California May Have Over-Taxed Some Nonresident Partnership Investors: Could You Be Eligible for a Tax Refund?

Selling an ownership interest in a partnership or LLC can create a significant tax bill. For investors who live outside California but own an interest in a business operating in the state, one important question is whether California has the right to tax the entire gain—or only certain portions of it.

A recent decision by the California Office of Tax Appeals (OTA) may create an opportunity for some nonresident investors to challenge how California taxed the sale of their partnership interests.

The decision could be particularly important for individuals who sold an interest in a California-based partnership or LLC and reported part of the gain as California income. Depending on the facts and the tax years involved, a review of previously filed returns may identify an opportunity to pursue a refund or address an existing tax assessment.

What happened?

In a recent decision, the California Office of Tax Appeals (OTA) ruled in favor of three taxpayers who lived outside California and challenged the state’s taxation of gains from the sale of partnership interests. The decision rejected the Franchise Tax Board’s (FTB) approach to taxing certain portions of those gains and may have important implications for other nonresident investors who previously paid California income tax on similar transactions.

The dispute arose when an investment partnership sold part of its ownership interest in another business. The FTB treated a portion of the resulting gain as California-source income, which increased the amount subject to California income tax.

The taxpayers disagreed with this treatment and appealed the FTB’s decision.

On July 24, 2026, the OTA ruled in their favor. It concluded that the federal tax treatment of part of the gain did not, by itself, mean that California could treat that portion as income earned from operating a business in the state.

In practical terms, the decision draws an important distinction between how a gain is classified for federal tax purposes and whether California has the right to tax it.

Why did California tax the sale in the first place?

The issue comes from a federal tax rule that applies when someone sells an ownership interest in a partnership.

In certain circumstances, federal tax law treats part of the profit from that sale as ordinary income rather than capital gain. This can happen when the partnership owns assets such as inventory or amounts it has earned but not yet collected.

The FTB relied on this rule to argue that the affected portion of the gain should be treated similarly to income from the partnership’s business operations. If the partnership conducted business in California, the FTB could then treat some of that income as taxable by California.

The OTA disagreed with that interpretation in the Burch and Carden case. It concluded that changing how a portion of the gain is classified for federal tax purposes does not automatically change the nature of the transaction for California tax purposes.

Put simply, a portion of the profit being classified as ordinary income does not automatically make it California-source income.

This distinction matters because California generally treats a nonresident’s gain from selling an ownership interest in a partnership as income from an intangible asset. In many situations, that income is sourced to the taxpayer’s state of residence rather than California.

Who could be affected by this decision?

The decision may be relevant to individuals who:

• Lived outside California when they sold an interest in a partnership or LLC.
• Owned an interest in a business or investment partnership with California operations.
• Reported income from the sale as California-source income.
• Paid California income tax on some or all of the gain.
• Received an FTB notice or assessment involving the California treatment of a partnership interest sale.

For example, consider an investor who lives in another state and owns an interest in an LLC that invests in businesses operating in California. The investor later sells that ownership interest and reports part of the profit on a California nonresident tax return.

If California tax was imposed because the FTB treated part of the gain as income from the partnership’s California business activities, the transaction may deserve another look in light of the OTA decision.

However, not every partnership sale qualifies for the same treatment. The ownership structure, the taxpayer’s residency, the nature of the transaction, and the business relationships involved can all affect the result.

Could you recover California taxes paid in a prior year?

Potentially, yes. Some taxpayers who previously paid California tax on gains from partnership interest sales may have grounds to review their returns and evaluate whether a refund claim is available.

However, a favorable tax decision does not automatically result in a refund. Each taxpayer’s situation must be reviewed separately.

Several factors are important:

• The year of the sale: Refund claims are subject to strict filing deadlines. A taxpayer may lose the opportunity to recover tax if the applicable deadline has passed.
• The structure of the transaction: A sale of a partnership interest is not necessarily treated the same way as a sale of the partnership’s underlying business assets.
• The taxpayer’s relationship to the business: Certain business arrangements or other circumstances may affect how income is sourced to California.
• The original tax reporting: The partnership’s tax documents, sale records, and California return must be reviewed to understand how the gain was reported and taxed.

The OTA decision is currently listed as pending precedential. Its status and the development of related California tax guidance should be considered when evaluating a potential refund claim or tax position.

For taxpayers with an open tax year, it may be important to review the available options promptly rather than assume that previously paid tax cannot be reconsidered.

Why a professional review matters

Partnership interest sales can involve multiple layers of ownership, complex tax reporting, and significant amounts of income. A mistake in determining where the gain is taxable can have a substantial financial impact.

A proper review should go beyond looking at the total gain reported on a tax return. It may require examining the partnership agreement, ownership structure, Schedule K-1s, sale documents, federal tax treatment, and the California return.

At Velin & Associates, Inc., we help individuals, investors, and business owners address complex California tax matters. Our work may include reviewing prior-year returns, evaluating the California tax treatment of partnership transactions, analyzing FTB assessments, and determining whether a refund claim or other response should be considered.

The goal is to determine whether the tax treatment was appropriate under the rules applicable to the transaction—not simply to assume that the amount previously reported was correct.

Have You Paid California Tax on the Sale of a Partnership or LLC Interest?

If you lived outside California and sold an ownership interest in a partnership or LLC with California business activities, the recent OTA decision may make it worthwhile to review how the transaction was reported.

You may have an opportunity to identify an incorrect California tax allocation, evaluate a potential refund, or address an existing FTB assessment. The first step is a careful review of the transaction and the tax returns involved.

Velin & Associates, Inc. assists investors, business owners, and individuals with complex California tax matters, partnership transactions, prior-year tax return reviews, and tax controversy matters.

Contact our office to discuss your situation and determine whether a review of your prior California tax filings may be appropriate.

Velin & Associates, Inc.

8159 Santa Monica Blvd STE 198/200
West Hollywood, CA 90046
📞 323-902-1000
📧 dmitriy@losangelescpa.org

This article is for general informational purposes only and does not constitute tax or legal advice. The application of the OTA decision depends on the specific facts, applicable law, and available filing deadlines. A review of the taxpayer’s records is necessary before determining whether a refund claim or other action is appropriate. CPA for YouTubers | CPA for Shopify Store | CPA for Commerce | CPA for Creators | Shopify Store CPA | CPA for Filmmakers | CPA for Amazon Business | Amazon Business CPA | CPA for Dental Practice | Dentist CPA | Dental Business CPA | Online Commerce CPA | CPA for Doctors | CPA for Medical Practice | CPA for High Net Worth Individuals | Tax Services Healthcare | Tax Services for a Business | Tax Services TikTok | Tax Services for Commerce | Tax Services Los Angeles | Bookkeeping and Tax Services | Tax Preparation | Accounting Firm | Tax Services for Doctor | Tax Services for Entertainment | Online CPA | CPA Los Angeles