United States

Gains from sale of U.S. partnership still taxable as ECI

TAX ALERT  | 

In a recently issued legal advice memorandum (LAFA 20123903F), the IRS Office of Chief Counsel reaffirmed the position taken by the IRS in Rev. Rul. 91-32 that gains recognized on the sale of an interest in a U.S. partnership engaged in a U.S. trade or business are effectively connected income (ECI) subject to U.S. net basis tax of 35 percent. The memorandum, issued to IRS examination personnel in response to the taxpayer’s protest of an IRS adjustment based on the revenue ruling, concludes, based on two theories, that the gain on the disposition of the partnership interest is ECI. First, the IRS applied the aggregate theory of partnerships to conclude that the disposition of the partnership interest should be viewed as a disposition of the ECI assets of the partnership. Second, the IRS asserted that the gain should be treated as ECI because the value of the partnership interest is affected by the value of the partnership’s U.S. trade or business activity. This latter theory is of questionable merit since there is no authority supporting the treatment of a partnership interest as an ECI asset solely because its value is affected by ECI assets held by the partnership.

The taxpayer disagreed with the application of the aggregate theory of partnerships and asserted that gain on the sale of the partnership should be characterized as capital gain because the taxpayer held the interest as a capital asset. The IRS flatly rejected this argument, citing Rev. Rul. 91-32 and certain court cases that adopted an aggregate theory of partnerships.

While not binding precedent, this memorandum clearly demonstrates that the IRS continues to vigorously assert the vitality of Rev. Rul. 91-32 and will challenge a taxpayer’s attempt to characterize gain as non-ECI upon the disposition of a partnership interest. Non-U.S. taxpayers with investments in partnerships engaged in a U.S. trade or business should carefully consider the strength of their position that gain on the sale of an interest in a partnership engaged in a U.S. trade or business is not ECI under the provisions of the Internal Revenue Code or a relevant U.S. income tax treaty.

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