professionals can help entities and their partners understand the state and local tax implications of partnership interest sales — before they happen — and seek ways to reduce your tax burden.

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