The Tax Court in Brief – February 6th – February 10th, 2023
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Tax Litigation: The Week of February 6th, 2022, through February 10th, 2023
- 3M Company and Subsidiaries v. Comm’r, 160 T.C. No. 3| February 9, 2023 |Morrison, J. | Dkt. No. 5816-13
Rawat v. Comm’r, T.C. Memo. 2023-14| February 7, 2023 | Gustafson, J. | Dkt. No. 15340-16
Summary: This case arises at the confluence of two areas of tax law—partnership taxation (subchapter K of the Code) and U.S. taxation of international transactions (subchapter N of the Code).
Ms. Rawat was a nonresident alien individual for federal income tax purposes during 2008 and 2009. She did not file returns for the 2008 and 2009 tax years. Innovation Ventures, LLC (“IV LLC”), is a U.S. business that manufactures and sells popular consumer products including 5-hour Energy drinks. IV LLC was treated as a partnership for federal income tax purposes. Ms. Rawat owned a 30% interest in IV LLC. In January 2008, Ms. Rawat executed a note for the sale of her interest in IV LLC to Manoj Bhargava for $438 million. The note provided for interest-only payments until 2028, when the note would mature. At the time the note was executed, IV LLC had inventory items with a basis of $6.4 million, which it held for future sale in the U.S. IV LLC later sold those inventory items for a profit of $22.4 million, and Ms. Rawat’s share of income “attributable to the inventory” was $6.5 million. Of the $438 million sale price, $6.5 million was allocable to inventory held in the U.S. for sale therein (“Inventory Gain”).
The IRS conducted an examination of IV LLC for the 2007 and 2008 tax years. The IRS issued Form 5701, “Notice of Proposed Adjustment”, to IV LLC and to Ms. Rawat, proposing to include in Ms. Rawat’s income for 2008 $6.5 million arising from the Inventory Gain issue. Ms. Rawat and the IRS signed an IRS Form 870–LT, “Agreement for Partnership Items and Partnership Level Determinations as to Penalties, Additions to Tax, and Additional Amounts and Agreement for Affected Items”. The Form 870-LT included a “Schedule of Adjustments” that included, under “Other income (loss)”, an adjustment of $6,523,176, with the explanation that “[o]ther income relates to unrealized receivables as defined under Section 751.”
In February 2012 the IRS issued to Ms. Rawat a Notice of Computational Adjustment for her 2008 tax year, based in part on the Form 870-LT. The notice included Form 4549–A, “Income Tax Discrepancy Adjustments”, that listed a $6.5 million increase in income and a tax liability of $2.3 million. Additionally, the IRS determined nearly $1 million in additions to tax under section 6651(a)(1) and (2) and section 6654. The IRS assessed these amounts and issued a Notice of Deficiency (“NOD”). The NOD reflected the previously determined income for 2008 (from the Inventory Gain issue, as stated in the Notice of Computational Adjustment) and further determined additional taxes owed under section 453A(c)(2)(B) as interest on the deferred tax liability attributable to the installment obligation (“Non-Inventory Gain”). The NOD indicated a $3.8 million deficiency in tax for 2008 and a $2.6 million deficiency in tax for 2009. In June 2016 Ms. Rawat paid $2.9 million in tax, interest, and additions to tax attributable to the initial assessments for the 2008 tax year (i.e., arising from the computational adjustments for the Inventory Gain issue). Ms. Rawat filed her petition with the Tax Court in order to challenge the items in the NOD and to invoke the Court’s overpayment jurisdiction under section 6512(b) with respect to her $2.9 million payment for the computational adjustment.
Key Issues: Whether the inventory exception in section 741 of the Code calls for distinct treatment of the inventory-related portion of sale proceeds when the selling partner is a nonresident alien individual?
Summation of Holding:
Potential U.S.-source income inheres in inventory that a partnership holds for sale in the United States, and when that inventory is later sold, U.S.-source income may be realized.
A foreign partner who sells a partnership interest before that inventory gain is realized thereby receives compensation for the value of that inventory but might avoid U.S. taxation on the receipt of that value. Where a nonresident alien’s distributive share of a partnership’s income is “effectively connected” to its U.S. inventory, the partner is liable for U.S. income tax on the partner’s portion of the partnership’s income that is effectively connected with its sale of that inventory in the United States, even if that receivable relating to “property other than a capital asset” is only “considered” to have been realized under section 751(a).
The Inventory Gain is “attributable to inventory” and is “considered” to have been “realized from the sale” of “inventory items”.
Thus, Rawat’s Inventory Gain portion of the sales proceeds is excepted from section 741 and, under section 751(a), this portion is “attributable to . . . inventory items”.
For that reason the Tax Court applied the “Exception for inventory property” that is provided in subsection (b) of section 865 for “income derived from the sale of inventory property”. That subsection—section 865(b)—dictates that the sourcing rules for the Inventory Gain in the provisions of “sections 861(a)(6), 862(a)(6), and 863” apply, and pursuant to those sections: “income derived from the . . . [sale] of inventory property”, §§ 861(a)(6), 862(a)(6); “income . . . from the sale . . . of inventory property”, § 863(b)(2); and income “derived from the . . . [sale] of inventory property”, § 863(b)(3), is “considered as an amount realized from the sale or exchange of property other than a capital asset.”
Consequently, Rawat’s motion for summary judgment on the issue was denied.
Key Points of Law:
U.S. “Source” and “Effective Connection” with a U.S. business. U.S. federal income tax is imposed on nonresident alien individuals by section 871. For “Income connected with the United States business”, subsection (b)(1) of section 871 provides: “A  nonresident alien individual  engaged in trade or business within the United States during the taxable year shall be taxable as provided in section 1 or 55 on his [or her] taxable income which is  effectively connected with the conduct of a trade or business within the United States.”
Partnership Interests, Generally. A partnership interest as a singular capital asset. For a taxpayer with an ownership interest in a partnership, the partnership is not itself subject to the income tax, but instead each partner separately reports on her individual income tax return her share of the partnership’s taxable income or loss. The partnership’s income is taxable to the partners to the extent of each partner’s respective distributive share. See 26 U.S.C. § 702(c). If the owner of a partnership interest sells that interest, then sections 741 and 751 come into play to determine the income tax treatment of that sale.
Gain or Loss and Inventory Exception. Generally, under section 741, the partner’s gain or loss “shall be considered as gain or loss from the sale or exchange of a capital asset”—but section 741 provides an exception—“except as otherwise provided in section 751 (relating to . . . inventory items).” Section 751(a)(2) in turn provides: “The amount of any money . . . received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to— . . . . (2) inventory items of the partnership, shall be considered as an amount realized from the sale or exchange of property other than a capital asset.”
The Exception of Section 751. Section 751 provides:
(a) Sale or exchange of interest in partnership.—The amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to—
(1) unrealized receivables of the partnership, or
(2) inventory items [plural] of the partnership, shall be considered as an amount realized from the sale or exchange of property other than a capital asset.
The general approach of section 741, which calls for the sold partnership interest to be analyzed not asset-by-asset but rather as a singular “capital asset”, gives way to the specific provision in section 751(a)(2) that the portion of the sold partnership interest attributable to inventory items must be separately “considered” as pertaining to “other than a capital asset”.
The Interaction of Sections 741 and 751 – Characterizing the Proceeds and Sale under Sections 741 and 751. Section 741 provides:
In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).
Under section 864(c)(3), “[a]ll income, gain, or loss from sources within the United States . . . shall be treated as effectively connected”, while under section 864(c)(4)(A), “no income . . . from sources without the United States shall be treated as effectively connected”.
And under section 865(a)(2), “income from the sale of personal property [such as a partnership interest] . . . by a nonresident shall be sourced outside the United States”.
Both sections 741 and 751 are provisions that define the character of the property sold and of its proceeds, to which the sourcing rules must then be applied. The proceeds of the sale are to be “considered as gain or loss from” such a sale. It is because of section 741 that the sale of a partnership interest is “considered as” the sale of a singular asset. However, section 741 has an explicit exception: “except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).”
Section 751 provides that the “inventory items” portion of proceeds “shall be considered as an amount realized from the sale or exchange of property other than a capital asset”. Section 741 does not apply to the “inventory items” portion addressed by section 751, to which section 741 yields.
Section 741 provides that in general the proceeds—shall be considered as gain or loss from the sale or exchange of a capital asset. But the exception in section 751(a) provides that the proceeds attributable to inventory—shall be considered as an amount realized from the sale or exchange of property other than a capital asset.
The general rule refers to gain or loss from the sale of a singular “asset”, § 741, whereas the exception refers to an amount realized from the sale of “property”.
Section 751 is a specific exception to section 741 that causes unrealized receivables and inventory items to be addressed separately from the remainder of the partnership interest when that interest is sold or liquidated. . . . We note that by the express terms of section 741, section 751 is (like section 897(g) . . .) an exception, and it mandates an “aggregation” approach for characterizing only gain “attributable to” “unrealized receivables” or “inventory items”.
Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. 63 (2017), aff’d, 926 F.3d 819 (D.C. Cir. 2019).
IMPORTANT NOTE: Congress effectively overruled Grecian Magnesite by adding to the Code section 864(c)(8) (Gain or loss of foreign persons from sale or exchange of certain partnership interests), effective for transactions after November 27, 2017.
Sourcing the Proceeds. The sourcing rules are given in sections 861–865. Section 865 provides in part as follows:
(a) General rule.—Except as otherwise provided in this section, income from the sale of personal property— (1) by a United States resident shall be sourced in the United States, or (2) by a nonresident shall be sourced outside the United States.
(b) Exception for inventory property.—In the case of income derived from the sale of inventory property— (1) this section shall not apply, and (2) such income shall be sourced under the rules of sections 861(a)(6), 862(a)(6), and 863.
The “General rule” of subsection (a) applies to the Non-Inventory Gain and sources it “outside the United States”. But see 26 U.S.C. § 864(c)(8) (covering sales on or after November 27, 2017).
Section 741 provides the character of the partnership interest sold (i.e., “a capital asset”), and section 865(a)(2) dictates its source (“outside the United States”).
Insights: Tax practitioners involved in sales or transfers of partnership interests owned by nonresident alien individuals and that involve the sale or transfer of value attributable to inventory owned by the partnership should take due note of Rawat v. Commissioner and not take note of Congress’s more recent addition of 26 U.S.C. subsection 864(c)(8).