In the Matter of the Consolidated Appeals of J. Burch, J. Carden, and K. Carden, OTA Case Nos. 230112266 & 230112267, 2026-OTA-28622 (Cal. Off. Tax App. July 24, 2026)

In a landmark decision for pass-through entity taxation and state income tax sourcing, the California Office of Tax Appeals (OTA) issued a consolidated opinion in the Appeals of J. Burch, J. Carden, and K. Carden (OTA Case Nos. 230112266 & 230112267, July 24, 2026). The OTA explicitly rejected the Franchise Tax Board’s (FTB) long-standing audit position—and its controversial FTB Legal Ruling 2022-02—which attempted to bifurcate the sale of a partnership interest by a nonresident into a deemed sale of underlying “hot assets” (unrealized receivables and inventory items under Internal Revenue Code (IRC) Section 751(a)) and a remaining sale of an intangible partnership interest under IRC Section 741.

Writing for a unanimous panel, Administrative Law Judge Kenneth Gast held that IRC Section 751(a) functions strictly as an anti-abuse characterization provision converting capital gain to ordinary income, rather than a sourcing provision that recasts a sale of an intangible partnership interest into an operational sale of underlying business assets. Aligning state tax jurisprudence with the U.S. Court of Appeals for the District of Columbia Circuit’s ruling in Rawat v. Commissioner, 108 F.4th 891 (D.C. Cir. 2024), the OTA held that California nonresident sourcing must follow California Revenue and Taxation Code (R&TC) Section 17952. Consequently, gains realized by nonresidents from the disposition of partnership interests are sourced to their state of domicile under the common law doctrine of mobilia sequuntur personam, unless the partnership interest itself acquired a business situs in California.

For tax practitioners representing nonresidents, partners in multi-tier structures, and private equity investors with California partnership holdings, this ruling provides crucial clarity and substantial precedent to challenge FTB audit assessments based on Legal Ruling 2022-02.

Factual Background and Partnership Structure

The taxpayers in this consolidated appeal, J. Burch, J. Carden, and K. Carden (collectively, “Appellants”), were nonresidents of California for individual personal income tax purposes during all tax years at issue (2012 and 2013). Appellants held direct membership interests in JCB Investments, LLC (“JCB”), an investment company classified as a partnership for both federal and California income tax reporting purposes.

JCB, in turn, held diverse investments, including a direct membership interest of approximately 28 percent in Tory Burch LLC (“Tory Burch”). Tory Burch was a prominent fashion brand operating retail outlets and e-commerce platforms nationwide. For federal and state tax purposes, Tory Burch was classified as a partnership and operated a unitary trade or business within and without California.

During tax years 2012 and 2013, JCB executed sales of portions of its partnership interests in Tory Burch. These dispositions generated significant net gains that were bifurcated for tax characterization purposes into:

Capital gain governed by IRC Section 741; and
Ordinary income under IRC Section 751(a) attributable to Tory Burch’s unrealized receivables and inventory items (commonly referenced as “hot assets” or “IRC 751(a) property”).

On its 2012 and 2013 California partnership tax returns (Form 565), JCB reported the net gains from these interest sales as nonbusiness income that was not derived from California sources. As direct partners in JCB, Appellants indirectly realized their proportionate shares of these gains. On their California Nonresident or Part-Year Resident Income Tax Returns (Form 540NR), Appellants reported their distributive shares of the gains as nontaxable, non-California source income pursuant to R&TC Section 17952.

Following an audit of Appellants’ tax returns, the FTB asserted that the dispositions must be treated for sourcing purposes as two separate and distinct transactions:

The IRC Section 751(a) Deemed Asset Sale: The FTB recharacterized the gain attributable to IRC Section 751(a) property as Appellants’ distributive share of Tory Burch’s apportionable business income, arising from Tory Burch’s “deemed sale” of its inventory and unrealized receivables immediately prior to the partnership interest sale. The FTB then apportioned this income to California under California Code of Regulations, title 18 (Regulation) Section 17951-4(d) using Tory Burch’s entity-level California apportionment factors (13.5581 percent for 2012 and 16.0753 percent for 2013).
The IRC Section 741 Intangible Sale: The FTB treated the remaining gain as a sale of an intangible asset (the partnership interest itself) governed by R&TC Section 17952, which was non-California source income because Appellants were nonresidents and the partnership interests had not acquired a business situs in California.

Based on this bifurcation model, the FTB issued a Notice of Proposed Assessment (NPA) and subsequent Notice of Action (NOA) for tax year 2012 to Appellants J. Carden and K. Carden proposing $1,507 in additional tax plus interest. For Appellant J. Burch, the FTB issued an NPA for 2012 and a Notice of Proposed Adjusted Carryover Amount for 2013, proposing to reduce his 2013 net operating loss (NOL) by $2,535,814 (comprising $206,532 directly for 2013 and $2,329,282 carried back from 2013 to offset proposed 2012 taxable income). Appellants filed timely appeals with the OTA, which consolidated the matters for hearing and decision.

Taxpayers’ Position and Request for Relief

Appellants requested full reversal of the FTB’s proposed deficiency assessment and NOL carryover adjustments. Appellants asserted that under California law, none of the gain recognized from the sale of JCB’s partnership interest in Tory Burch was subject to California personal income tax.

In support of their position, Appellants argued that:

Under R&TC Section 17952, Regulation Section 17952, and longstanding Board of Equalization (BOE) precedent (Appeals of Ames, et al., 87-SBE-042), a partnership interest is intangible personal property. Income or gain realized from its sale by a nonresident nondomiciliary cannot be taxed by California unless the partnership interest itself has acquired a business situs within the state.
IRC Section 751(a) is purely a characterization mechanism under federal tax law. Its statutory mandate that gain attributable to hot assets “shall be considered as an amount realized from the sale or exchange of property other than a capital asset” alters only the character of the income (ordinary vs. capital) to prevent tax avoidance at federal ordinary rates. It does not recharacterize the underlying transaction from a sale of a partnership interest into a sale of assets, nor does it create a deemed distribution of operational income from the partnership for state sourcing purposes.

Judicial Analysis of the Governing Statutory Framework

The OTA began its legal analysis by establishing the statutory standards governing California personal income taxation of nonresidents.

Burden of Proof and Nonresident Taxing Jurisdiction

Under California law, the FTB’s proposed tax assessment is presumed correct, and the taxpayer carries the burden of proving it incorrect by a preponderance of the evidence (Appeal of Smith, 2023-OTA-069P; Regulation Section 30219(b)). Taxpayers also bear the burden of establishing the existence and amount of an NOL (Appeal of Sadatnejad and Marconet, 2024-OTA-625P).

Pursuant to R&TC Sections 17041(a), (b), (i)(1)(B), and 17951(a), California taxes residents on all income regardless of source, but taxes nonresidents only on income derived from California sources. Where a nonresident derives income from sources both within and outside California, R&TC Section 17954 delegates authority to the FTB to prescribe allocation and apportionment rules.

Under this statutory grant, two distinct regulatory regimes exist for nonresidents:

Business Income Sourcing (Regulation Section 17951-4(d)): Governs a nonresident partner’s distributive share of business income from a partnership conducting a unitary trade or business within and without California. Such income is apportioned at the partnership level under the Uniform Division of Income for Tax Purposes Act (UDITPA; R&TC Section 25120 et seq.).
Intangible Income Sourcing (R&TC Section 17952 and Regulation Section 17952): Codifies the common law rule of mobilia sequuntur personam (“movables follow the person”). Under R&TC Section 17952, income derived from stocks, bonds, notes, or other intangible personal property by a nonresident is non-California source income unless the intangible property has acquired a business situs in California.

California Conformity to Federal Subchapter K

California conforms to federal partnership tax provisions under Subchapter K of the IRC (IRC Sections 701–761) pursuant to R&TC Sections 17851 and 17024.5(a)(1)(O). Under R&TC Section 17024.5(d), federal Treasury Regulations apply for state tax purposes to the extent they do not conflict with California statutes or FTB regulations. Furthermore, where state tax statutes are substantially identical to federal analogs, federal judicial interpretations are highly persuasive (Appeal of Akhtar, 2021-OTA-118P).

Under general partnership tax principles, IRC Section 741 adopts the “entity theory,” treating the sale of a partnership interest as the sale of a single capital asset. IRC Section 751(a) creates an exception, specifying that amounts realized attributable to unrealized receivables or inventory items “shall be considered as an amount realized from the sale or exchange of property other than a capital asset.”

Persuasiveness of Rawat v. Commissioner

The central legal question before the OTA was whether IRC Section 751(a) forces a statutory bifurcation of a partnership interest sale into a deemed asset sale by the partnership followed by a distribution of operational business income.

The OTA noted that the exact argument advanced by the FTB had been advanced by the Internal Revenue Service and explicitly rejected by the U.S. Court of Appeals for the District of Columbia Circuit in Rawat v. Commissioner, 108 F.4th 891 (D.C. Cir. 2024), reversing T.C. Memo. 2023-14. In Rawat, the D.C. Circuit held that a foreign nonresident individual’s gain on the sale of a partnership interest attributable to inventory was not U.S.-source income because IRC Section 751(a) modifies income character, not statutory sourcing rules.

Analyzing the “pivotal clause” of IRC Section 751(a)—“shall be considered as an amount realized from the sale or exchange of property other than a capital asset”—the D.C. Circuit concluded that in light of IRC Section 64's definition of ordinary income, the clause simply means “shall be considered as ordinary income” (Rawat, 108 F.4th at 895). The OTA emphasized key highlights of the D.C. Circuit’s textual and structural analysis:

Interlocking Characterization: IRC Section 751(a) functions solely to recharacterize capital gain into ordinary income to prevent tax avoidance; it does not contrive a separate, fictional transaction.
Structural Contrast with IRC Section 751(b): Unlike IRC Section 751(a), IRC Section 751(b) explicitly provides that certain non-pro-rata distributions shall be treated “as a sale or exchange of such property between the distributee and the partnership.” The absence of such “treated as a sale or exchange” language in Section 751(a) demonstrates Congressional intent not to deem an actual sale of underlying assets.
Hypothetical Computational Rules: Treasury Regulation Section 1.751-1(a)(2) sets forth a hypothetical asset sale calculation solely to quantify the amount of ordinary income generated by the transfer, but does not recharacterize the nature of the transaction itself.

Quoting Rawat, the OTA highlighted the fundamental principle:

“The short of it is that [IRC section] 751(a) does not of its own force render [IRC 751(a) property] taxable because it does not change the fact that [the taxpayer] sold a partnership interest, not [IRC 751(a) property].” (Rawat, 108 F.4th at 899)

The OTA concluded that while Rawat is not binding precedent on California state courts or administrative tribunals, its statutory construction and reasoning are “highly persuasive.”

Application of the Law to the Facts and Rejection of FTB Legal Ruling 2022-02

Applying these statutory principles to Appellants’ appeals, the OTA evaluated and systematically rejected the FTB’s arguments and its administrative guidance set forth in FTB Legal Ruling 2022-02.

Rejection of Deemed Asset Sale Theory and Entity-vs.-Aggregate Arguments

The FTB argued that Subchapter K incorporates the “aggregate theory” of partnership taxation for hot assets, treating the partner as selling an undivided interest in underlying partnership property. The OTA rejected this argument, observing that Rawat performed a rigorous statutory construction analysis that foreclosed the FTB’s position.

The OTA explained that IRC Section 751(a) does not convert a disposition of a partnership interest into a sale of assets by the partnership:

“Rawat plainly concluded that IRC section 751(a) does not change the fact that a partnership interest is sold—not inventory... This necessarily means that when a partnership interest is sold, a partner does not have income from partnership operations and, accordingly, there is neither an actual or deemed sale of IRC 751(a) property at the partner-level nor a distributive share of such gain at the partnership-level that passes through to its partners.”

Distinguishing FTB’s Cited Precedents

The FTB placed heavy reliance on three prior decisions: Appeal of Bense (79-SBE-055), Appeal of Smith (2023-OTA-069P), and The 2009 Metropoulos Family Trust v. Franchise Tax Board (2022) 79 Cal.App.5th 245. The OTA distinguished each case:

Appeal of Bense: In Bense, the BOE observed that a partnership interest sale “should have been fragmented and treated as two sales.” However, the OTA clarified that Bense discussed fragmentation solely in the context of ordinary income recharacterization under anti-abuse principles. Bense did not deem the partnership to have sold assets, nor did it involve nonresident sourcing, as the taxpayers in Bense were California residents taxed on worldwide income.
Appeal of Smith and Metropoulos: In Smith and Metropoulos, gain was generated at a holding-entity partnership level from the sale of an interest in an operating partnership, which constituted apportionable business income at the holding-entity level under Regulation Section 17951-4(d). Here, in contrast:

“in contrast to both Smith and Metropoulos, FTB does not argue JCB and Tory Burch are unitary or the partnership-interest sales constitute apportionable business income at JCB’s level that is reported to appellants as distributive shares of income.”

Furthermore, the OTA noted that Smith explicitly declined in footnote 14 to rule on the FTB’s alternative Section 751(a) deemed sale theory under Legal Ruling 2022-02.

Absence of California Statutory Authority for “Investee Apportionment”

The OTA emphasized that state tax sourcing depends strictly on state statutory enactments. The OTA contrasted IRC Section 751(a) with IRC Section 338(h)(10) elections (where IRC Section 338(a)(1) explicitly provides that the target corporation “shall be treated as having sold all of its assets,” as analyzed in Appeals of Amarr Company, 2022-OTA-041P). IRC Section 751(a) contains no such statutory deeming language.

The OTA observed that when the California Legislature intends to source partnership-related income to California based on entity-level factors, it enacts specific statutory mechanisms:

R&TC Section 17854 and Regulation Section 17951-4(d)(3) explicitly source nonresident guaranteed payments in the same manner as a distributive share;
R&TC Section 25125 and Regulation Section 25136-2(d)(1)(A)1. provide specific corporate rules for sourcing partnership interest sales.

No such statute or regulation exists in California personal income tax law for individual nonresident sales of partnership interests under IRC Section 751(a). The FTB’s position attempted to enforce an “investee apportionment” methodology without legislative sanction:

“Unlike the above examples, neither the R&TC, its accompanying regulations, nor case law provides for the sourcing result FTB seeks... Regulation section 17951-4(d), by its plain terms, is only applicable to a nonresident partner’s ‘distributive share of [unitary] partnership income,’ not a nonresident partner’s sale of a partnership interest... If FTB wishes to source such sales based on its proposed method, it is free, for example, to approach the Legislature to seek a statutory change.”

Conclusions and Holding

The OTA formally rejected FTB Legal Ruling 2022-02 and ruled entirely in favor of Appellants. The court articulated its primary conclusions as follows:

IRC Section 751(a) alters the tax character of gain (converting capital gain to ordinary income) but does not alter the nature of the transaction or convert a sale of an intangible partnership interest into an operational sale of underlying partnership assets.
For California personal income tax sourcing purposes, the disposition of a partnership interest by a nonresident must be sourced in its entirety under R&TC Section 17952.
Because Appellants were nonresidents and their partnership interests in JCB/Tory Burch had not acquired a business situs in California, the entire gain realized was non-California source income.

The OTA issued the following formal holding and disposition:

HOLDING: Appellants did not generate California source income from the sales of partnership interests for amounts attributable to unrealized receivables and inventory items under IRC section 751(a).

DISPOSITION: FTB’s actions are reversed in full.

Prepared with assistance from Gemini Notebook.