Decision in detail
Background
In 2005, Craig Welch co-founded AcadiaSoft, Inc., a corporation organized in Massachusetts, receiving a 50% interest in the company through founder’s stock. The corporation subsequently converted from an S corporation to a C corporation and, over time, his ownership percentage was diluted due to recapitalizations to admit other investors. From the time of its formation until 2015, AcadiaSoft was headquartered in Massachusetts and filed corporate excise tax returns apportioning all of its income to Massachusetts. Throughout his tenure at AcadiaSoft, the taxpayer held multiple executive positions including chief executive officer (CEO), president, vice president and treasurer.
In June 2015, Mr. Welch participated in a stock repurchase offering and sold his shares of stock back to AcadiaSoft, generating a capital gain. Notably in April 2015, Mr. Welch changed his domicile from Massachusetts to New Hampshire and was therefore a New Hampshire resident when he recognized the gain from his sale of stock. Mr. Welch filed a Massachusetts personal income tax return as a part-year resident for the 2015 tax year, sourcing none of the gain to Massachusetts. On audit, the Massachusetts Department of Revenue asserted that the gain was fully taxable in Massachusetts as Massachusetts source income. Specifically, the department argued that the gain derived from the buyout of Mr. Welch’s stock was effectively connected with a trade or business carried on in Massachusetts and his state of residence at the time of this transaction was therefore not relevant.
Appellate Tax Board decision
In its decision, the ATB ruled that the language of the controlling statute permitted the department to assert that Mr. Welch’s gain was taxable as Massachusetts source income as the income was effectively connected with a Massachusetts trade or business. The ATB stated that statute’s language is “patently inclusive” and that neither the character nor the timing of the income was determinative of the Massachusetts tax treatment, but rather, whether Massachusetts has a right to tax it based on the income’s “provenance.” The ATB noted that Mr. Welch’s employment with AcadiaSoft was not a passive venture, because he was responsible for “crucial contributions that added to and were critical to, the company’s value.” Further, the ATB observed that Mr. Welch did not acquire his shares through a purchase. Additionally, the wages he received from AcadiaSoft during the company’s early years were not commensurate with the time and effort he spent working on behalf of the company. On this basis, the ATB determined that the stock was compensatory in nature for the services provided by Mr. Welch, and ultimately ruled in favor of the department. Mr. Welch subsequently appealed the decision to the Massachusetts Appeals Court.
Massachusetts Appeals Court decision
On appeal, the Court upheld the decision of the ATB and the department’s application of the relevant sourcing regulation for nonresidents. Specifically, the regulation provides that the gain from the sale of shares of stock in a C corporation ‘generally’ is not considered Massachusetts source income to the extent such gain is characterized as capital gain for federal income tax purposes. The Court held that this general rule “is not absolute,” and contains an exception that in certain circumstances “give rise to Massachusetts source income if, for example, the gain is otherwise connected with the taxpayer’s conduct of a trade or business, including employment (as in a case where the stock is related to the taxpayer’s compensation for services)...” The Court determined that the regulation, when read as a whole, made clear that the gain from the sale of stock in a C corporation may be Massachusetts source income if the stock is related to the taxpayer’s compensation for services. The Court found that the ATB’s application of the law to Mr. Welch’s facts to be reasonable, and upheld the decision that the gain from the sale of stock in this case was related to compensation derived from and effectively connected with a Massachusetts trade or business, and was therefore taxable as Massachusetts source income.
Takeaways
The Court’s decision in Welch leaves open several questions for individuals who previously participated in the business or management of a Massachusetts corporation that are nonresidents.
Based upon the department’s interpretation of its existing nonresident income tax regulation, the department could assert that a gain derived from a nonresident’s sale of an interest in a C or S corporation is subject to Massachusetts income tax. This could be to any individual that previously was an active participant, in any capacity, in a company doing business in Massachusetts. Welch suggests that the department should first consider whether such gain could be construed as compensation for services in order to be taxable as Massachusetts source income. However, the department has not published any guidance defining what it means for a nonresident to have been actively engaged in a Massachusetts trade or business.
Taxpayers with questions about the Welch case or Massachusetts income sourcing should speak to their tax advisers for more information.
