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Saturday, July 22, 2017

Disposition of U.S. Partnership Interest Will Not Result in Effectively Connected Income to Foreign Partner

What happens when a foreign individual or corporation sells an interest in a partnership that is engaged in a U.S. trade or business? The Internal Revenue Code does not directly answer this question - the answer lies at the intersection of several provisions and principles:

a. Foreign persons are subject to U.S. income taxes on their income effectively connected with a U.S. trade or business (ECI);

b. Foreign persons are usually not subject to tax on their capital gains (with exceptions for gains arising from disposition of U.S. real property interests and for individuals present too long in the U.S.);

c. Subject to some exceptions, the disposition of a partnership interest for a profit results in capital gain; and

d. The business character of the income of a partnership flows through to a partner, with the effect that a partner of a partnership with ECI treats its share of the income of the partnership as ECI (thus typically resulting in U.S. income taxation of that partner on its share of the partnership ECI.

In 1991, the IRS put those principles into a bag, shook them up, and issued Rev.Rul. 91-32 which held that a partner with capital gain from the disposition of a partnership that is engaged in a U.S. trade or business will be treated as incurring ECI on the portion of the gain attributable to the business assets of the partnership.

In Grecian Magnesite Mining v. Comm., the Tax Court recently disregarded Rev.Rul. 91-32 and held that a foreign partner with capital gain from the redemption of its partnership interest in a partnership conducting a U.S. trade or business was NOT subject to U.S income tax on that gain (other than the portion attributable to U.S. real property of the partnership) - that is, the gain would not be treated as ECI. In so doing, the Tax Court adopted an entity theory of taxation for partnerships when interests in the partnerships are sold, instead of a look-through or aggregate approach.

Foreign taxpayers who are in the unusual circumstance of being in the U.S. trade or business of trading in partnership interests will not benefit from this holding since their gains on such trading would likely still be ECI.

The court did not address the taxation of the portion of the gain taxable as ordinary income - particularly under Code Section 751 as to the portion of the gain attributable to inventory and receivables of the partnership.

The holding has a major impact on inbound business structuring, since it allows foreign partners to obtain pass-through treatment on the business income of the partnership, but will be able to sell their interests later and not be subject to U.S. income tax on its capital gain.Thus it provides a new incentive to operating U.S. businesses through U.S. partnerships and limited liability companies (although of course there may be other tax and business reasons not to conduct business in such a form).

Perhaps the result may be reversed on appeal, or the IRS attempts to change the result by regulation or new legislation. If not, this taxpayer-favorable ruling will be of benefit in many circumstances.

Grecian Magnesite Mining, v. Commissionr, 149 T.C. No. 3 (July 13, 2017)


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