I am skimming a decision from the Appeals Court for the
District of Columbia. I am surprised that it is only 15 pages long, as it
involves a gnarly intersection of partnership tax and the taxation of nonresident
aliens.
Let’s talk about it.
In general, partnerships are not treated as a taxable
entity. A partnership is a reporting entity; it reports income and expenses and
then allocates the same to its partners for reporting on their tax returns.
Mind you, this can get mind-numbing, as a partner in a partnership can itself
be another partnership. Keep this going a few iterations and being a tax
professional begins to lose its charm.
A partner will - again, in general - report the income
as if the partner received the income directly rather than through the partnership.
If it was ordinary income or capital gain to the partnership, it will likewise
be ordinary income or capital gain to the partner.
Let’s introduce a nonresident alien partner.
We have another tranche of tax law to wade through.
A nonresident alien is fancy talk for someone who does
not live in the United States. That person could still have U.S. income and
U.S. tax, though.
How?
Well, through a partnership, for example.
Say the partnership operates exclusively in the United
States. A nonresident alien generally pays tax on income received from sources
within the United States. Let’s look at one type of income: business income. We
will get to nonbusiness income in a moment.
The tax Code wants to know if that business income is “effectively
connected” with a U.S. trade or business.
The business income in our example is effectively
connected, as the partnership operates exclusively in the United States. One
cannot be any more connected than that.
The partnership will issue Schedules K-1 to its
partners, including its nonresident alien partner who will file a U.S. nonresident
tax return (Form 1040-NR).
Question: Will any nonbusiness income on the K-1 be reportable on the nonresident?
The tax Code separates business and nonbusiness income
because they might be taxed differently for nonresidents. Nonbusiness income
can go from having 30% withholding at the source (think dividends) to not being
taxed at all (think most types of interest income).
What if the Schedule K-1 reports capital gains?
I normally think of capital gains as nonbusiness
income.
But they do not have to be.
There is a test:
If the income is derived
from assets used or held for use in the conduct of an effectively connected
business – and business activities were a material factor in generating the income
– then the income will taxable to a
nonresident alien.
Think capital gain from the sale of farm assets. Held
for use in farming? Check. Material factor in generating farm income? Check. This
capital gain will be taxable to a nonresident.
Forget the K-1. Say that the nonresident alien sold
his/her partnership interest altogether.
On first impression, I am not seeing capital gain from
the sale of the partnership interest (rather than assets inside the
partnership) as meeting the “held for use/material factor” test.
Problem: partnership taxation has something called the “hot asset” rule. The purpose is to disallow capital gains treatment to the extent any gain is attributable to certain no-no assets – that is, the “hot assets.”
An example of a hot asset is inventory.
The Code does not want the partnership to load up on
inventory with substantial markup and then have a partner sell his/her partnership
interest rather than wait for the partnership to sell the inventory. This would
be a flip between ordinary and capital gain income, and the IRS is having none
of it.
Question: have you ever had a 5-hour Energy drink?
That is the company we are talking about today.
Indu Rawat was a 29.2% partner in a Michigan partnership which sells 5-hour Energy. She sold her stake in 2008 for $438 million.
I can only wish.
At the time of sale, the company had inventory with a cost
of $6.4 million and a sales price of $22.4 million. Her slice of the profit pending
in that inventory was $6.5 million.
A hot asset.
The IRS wanted tax on the $6.5 million.
Mind you, Indu Rawat did not sell inventory. She sold
a partnership interest in a business that owned inventory. That would be enough
to catch you or me, but could the hot asset rule catch a nonresident alien?
The Tax Court agreed with the IRS that the hot asset gain
was taxable to her.
That decision was appealed.
The Appeals Court reversed the Tax Court.
The Appeals Court noted that there had to be a taxable
gain before the hot asset rule could kick in. The rule recharacterizes – but does
not create – capital gain.
This capital gain does not appear to meet the “held
for use/material factor test” we talked about above. You can recharacterize all
you want, but when you start at zero, the amount recharacterized cannot be more
than zero.
Indu Rawat won on Appeal.
By the way, tax law in this area has changed since Rawat’s
sale. New law would tax Rawat on her share of effectively connected gain as if the partnership had sold all its assets at fair market value. Congress made a statement,
and that statement was “no more.”
Our case this time was Indu Rawat v Commissioner, No 23-1142
(D.C. Cir. July 23, 2024).
