Key Takeaways
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The OTA held that IRC §751(a) changes the character of gain, but not the nature of the transaction.
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Gain from the sale of a partnership interest was sourced to the nonresident owners' state of residence, not apportioned to California.
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The decision may provide planning opportunities and reduce California tax exposure in partnership exit transactions.
On July 24, 2026, the California Office of Tax Appeals (OTA) issued a taxpayer-favorable decision that could have important implications for nonresident partners selling interests in partnerships with California business activities. The OTA rejected the Franchise Tax Board’s (FTB) position that gain recognized under IRC Section 751(a) (ordinary income) should be treated as California source income.
Background
This case involved nonresident individuals who indirectly owned a multistate operating partnership through a holding partnership. The operating partnership conducted business in California. When part of the operating partnership interest was sold, two categories of federal tax gain were generated:
- Capital gain attributable to the partnership interest; and
- Ordinary income attributable to “hot assets,” such as unrealized receivables and inventory under IRC Section 751(a).
The FTB argued that the ordinary portion of the gain should be sourced to California using the operating partnership’s California apportionment percentage. This position was based primarily on FTB Legal Ruling 2022-02, which treats a transaction like this as though the partnership’s underlying business assets had been sold rather than a partnership interest.
OTA Decision
The OTA disagreed with the FTB and concluded that IRC Section 751(a) changes the character of the gain, but not the nature of the transaction. Although Section 751(a) recharacterized a portion of the gain as ordinary income, the transaction remained a sale of a partnership interest, not a sale of the partnership’s underlying assets. As a result, the OTA determined that California could not source the gain using apportionment rules that apply to partnership operating income. Instead, the gain was subject to California’s general sourcing rule for sales of intangible property by nonresidents and was sourced to the taxpayer’s state of residence.
The decision supports the position that treating gain as ordinary income does not necessarily change how that gain is sourced for California purposes. This distinction could be particularly relevant in mergers and acquisitions, private equity transactions, and other partnership exits where the sourcing of gain could have a very large impact on state tax liability.
What Happens Next
Both parties have 30 days to petition for rehearing – if a petition is not filed or if a petition is denied, this opinion will become final. At that point, it will then be designated as either precedential or nonprecedential under the OTA’s rules. Importantly, this decision could become one in which the OTA looks to for guidance in future appeals.
If your business is considering a partnership transaction or needs help understanding California’s sourcing rules in light of this new guidance, Eide Bailly’s State and Local Tax professionals can help evaluate how the decision may apply, assess potential exposure, and navigate the ever-changing state tax landscape.
