Last updated: October 9, 2026 · By the Flex Tax and Consulting Group team
California’s Office of Tax Appeals (OTA) has rejected the Franchise Tax Board’s (FTB) method for taxing nonresidents who sell a partnership interest. The FTB had argued that the “hot asset” part of the gain under Internal Revenue Code section 751(a) should be sourced to California using the partnership’s California business activity. The OTA disagreed: in the case it decided, the entire gain on the sale of the partnership interest was sourced to the sellers’ states of residence. The opinion, in the consolidated appeals of J. Burch, J. Carden and K. Carden, was decided July 24, 2026 and published this month as “pending precedential.” It matters most to partners, fund investors and business owners who live outside California, or who have moved away, and sell an interest in a partnership or LLC that does business here.
Key takeaways
- The OTA held that section 751(a) changes only the character of gain (ordinary vs. capital), not the nature of the transaction. A sale of a partnership interest is still a sale of an intangible.
- For a nonresident, gain on an intangible is generally sourced to the seller’s state of residence under California Revenue and Taxation Code section 17952, unless the interest has a business situs in California.
- The decision rejects the approach in FTB Legal Ruling 2022-02, which treated hot-asset gain as California business income apportioned with the partnership’s factors.
- The OTA distinguished a holding entity that is unitary with the operating partnership it sells. That gain can still be apportioned as business income.
- The opinion is “pending precedential,” so its final status is not settled yet. It does not change how California taxes residents, who are taxed on all their income.
- Nonresidents who previously reported section 751 gain as California-source income may want to have those returns reviewed while the refund window is open.
What the FTB argued: the “hot asset” theory
When a partner sells a partnership interest, federal law generally treats the gain as capital gain (section 741). Section 751(a) carves out the part of the price tied to the partnership’s “hot assets,” mainly unrealized receivables and inventory, and treats that part as ordinary income.
In Legal Ruling 2022-02, issued in July 2022, the FTB took the position that a nonresident selling a partnership interest should be treated as if the partnership itself had sold its hot assets. Under that view, the hot-asset portion became business income. For a partnership operating only in California, all of it was California-source. For a multistate partnership, it was apportioned to California using the partnership’s apportionment factors. Before that ruling, many advisors treated an individual’s sale of a partnership interest as a sale of intangible property sourced to where the seller lives.
What the OTA decided
The appeals involved nonresident individuals who held an upper-tier investment partnership. That partnership owned a minority interest in a lower-tier operating partnership that did business in California and other states, and it sold part of that interest. The FTB sourced the section 751(a) ordinary income to California using the lower-tier partnership’s apportionment percentage, relying on Legal Ruling 2022-02.
A unanimous OTA panel rejected that approach. In summary, the panel reasoned that:
- Section 751(a) is a character rule, not a sourcing rule. It turns part of the gain into ordinary income, but the taxpayer still sold a partnership interest, not the partnership’s underlying assets.
- California’s intangible-property rule applies. Because the interest was not unitary with its owner, the gain was income from a non-unitary intangible. Under section 17952 and the long-standing rule that intangibles follow the owner’s domicile, it was sourced to the owners’ states of residence.
- Federal case law points the same way. The OTA relied in part on Rawat v. Commissioner (D.C. Cir. 2024), which read section 751(a) the same way in a federal case involving a foreign partner. (Congress has since added a separate federal rule for foreign partners, section 864(c)(8), so Rawat does not control current federal treatment of foreign partners.)
| Question | FTB Legal Ruling 2022-02 | OTA decision (2026) |
|---|---|---|
| What is the section 751(a) portion? | Treated as if the partnership sold its hot assets | Still part of a sale of a partnership interest; only the character changes |
| How is it sourced for a nonresident? | As business income, using the partnership’s California factors | As gain on a non-unitary intangible, to the seller’s state of residence |
| Capital gain portion (section 741) | State of residence, unless business situs in California | Same |
| Seller that is unitary with the operating partnership | Apportioned as business income | Apportioned as business income (distinguished, not changed) |
Who this affects
- Former Californians who moved to another state and later sell an interest in a California partnership or multi-member LLC.
- Out-of-state investors in funds, holding partnerships or operating partnerships with California activity, including private equity and real estate structures.
- Founders and service-business owners organized as partnerships or LLCs (for example, professional firms with large receivables) whose owners live outside California.
- Buyers and their advisors who model state tax and nonresident withholding in partnership deals.
What did not change
- California residents are still taxed on all their income, wherever it comes from.
- Federal tax is unchanged. Section 751(a) gain is still ordinary income on your federal return.
- Business situs still matters. If a partnership interest has acquired a business situs in California, gain on it can be California-source.
- Unitary structures are different. A holding company that is unitary with the business it sells may still apportion the gain to California.
- Your share of partnership income while you own the interest is still sourced under the normal business-income rules.
- Residency itself is a separate question. If the FTB considers you a California resident at the time of sale, this decision does not help. See our guide on moving out of California for how residency and sourcing work for equity compensation.
Why it isn’t final yet
OTA opinions are not court decisions. A party generally has 30 days to petition for rehearing, and an opinion is then designated precedential or nonprecedential under OTA rules. This one is currently listed as “pending precedential.” As of this writing, we have not seen the FTB withdraw Legal Ruling 2022-02, so expect the FTB’s position in audits to remain an open issue until the status is settled or the FTB issues new guidance.
What to review now
- Look back at past California nonresident returns (Form 540NR) that reported section 751 gain from a partnership interest sale as California-source income.
- Check the refund deadline. According to the FTB, a claim for refund is generally due by the later of 4 years from the original return due date (or the filing date, if filed within an extension) or 1 year from the date of overpayment.
- Gather the deal documents: the partnership’s section 751 statement, the K-1 for the year of sale, the purchase agreement and your residency records for that year.
- For a pending sale, have the state sourcing, residency date and entity structure reviewed before closing rather than after.
Whether a refund claim or a particular reporting position makes sense depends on your facts, so it’s a conversation for a consultation rather than a blog post. If you’re also weighing a stock sale this year, see QSBS: How to Sell C Corporation Shares Partly or Fully Tax-Free and our 2026 Year-End Tax Planning Checklist.
FAQ
Does California tax a nonresident on the sale of a partnership interest?
Generally, gain on the sale of a partnership interest is gain on an intangible, which California sources to the seller’s state of residence. The main exceptions are an interest with a business situs in California and a seller that is unitary with the partnership. The 2026 OTA decision applies this rule to the section 751(a) hot-asset portion too.
What are “hot assets” in a partnership?
Under section 751, hot assets are mainly unrealized receivables and inventory. When you sell a partnership interest, the part of your gain tied to them is taxed as ordinary income instead of capital gain.
Is FTB Legal Ruling 2022-02 still in effect?
As of October 9, 2026, we have not seen the FTB withdraw it. The OTA rejected its approach in this case, and the opinion is pending precedential status.
Can I get a refund if I already paid California tax on section 751 gain as a nonresident?
Possibly, if the refund statute is still open and your facts fit the decision. The general FTB deadline is the later of 4 years from the original due date or 1 year from payment. Have a tax professional review your return before filing a claim.
Does this apply if I was a California resident when I sold?
No. California residents are taxed on all their income. The decision is about how nonresidents source this type of gain.
Related reading
- California Equity-Based Compensation Guidelines: Moving from CA to Other States
- QSBS: How to Sell C Corporation Shares Partly or Fully Tax-Free
- 2026 Year-End Tax Planning Checklist for High Earners, Business Owners & Investors
Sources
Last reviewed October 9, 2026.
- FTB: Legal Ruling 2022-02 (sourcing of IRC section 751 gain)
- FTB Tax News Flash: Legal ruling on sourcing of gain from sale of IRC section 751 assets
- Office of Tax Appeals: Burch and Carden hearing transcript (Case Nos. 230112266, 230112267)
- FTB: Claim for refund (deadlines)
- KPMG TaxNewsFlash: California OTA decision on IRC section 751(a) gain (Oct. 2026)
Sold, or selling, a partnership interest after leaving California?
This article provides general information only and is not tax or legal advice. Tax outcomes depend on individual facts and circumstances. Contact us about your specific situation.