Burch and Carden: Ordinary Income Was Not Automatically California-Source Gain

Nonresident partners who sell an interest in a partnership do not generate California-source ordinary income simply because the underlying business holds "hot assets" like inventory or unrealized receivables. In Appeals of Burch and Carden (2026-OTA-527P), the California Office of Tax Appeals (OTA) held that Internal Revenue Code (IRC) Section 751(a) recharacterizes gain as ordinary income rather than capital gain, but it does not construct a fictional deemed sale of assets by the underlying partnership for state sourcing purposes. However, taxpayers must note that this July 24, 2026 decision carries a "Pending Precedential" status header upon its October 2026 release, and it does not protect nonresidents if the partnership interest itself acquired an independent business situs in California or if specific operational rules apply to multi-tiered unitary structures.

The FTB's Two-Transaction Sourcing Theory

The taxpayers, J. Burch, J. Carden, and K. Carden, were California nonresidents who held direct membership interests in an investment company, JCB Investments, LLC. JCB held approximately 28 percent of the direct membership interests in Tory Burch LLC, a unitary business operating retail stores and online sales within and outside California (slip op. at p. 2). In 2012 and 2013, JCB sold portions of its partnership interest in Tory Burch, generating net gains classified partly as capital gain under IRC Section 741 and partly as ordinary income under IRC Section 751(a) attributable to Tory Burch's unrealized receivables and inventory.

The nonresidents reported their distributive shares of the gains as nontaxable, non-California source income from intangible personal property under Revenue and Taxation Code (R&TC) Section 17952. On audit, the Franchise Tax Board (FTB) bifurcated the sales. Relying on its Legal Ruling 2022-02, the FTB argued that the IRC Section 751(a) gain had to be treated as if Tory Burch sold its own inventory and receivables at the partnership level. The FTB then apportioned that income to California under California Code of Regulations, title 18, Section 17951-4(d), issuing notices that reduced appellant Burch's net operating loss carryover by $2,535,814 and assessed additional tax against the Cardens (slip op. at pp. 2–3).

Why Ordinary Income Recharacterization Is Not a Deemed Asset Sale

The OTA rejected the sourcing position advanced through FTB Legal Ruling 2022-02 (slip op. at pp. 11–13) and reversed FTB’s actions in full (page 14). Drawing heavily on the D.C. Circuit Court of Appeals decision in Rawat v. Commissioner (2024) 108 F.4th 891, the OTA explained that IRC Section 751(a) has an anti-abuse purpose: it prevents taxpayers from converting ordinary income into capital gain by selling a partnership interest. However, Section 751(a) only recharacterizes the income type; it does not alter the fact that the partner sold an intangible partnership interest rather than the underlying physical assets (slip op. at pp. 7–8).

The OTA rejected the FTB's attempt to use Subchapter K's aggregate partnership theory to create a deemed asset sale. Unlike statutory provisions such as IRC Section 338(a) or IRC Section 751(b)—which explicitly create deemed asset exchanges—IRC Section 751(a) contains no statutory language recasting a partnership-interest sale into a direct asset disposition by the operating partnership (slip op. at pp. 7, 11).

Statutory Limits on California's Sourcing Rules

California sources nonresident income from intangible personal property, including stock and partnership interests, based on the owner's state of domicile under R&TC Section 17952, unless the property acquires a California business situs (slip op. at p. 4). Regulation Section 17951-4(d) governs a nonresident's distributive share of business income from partnership operations, but it does not govern a partner's sale of the partnership interest itself.

The OTA pointed out that when the California Legislature intends to source partnership gains using underlying partnership activities, it passes explicit legislation—such as R&TC Section 17854 for guaranteed payments or R&TC Section 25120(d) for corporate nonbusiness income (slip op. at p. 12). For these 2012 and 2013 transactions, OTA found no authority supporting FTB’s proposed deemed-sale sourcing theory. That conclusion does not eliminate every other possible California sourcing theory. The panel also distinguished Appeal of Smith (2023-OTA-069P), where California-source income arose because gain was recognized directly by a unitary holding partnership, under a unitary holding-partnership theory that FTB did not advance here (slip op. at pp. 10–11).

Reviewing Nonresident California Tax Positions

Nonresident investors facing FTB audits or proposed assessments on partnership dispositions should carefully evaluate how their gains were categorized. Whether gain from an entity disposition is subject to California personal income tax depends on the specific ownership tier, whether the intangible asset acquired a local business situs, and whether the taxable years remain open under applicable statutes. If you need assistance reviewing an FTB Notice of Action, evaluating pass-through entity sourcing adjustments, or determining how recent OTA decisions affect your filing obligations, you can contact our Tax Legal Services team to review your matter.