Massachusetts v. Welch: Taxing a Nonresident on Intangible Stock Sales

As states continue to seek increased revenues, especially those high-tax states dealing with a dwindling tax base, we’re starting to see some states take unusual and fairly aggressive positions in tax cases. One recent example we covered involved New York and the enforcement of its “convenience rule” in the Zelinsky case. In November 2023, the Massachusetts Appellate Tax Board issued another doozy, holding in Welch v. Commissioner of Revenue that a nonresident could be taxed on the gain from the sale of stock. (Docket No. C339531 (November 29, 2023)).

Needless to say, we have some questions.

The taxpayer in Welch founded the Massachusetts-headquartered company in 2003, and after multiple rounds of funding, he was ultimately left with an ownership interest of 11.86%. He considered himself the “chief evangelist” of the company, was an employee, and held numerous responsibilities and positions at times, including CEO, President, Vice President, and Treasurer. In June 2015, after he had moved out of the state, he sold his shares for $4 million and exited the company. 

Normally, the gain from the sale would be off-limits to Massachusetts. Mr. Welch was a nonresident, he sold stock (an intangible), and states generally don’t tax nonresidents on gains from the sale of intangibles.

But Massachusetts’s tax law provides for a broad tax on nonresidents, including in its definition of source income “items of gross income derived from or effectively connected with . . . any trade or business, including any employment carried on by the taxpayer in [Massachusetts].” (Mass. G.L. c. 62, § 5A(a)).  And more to the point, the definition of “gross income derived from or effectively connected with any trade or business” is defined to include “gain from the sale of a business or of an interest in a business.” (Mass. G.L. c. 62, § 5A(a) (emphasis added)).

That last clause seems a bit odd, again given that states are usually hands-off when a nonresident sells stock, but the Board noted that there was a limiting principle to this, in that the rule normally does not apply to sales of stock by a nonresident business-owner:

While the regulation states that this rule ‘generally does not apply . . . to the sale of shares of stock in a C or S corporation, to the extent that the income from such gain is characterized for federal income tax purposes as capital gains,’ it makes clear that ‘[s]uch gain may . . . 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).’ 830 CMR 62.5A.1(3)(c)8 (emphasis added).

We’ll come back to the “emphasis added” reference in a moment. But the Board’s determination relied on its conclusion that the taxpayer’s gain resulted from the taxpayer’s engagement in a trade or business of employment in Massachusetts. For example, the Board mentioned the range of responsibilities the taxpayer performed as an employee at the Massachusetts company; that he worked mostly in Massachusetts and was a resident of Massachusetts from the company’s founding until a couple of months before the gain occurred; that he engaged in his employment with continuity and regularity; and that:

He was a founder of AcadiaSoft and dedicated himself to its success, and he expected all his hard work would culminate with a payout at some point in the future. This was not a passive venture . . . but one to which he exclusively devoted his life . . . and to which he made crucial contributions that added to, and were critical to, the company’s value. His payout – the stock gain – was of a compensatory nature that ‘result[ed] from, [was] earned by, [was] credited to . . . or otherwise attributable to’ his employment and thus the gain here derived from and was effectively connected with the trade or business of employment carried on … in [Massachusetts]. (emphasis added).

So, the gain was of a “compensatory nature?” Note that the Board needed this factual conclusion in order to overcome the general rule, which is that nonresidents can’t be taxed on the gain from the sale of stock in the normal course. But does this conclusion check out?

To answer that question, let’s look back at a New York case where a similar debate played out. In Matter of Nielsen, (DTA No. 818817 (April 22, 2004)), an ALJ in New York’s Division of Tax Appeals held that income from a nonresident taxpayer’s sale of his shares of stock is New York source income, subject to New York tax. And central to the conclusion was that while the gain was derived from an intangible and resulted in capital gains (as opposed to ordinary income), the income from the shares was nonetheless compensatory in nature, since the taxpayer only was able to acquire the shares—for less than their market value—in exchange for the performance of services. The ALJ explained that “an employee's payment of less than fair market value in exchange for property received from his employer gives rise to the receipt of compensation income by the employee required to be recognized and subjected to tax” and that “[b]ut for petitioner's prior, ongoing and future active service (i.e., employment) . . . he could neither have acquired his stock in the first instance, nor continued to own such stock or receive the benefits resulting therefrom.” 

The Board’s analysis in Welch, however, does not clearly articulate how the taxpayer’s stock gain was in exchange for his services. Yes, the taxpayer in Welch worked diligently to grow his company’s value over the years, but the Board’s decision ignores the emphasized regulatory language above, stating that for an income item of this nature to be sourced to Massachusetts, it should be “related to the taxpayer’s compensation for services.” That language seemingly refers to something like we saw in the Nielsen case, where stock was given to the taxpayer in exchange for services. 

But in Welch, the taxpayer’s stock was never a part of his compensation package; he founded the company and held his shares since the early years of its inception. To hold that the creation of value in the company that the taxpayer worked towards is “related to [his] compensation for services” is too surface-level of an analysis to hold water. This same rationale could apply to any employee who owned stock of their employer, regardless of whether it was received as part of a compensation package: if the employee did good work and the stock price went up, you could always conclude that the gain was related to the taxpayer’s services. But that’s not the test; the rules make clear that the gain from the sale of stock is NOT taxed to a nonresident and is not connected with a trade or business unless it is related to the taxpayer’s compensation for services. And in Mr. Welch’s case, the stock itself was not related to his compensation for services; it was reflective of his founding and ownership of an interest in the company, an interest of an intangible nature that states usually won’t tax if the taxpayer is a nonresident. 

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