Locke Lord QuickStudy: Recent U.S. Tax Court Case Reverses Long Held IRS Position Regarding Taxation of Sales of Partnership Interests by Foreign Investors

July 25, 2017

Following the inauguration of the new administration in January 2017, many investors were anticipating the passage of a transformative tax reform bill at some point in 2017. Although legislative tax reform is seemingly stalled in Washington, D.C., significant innovations in the application of the U.S. tax laws are still possible. The U.S. Tax Court’s July 13, 2017 decision in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner, 149 T.C. 3 (2017), (“Grecian”) may fundamentally alter how foreign persons exit investments in U.S. businesses that operate as pass-through entities for U.S. federal income tax purposes. In Grecian, the Tax Court rejected the Internal Revenue Service’s (the “IRS”) longstanding position, reflected in Revenue Ruling 91-32, 1991-1 C.B. 107, that a foreign person’s gain on the sale of a U.S. partnership interest is generally U.S. source income that is effective connected with a U.S. trade or business. The impact of the IRS’s position was that foreign persons generally had to file U.S. federal income tax returns and pay U.S. federal income taxes to the extent any income generated on the sale of such interest was attributable to the partnership’s U.S. trade or business. Under Grecian, this is no longer the case. The Grecian decision may meaningfully increase future planning and structuring alternatives for foreign investors, although, at this point in time, foreign investors may want to delay the implementation of such strategies as the IRS could appeal the Grecian decision.


In Grecian, a foreign corporation purchased an interest in a U.S. entity (an LLC) that was treated as a partnership for U.S. federal income tax purposes. The foreign corporation held that partnership interest for a number of years until the U.S. entity redeemed the interest and the foreign corporation realized gain totaling $6.2M, of which $2.2M was attributable to U.S. real property interests. Since the $2.2M was clearly subject to U.S. taxation based upon the Foreign Investment in Real Property Tax Act (FIRPTA), the case turned on whether the remaining $4M of gain was subject to U.S. taxation based on the theory that such income was effectively connected with a U.S. trade or business.

Tax Court Decision.

From the IRS’s perspective, the U.S. tax code does not directly address how gain realized by a foreign person on the sale of a U.S. partnership interest should be taxed. To remedy this perceived lack of clarity, in 1991, the IRS released Revenue Ruling 91-32, in which the IRS concluded “that any gain realized by a foreign partner upon the disposition of its interest in a U.S. partnership should be analyzed asset by asset, and that, to the extent the assets of the partnership would give rise to effectively connected income if sold by the entity, the [foreign] partner’s pro rata share of such gain should be treated as effectively connected income.” Grecian, 149 T.C. 3. The IRS reached this conclusion based upon the aggregate partnership theory pursuant to which a foreign person’s disposition of a partnership interest is actually a disposition of an aggregate interest in the partnership’s underlying property. 

The Tax Court rejected the aggregate approach posited by the IRS in Revenue Ruling 91-32 because, while the U.S. tax code employs the aggregate partnership theory in certain circumstances (such as the treatment of unrealized receivables and inventory items under Section 751 of the Internal Revenue Code of 1986, as amended (the “Code”), it is an exception to the entity partnership theory (embodied in Code Section 741) pursuant to which a partnership is an entity with a legal existence that is separate and apart from its individual partners. Section 741 of the Code provides that income realized on the sale of a partnership interest “shall be considered gain . . . from the sale or exchange of a capital asset, except as otherwise provided in Section 751.” Utilizing plain language principles of statutory construction, the Tax Court found Congress’s use of the singular “asset,” rather than the plural “assets,” to be significant as the singular term is consistent with the entity theory. If Congress had intended for the aggregate partnership theory to apply to sales of partnership interests, it would have done so in the statute.

After the Tax Court concluded that the gain recognized by the foreign corporation upon the redemption of its partnership interest constituted gain from the sale or exchange of a single capital asset, the Tax Court analyzed whether such gain was U.S. source income that was effectively connected with a U.S. trade or business under the sale of personal property rules. In general, gain from the sale of personal property is sourced to the residence of the transferor, unless such gain is attributable to an office or other fixed place of business in the United States. Since the foreign corporation did not maintain an office or other fixed place of business in the United States itself, the IRS argued that the foreign corporation’s redemption gain fit within the so-called U.S. office exception on the grounds that it was attributable to the U.S. office maintained by the U.S. partnership in which the foreign corporation invested. The Tax Court rejected this argument because the partnership’s U.S. office was neither a material factor nor an essential economic element in the gain the foreign corporation recognized upon the redemption of its partnership interest. As a result, the Tax Court concluded that the redemption gain the foreign corporation recognized was foreign source income and not subject to U.S. tax.


The Grecian decision, which does not change the U.S. taxation of partnership operating income, provides foreign investors with additional flexibility in how they might structure their investments in a U.S. business that is treated as a partnership for U.S. federal income tax purposes. Namely, since foreign investors may now plan to structure an exit transaction as a direct sale of the U.S. partnership interests (which may avoid U.S. tax under Grecian) as opposed to a sale of underlying partnership assets (which would likely be subject to U.S. tax), this might alter the formula as to whether foreign or U.S. intermediary blocker companies are advantageous. As there are many variables that remain in play (including, but not limited to, whether the foreign investor wishes to avoid filing U.S. tax returns on its distributable share of effectively connected income (prior to the exit), the extent of expected operational effectively connected income versus capital gain income on exit, U.S. estate tax concerns, and the potential interplay of the branch profits tax), foreign investors and their tax advisors should continue to carefully consider how they can utilize Grecian in structuring their U.S. investment transactions. Moreover, it should be noted that the principles of Grecian are not limited to foreign investors.  The rejection of the aggregate view of the partnership (except in Code Sections 751 and 897) may likely have impact across the domestic and international tax spectrum when there are partnership interest redemptions or sales. It may be advisable, however, to delay the implementation of any Grecian strategies until the IRS decides whether or not to appeal the Tax Court’s decision. Foreign investors who have already paid U.S. taxes on sales of partnership interests may want to file protective refund claims pending the outcome of any appeal of Grecian.