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Sunday, March 17, 2013


Nonresidents are generally not subject to U.S. income taxes on their capital gains if present in the U.S. for less than 183 days in the tax year. Code Section 741 treats the gain from the sale or exchange of a partnership interest as capital gain (subject to some limited exceptions). Therefore, if a nonresident who has been in the U.S. for less than 183 days sells a U.S. partnership interest, then it appears that any resulting gain is capital gain, which is not subject to U.S. income tax.

A recent Legal Advice Issued by Field Attorney advises that such gains will be subject to U.S. income tax if the partnership was engaged in a U.S. trade or business. The LAFA strings together several Code provisions to support this conclusion, but such provisions do not fully resolve the issue (contrary to the IRS’ position).

Code Section 875(1) states that “a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged.” This provision thus supports the conclusion that the NRA partner of a partnership that is engaged in U.S. trade or business is himself deemed engaged in a U.S. trade or business. However, the partnership interest of the partner is not directly used in the business. Therefore, Code Section 875(1) without more should not convert the gain on sale of a partnership interest into effectively connected income (ECI) that is taxable to the NRA.

Code Section 864(c)(2) looks like it may support such gain as ECI when it provides that ECI includes (A) the income, gain, or loss is derived from assets used in or held for use in the conduct of such trade or business, or (B) the activities of such trade or business were a material factor in the realization of the income, gain, or loss. But the face of the statute again does not provide direct support to ECI since under (A) the partnership interest itself is not used in the trade or business, and it is unclear how under (B) the partnership trade or business activities become a material factor in the sale of the partnership interest.

The foregoing nontaxation arguments have force when the partnership is viewed as an entity. However, we all know that the IRS at times will treat a partnership as an aggregate of its assets and treat its partners as owning such assets. It is by applying an aggregate theory that the IRS counsel concludes that the sale of the partnership interest generates ECI for the selling NRA partner. However, given the express entity methodology used in Code Section 741, a strong argument against the use of the aggregate theory here exists.
The IRS is not without support in this area. Rev.Rul. 91-32 supports the use of the aggregate theory in this context, and the IRS counsel cites to it.

There have been proposals to codify Rev.Rul. 91-32 in recent years. However, the very existence of such codification attempts raises the question of the correctness and authority of the Revenue Ruling until the Code is changed.

Notwithstanding this IRS analysis and Rev.Rul. 91-32, there are those that still consider this an unresolved issue, at least until some court weighs in on the issue.

Note that if the gain is not subject to tax, Code Section 754 may operate on the sale to step up the basis of the partnership assets, thus reducing future gains on sales of assets by the partnership allocable to the sold partnership interest.

Legal Advice Issued by Field Attorney 20123903F

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