California Office of Tax Appeals: Hot Asset Sale Is Treated as Sale of Intangible Property

The California Office of Tax Appeals (OTA) concluded that the gain on the sale of a partnership interest was not a California source merely because the gain was characterized as ordinary income.¹ The pending precedential decision, largely relying on federal case law, should prompt corporate partners to consider how they treated similar transactions for California apportionment purposes. The taxpayers in the OTA appeal were California nonresidents who held direct interests in an investment partnership. The investment partnership sold portions of its interest in another partnership (Tory Burch, a luxury brand) with which it was unitary. Federally, the investment partnership treated a portion of the gain as capital gain under IRC § 741 and a portion of the gain as ordinary income under IRC § 751(a). This latter portion was attributable to Burch’s unrealized receivables and inventory, commonly referred to as hot assets. California conforms to the federal rules, and the investment partnership reported the gain as nonbusiness income allocable outside of California sources; therefore, the nonresident individual partners were not subject to California tax.  

The OTA was tasked with determining how to source the nonresidents’ gains from the sale. The FTB argued that 18 CCR § 17951-4(d) requires a partnership that is a unitary business to apportion its business income at the partnership level. 18 CCR § 17952 specifies when California may tax nonresident income from intangible personal property and provides an alternative sourcing rule to 18 CCR § 17951-4(d) under which the income is not from sources within California unless the property has acquired a business situs in this state. 

The FTB cited its Legal Ruling 2022-02 and tried to use a bifurcated approach under which the portion of the gain attributable to hot assets could not be sourced under § 17952 and should be treated as if the nonresidents sold the assets. This would have generated partnership-level gains that would eventually flow through to the taxpayers as a distributive share of apportionable business income sourced to California using the nonresidents’ apportionment percentages.  

In reaching a conclusion, the OTA was guided by the U.S. Court of Appeals’ 2024 decision in Rawat v. Commissioner,² which found that a foreign individual’s gain from the sale of a partnership interest attributable to hot assets was not U.S.-source income. The OTA agreed with the federal court that IRC § 751(a) “simply converts capital gain into ordinary income and does not treat the partnership-interest sale as a sale of inventory items or unrealized receivables.” While acknowledging that the federal decision is not binding in California, the OTA found the issues on point and the decision persuasive.  

The OTA observed that the law makes no mention of the FTB’s bifurcated approach. Moreover, 18 CCR § 17951-4(d), by its own terms, only applies to the distributive share of partnership income and not the sale of a partnership interest. Thus, a nonresident’s gain from the sale of a partnership interest is not sourced to California unless the interest acquires a California business situs. 

Ryan’s Take and Action Steps 

Although this case involved individual taxpayer-partners, this decision makes clear that a hot asset sale (unrealized receivables and inventory) is the sale of a partnership interest and not the underlying sale of the assets. Corporate partners with similar transactions need to undertake a business and nonbusiness income analysis as a first step in determining the proper sourcing. Although the sourcing rules for the corporate income/franchise tax are not identical to those at issue in this decision, the threshold issue that a hot asset sale is not to be treated as a sale of underlying inventory or unrealized receivables by the partnership is crucial in determining how corporate partners should apportion such gains. For questions regarding California sourcing rules, please reach out to a Ryan specialist. 

¹ In the Matter of the Consolidated Appeals of Burch, Carden and Carden, OTA Nos. 230112266 and 230112267 (July 24, 2026). 

² Rawat v. Commissioner, No. 23-1142 (D.C. Cir. July 23, 2024). 

Author

Josh Booth  
Principal

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