Can California tax part of a nonresident’s gain from selling a partnership interest simply because federal law labels that portion ordinary income? In Appeals of Burch and Carden, 2026-OTA-527P, the Office of Tax Appeals answered no. The decision, currently designated pending precedential, rejects the Franchise Tax Board’s position in Legal Ruling 2022-02 and reinforces a distinction that can get lost in a complicated transaction: the character of income does not necessarily determine its source.
The case involved nonresident individuals who owned interests in JCB Investments, LLC, an investment partnership. JCB held approximately 28 percent of Tory Burch LLC, the fashion business, along with other unrelated investments. In 2012 and 2013, JCB sold portions of its Tory Burch interests and reported the resulting gains as nonbusiness income outside California’s taxing reach.
For federal purposes, those gains fell into two buckets. Section 741 generally treats gain from selling a partnership interest as capital gain. Section 751(a), however, treats the portion attributable to unrealized receivables and inventory—commonly called “hot assets”—as ordinary income. That rule prevents taxpayers from converting ordinary income into capital gain simply by selling their partnership interests instead of the underlying assets.
The FTB agreed that the capital-gain portion was not California-source income. But it took a different approach to the hot-asset portion. Relying largely on Legal Ruling 2022-02, the FTB treated Tory Burch as having sold those assets and passed the resulting business income through to the investors. Under that theory, Tory Burch’s California apportionment percentages determined California’s share.
The problem? No such asset sale occurred, and section 751(a) did not create one.
OTA found the D.C. Circuit’s decision in Rawat v. Commissioner, 108 F.4th 891 (2024), highly persuasive. Rawat rejected a similar IRS argument in the federal international sourcing context. Section 751(a) changes the character of the gain; it does not transform a partnership-interest sale into a sale of inventory or receivables. Even the hypothetical asset-sale calculations used to determine the ordinary-income amount do not change what was actually sold.
That distinction carried the day. Under Revenue and Taxation Code section 17952, a nonresident’s income from intangible property generally falls outside California’s tax base unless the property has acquired a California business situs. The FTB conceded that the partnership interests had no such situs. Nothing in California’s applicable sourcing rules authorized the FTB to carve out the ordinary-income portion and source it differently merely because section 751(a) applied. OTA reversed the FTB’s actions in full, including reductions totaling approximately $2.54 million to Burch’s net operating loss.
There is an important limit to this taxpayer victory. The sale occurred through a holding partnership, but the FTB did not argue that JCB and Tory Burch were unitary (JCB had 28% ownership interest) or that the gain was apportionable business income at JCB’s level. OTA distinguished Appeal of Smith, 2023-OTA-069P, where a unitary relationship supported California taxation of a holding partnership’s gain flowing through to a nonresident. Burch and Carden therefore does not establish that every partnership-interest sale escapes California tax whenever the ultimate owners live elsewhere.
The decision also highlights the difference between interpreting an existing sourcing rule and creating a new one. OTA observed that California has expressly adopted look-through sourcing rules in other contexts, but found no comparable authority for the FTB’s treatment of section 751(a) gain here. If the FTB wants that result, OTA explained, it can seek a statutory change. Under the law applied in this appeal, however, ordinary-income treatment did not change the asset sold or supply an independent basis for California taxation.
