Rawat v. Commissioner: Inventory Gain in a Pre-2017 Partnership-Interest Sale

The United States Court of Appeals for the District of Columbia Circuit held in Rawat v. Commissioner, No. 23-1142 (D.C. Cir. July 23, 2024), that Internal Revenue Code Section 751(a) recharacterizes a foreign partner's gain attributable to partnership inventory as ordinary income, but does not deem an actual sale of inventory to convert foreign-source personal property gain into taxable U.S.-source income under pre-2017 tax law. Chief Judge Srinivasan, writing for a unanimous panel that included Circuit Judges Millett and Walker, reversed the United States Tax Court and established that Section 751(a) functions as a characterization provision rather than an independent asset-sourcing mechanism.

Facts Chronology and Procedural Posture

The legal dispute arose from investments made in the early 2000s by Indu Rawat, a nonresident alien. Rawat acquired a 29.2% equity interest in Innovation Ventures, LLC, a Michigan limited liability company treated as a partnership for U.S. federal tax purposes. Innovation Ventures owned Living Essentials, LLC, the operating entity responsible for manufacturing and distributing the popular energy drink 5-Hour Energy.

In 2008, Innovation Ventures bought back Rawat's entire 29.2% partnership stake in exchange for a promissory note valued at approximately $438 million. At the time of the redemption sale, Innovation Ventures held physical product inventory valued at $6.4 million, which was subsequently sold for a commercial profit of $22.4 million. Because Rawat held a 29.2% partnership interest at the time of disposition, $6.5 million of the $438 million total realization was legally attributable to inventory appreciation under partnership tax principles.

Rawat recognized $6.5 million of ordinary income for the 2008 tax year but maintained that the gain was non-U.S. source income exempt from U.S. taxation. The Commissioner of Internal Revenue audited the return, asserted that the $6.5 million inventory gain constituted taxable U.S.-source income, and issued a notice of deficiency for approximately $2.3 million in federal tax, plus statutory interest and penalties. Rawat paid the full assessed deficiency and filed a refund petition in the United States Tax Court, contending that the gain was foreign-source income derived from the sale of personal property by a nonresident alien.

The Commissioner conceded that if Rawat had not sold inventory, the partnership-interest sale income would be treated as nontaxable foreign-source income. The Tax Court ruled in favor of the Commissioner, holding that Section 751(a) required the transaction to be treated as if Rawat had directly sold her proportionate share of the underlying inventory itself, thereby triggering U.S. inventory sourcing rules. Rawat appealed the Tax Court's decision to the D.C. Circuit.

Rawat, slip op. at 4–6.

Precise Questions Presented

The D.C. Circuit addressed a specific statutory question under pre-2017 federal tax law:

• Whether IRC Section 751(a)—which provides that gain from the sale of a partnership interest attributable to inventory items shall be considered as an amount realized from the sale or exchange of property other than a capital asset—merely dictates that the gain is taxed as ordinary income, or whether it also deems an actual sale of underlying inventory, thereby subjecting the gain to federal inventory sourcing rules under IRC Sections 861(a)(6), 862(a)(6), and 865(b).

Rawat, slip op. at 5–7.

Step-by-Step Argument and Statutory Reasoning

The D.C. Circuit reviewed the Tax Court's legal interpretations de novo and reversed its judgment through a step-by-step statutory analysis of the Internal Revenue Code:

1. Interplay Between Section 741 and Section 751(a)

The court began by examining the general framework governing partnership interest transfers. Under IRC Section 741, gain or loss realized on the sale of a partnership interest is treated as gain or loss from the sale of a capital asset, "except as otherwise provided in section 751." Section 751(a) creates a specific exception for unrealized receivables and inventory items, directing that amounts realized attributable to such items "shall be considered as an amount realized from the sale or exchange of property other than a capital asset."

Rawat, slip op. at 2–3, 7–10.

2. Textual Harmonization with Section 64

Chief Judge Srinivasan emphasized that the key statutory clause in Section 751(a)—"considered as an amount realized from the sale or exchange of property other than a capital asset"—mirrors the core operative text of IRC Section 64, which defines "ordinary income" as "any gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b)." Reading Section 751(a) alongside Section 64 leads to the statutory conclusion that Section 751(a) means "shall be considered as ordinary income." The court noted that statutory definitions are virtually conclusive, and Congress routinely substituted "ordinary income" for functionally identical phrasing throughout the Internal Revenue Code.

Rawat, slip op. at 7–10.

3. Comparison with Section 751(b)(1)

To evaluate whether Congress intended to create a "deemed sale" of underlying assets in Section 751(a), the court compared Section 751(a) directly with its adjacent companion provision, Section 751(b)(1). In Section 751(b)(1), Congress explicitly mandated that certain partnership distributions involving unrealized receivables or inventory "shall . . . be considered as a sale or exchange of such property between the distributee and the partnership." Applying the established canon of statutory construction that the exclusion of specific language in one statutory section while including it in an adjacent, simultaneously enacted provision reflects deliberate legislative intent, the court held that Congress knew how to create a deemed asset sale when it wished to do so, but deliberately chose not to include deemed-sale language in Section 751(a).

Rawat, slip op. at 11–12.

4. Legislative History and Prophylactic Purpose

The court reviewed the legislative history of the Internal Revenue Code of 1954, noting that Congress enacted Section 751(a) as a prophylactic measure to prevent partners from abusing the entity theory of partnerships to convert ordinary income into lower-taxed capital gains. Committee reports from the House Ways and Means Committee and Senate Finance Committee confirmed that Congress intended Section 751(a) to mandate ordinary-income treatment for inventory gains, not to construct a fictional sale of inventory for all tax purposes, including international sourcing rules.

Rawat, slip op. at 12–13.

5. Regulatory Interpretation and Judicial Precedents

The Commissioner pointed to Treasury Regulations Section 1.751-1(a)(2), which utilizes a hypothetical sale calculation to determine the amount of ordinary income recognized under Section 751(a). The court explained that utilizing a hypothetical sale as a mathematical formula to isolate ordinary income does not mean the statute deems an actual sale of inventory for sourcing rules. The court declined to rely on out-of-circuit decisions cited by the IRS (such as Mingo v. Commissioner, 773 F.3d 629 (5th Cir. 2014); United States v. Woolsey, 326 F.2d 287 (5th Cir. 1963); and Quick's Trust v. Commissioner, 444 F.2d 90 (8th Cir. 1971)), finding that those decisions did not directly address the interpretive question before the court and spoke to it, at most, only indirectly.

Rawat, slip op. at 13–15.

Panel Composition and Unanimity

The decision of the court was unanimous. Chief Judge Srinivasan authored the opinion for the court, joined in full by Circuit Judge Millett and Circuit Judge Walker. No concurring or dissenting opinions were filed.

Exact Disposition

The Court of Appeals reversed the judgment of the United States Tax Court, holding that Rawat's $6.5 million inventory gain was foreign-source income on which she owed no U.S. federal income tax.

Rawat, slip op. at 15.

Character and source answer different questions

The ordinary-income conclusion under §751 was agreed, not a victory for capital-gain treatment. The disagreement concerned whether that characterization also transformed the underlying transaction into an inventory sale for international sourcing. The court’s answer preserved the distinction between computing the inventory-related component and identifying the property actually sold. Rawat, slip op. at 5–10, 13–15.

The Commissioner’s concession mattered: Once the court rejected a deemed inventory sale under §751(a), the parties’ agreed alternative resolved the source result. The opinion did not evaluate every possible source exception for every foreign seller. Counsel applying an older transaction rule still must examine the actual facts and the other applicable provisions.

Practical Significance, Limits, and Current Law

The ruling in Rawat v. Commissioner provides an authoritative interpretation of pre-2017 tax law, clarifying the precise statutory boundaries of Section 751(a). However, taxpayers and practitioners must recognize the strict historical limits of the decision when analyzing modern transactions:

• Historical Scope (Pre-2017 Sales): The result in Rawat concerned a 2008 transaction, the meaning of §751(a), and the Commissioner’s concession about the alternative source treatment. Under former law, personal property sourcing rules under IRC Section 865(a)(2) treated gains realized by nonresidents as foreign-source income.
• Enactment of IRC Section 864(c)(8): Congress addressed this statutory gap in the Tax Cuts and Jobs Act of 2017. For sales, exchanges, or dispositions occurring on or after November 27, 2017, IRC Section 864(c)(8) explicitly provides that gain realized by a foreign partner on the sale of a partnership interest is treated as effectively connected income (ECI) to the extent of the partner's share of gain from a hypothetical fair-market-value sale of partnership assets.
• Enactment of IRC Section 1446(f): To ensure collection of tax under Section 864(c)(8), Congress enacted Section 1446(f), requiring transferees to withhold 10% of the gross amount realized on partnership interest sales occurring on or after January 1, 2018 (with Treasury issuing final regulations effective January 29, 2021, and PTP rules taking effect January 1, 2023).
• Application Guardrails: The refund conclusion in Rawat cannot be applied to sales governed by current Section 864(c)(8) or Section 1446(f), nor does it govern state income or withholding obligations. This federal partnership-interest question is also distinct from a corporate stock sale, an earnout, or California service-payment withholding.

For additional analysis on organizing partnership transaction records and managing current federal withholding obligations, read our practical companion guide: Selling a U.S. Partnership Interest as a Nonresident: Separate the Sale Date and Asset Records. To discuss a pending disposition, contact our Tax Legal Services team.

Current law: 26 U.S.C. §864(c)(8) and §1446(f). The IRS partnership withholding guide explains the separate withholding regimes.