Executive summary:
Massachusetts Appellate Tax Board upholds tax on capital gains
On Nov. 29, 2023, the Massachusetts Appellate Tax Board (ATB) upheld the Massachusetts Department of Revenue’s determination that capital gain realized by Craig Welch (Welch), a nonresident at the time he sold his shares of C corporation common stock in AcadiaSoft, Inc., was subject to personal income tax in Massachusetts. This decision is the latest in a string of cases in which the ATB or the Massachusetts courts have considered the department’s imposition of tax on capital gains from the sale of a business realized by a nonresident. The department asserted that, pursuant to Mass. Gen. Laws ch. 62, section 5A, the gain generated from the sale was income derived from his employment with the corporation. Therefore, the gain was derived from, and effectively connected to, a trade or business carried on in the Commonwealth such that the state had authority to tax the entirety of the gain, despite the fact that Welch was a nonresident at the time of sale. A summary of the case and what the decision means for taxpayers follows below.
Massachusetts upholds tax on nonresident’s gain from sale of C corporation stock
Welch decision in detail
Case Facts
Welch, a Massachusetts resident, was the co-founder of AcadiaSoft, Inc. (AcadiaSoft or Company) a Delaware corporation that develops and markets derivatives and collateral management solutions for institutional investors. From the time of the Company’s inception in 2003 through 2014, Welch was heavily involved in its operations. He held multiple high-level positions throughout his tenure, including CEO, president, vice president, and treasurer. Welch took only a nominal salary for the services he performed during the Company’s first few years, but his salary increased year over year, with his final annual salary totaling more than $500,000. During this period, the value of AcadiaSoft’s stock increased substantially due in large part to the work performed by Welch. In 2015, Welch resigned from the company, moved out of Massachusetts, and became a resident of New Hampshire. Two months after moving to New Hampshire, he sold his founder’s stock for a gain of $4,744,759.96.
Welch filed a Massachusetts Form 1, Nonresident/Part-Year Resident Tax Return, excluding the capital gain from his Massachusetts taxable income because it was not state sourced. On March 5, 2019, the Commonwealth issued a Notice of Assessment assessing tax on the entirety of the gain. This assessment was based on the department’s determination that the income generated from the sale of the stock was compensation for Welch’s work as a founder and employee of the company. Therefore, Massachusetts had jurisdiction to tax the gain because it was effectively connected to a trade or business carried on in the Commonwealth. Welch appealed to the ATB, asserting that the applicable regulation did not allow Massachusetts to tax capital gain derived from the sale of C corporation stock.
The ATB decision
The ATB upheld the department’s assessment and ruled that the gain on the sale of Welch’s AcadiaSoft common stock was Massachusetts source income subject to taxation. Relying on section 5A, the court reasoned that the gain Welch realized was inextricably connected to his contributions to the Company in his capacity as an employee. The board wrote that “[t]his was not a passive venture for Mr. Welch, but one to which he exclusively devoted his life for more than a decade and to which he made crucial contributions that added to, and were critical to, the company’s value.” The nature of Welch’s dedication to AcadiaSoft and his heavy involvement in everyday operations was strong evidence that the gain was of a compensatory nature that “resulted from, was earned by, was credited to . . . or otherwise attributable to” his employment. The board concluded that this type of involvement as an employee of a Massachusetts business supported a finding that the stock gain was effectively connected to a trade or business carried on in the Commonwealth, regardless of the fact that Welch was a nonresident at the time he sold his shares.
Massachusetts decisions on nonresident sourcing of capital gains from the sale of a business
As noted above, the Welch decision is the latest in a string of cases in which the ATB or the Massachusetts courts have considered the department’s imposition of tax on capital gains from the sale of a business realized by a nonresident. In each of these cases, the court/board analyzed whether the taxpayer was actively engaged in the operations of the business in making the determination of whether the gains from the sale were sourced to Massachusetts, and therefore taxable. The case law stresses that making this determination requires an examination of the facts of each case, and an assessment of whether the taxpayer was involved with continuity and regularity in the business operations in the Commonwealth for purposes of income or profit.
There have been decisions in favor of the taxpayer (see, e.g., VAS Holdings & Investments LLC v. Commissioner of Revenue, 489 Mass. 669 (2022) (the LLC, as the holder of a 50% membership interest in a Massachusetts limited liability company with no other involvement in the business, did not carry on a trade or business in Massachusetts)) and decisions where the board/court has held for the department (see, e.g., Welch, supra; McTygue v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 2010-329, 344 (interest income from a promissory note for the sale of a business was Massachusetts source income because the interest income at issue was 'directly and solely traceable' to McTygue's sale of the company, and because the company’s financial success and ability to meet its obligations under the note were dependent upon McTygue's employment with the company in Massachusetts)).
Takeaways
While the decisions from the Massachusetts courts and the ATB have been split on whether capital gains from the sale of a business can be considered state sourced income to a nonresident, it is clear that the department will continue to impose tax in these situations where it believes the gain is effectively connected to a trade or business carried on by the taxpayer in the Commonwealth. That determination is heavily dependent on the facts and circumstances of each particular case and should be analyzed carefully when determining Massachusetts tax reporting requirements.
Taxpayers with questions about Welch or Massachusetts income sourcing generally should speak to their Commonwealth tax advisers for more information.
