On July 23, 2024, the U.S. Court of Appeals for the DC Circuit reversed the Tax Court's decision in Rawat v. Commissioner and held that when a partner sells an interest in a partnership with "hot assets" – unrealized receivables or inventory items – section 751(a) applies only to determine the character of the partner's gain or loss as capital or ordinary, and it does not apply an aggregate approach for any other purpose of the Internal Revenue Code. 

As discussed in our prior coverage, the taxpayer in Rawat was a nonresident alien partner in a U.S. partnership that manufactures and sells energy drinks. In 2008, the taxpayer sold her entire interest in the partnership for $438 million. Of that amount, a comparatively small sum ($6.5 million) was attributable to gain on the partnership's inventory. If section 751(a) applied an aggregate approach, part of the transaction would be deemed to be a sale of inventory directly by the nonresident alien taxpayer, which the parties agreed in this case (under 2008 law) would have been domestic source income, subject to U.S. federal income tax. Instead, the DC Circuit concluded that, for purposes of determining source, section 751(a) does not deem the selling partner to directly sell the inventory, and the entire sale of the partnership interest was sourced to the residence of the seller under the law at the time of the transaction – which, in this case, resulted in foreign source income not subject to U.S. federal income tax. 

In reaching this conclusion, the DC Circuit observed that the "operative language" in section 751(a) is "materially identical" to the Code's definition of "ordinary income" in section 64, and reasoned that Congress therefore intended section 751(a) to apply only for the limited purpose of determining whether gain attributable to "hot assets" resulted in ordinary income. Section 64 was added to Code in 1976, to "replace the cumbersome and lengthy terminology" for gain from the sale of property which is not a capital asset, and the newly defined term was then deployed to replace that "cumbersome" phrasing throughout the Code. The court's decision never addresses why, if Congress intended the scope of section 751(a) to be limited to determining whether an amount constituted ordinary income, Congress refrained from replacing the "operative language" in section 751(a) with the straightforward terminology established with the enactment of section 64. 

While the DC Circuit's decision may have implications on the interpretation of section 751(a) beyond the narrow sourcing issue in Rawat, the opinion is binding on the Tax Court only with respect to cases appealable to the DC Circuit. The court's opinion included only glancing mention of the "out-of-circuit decisions on which the Commissioner relie[d]." The Tax Court may continue to apply its analysis under section 751(a) in cases appealable to other circuit courts of appeal. 

For more information, please contact:

Jeffrey M. Tebbs, jtebbs@milchev.com, 202-626-1480

Samuel A. Lapin, slapin@milchev.com, 202-626-5807

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