Navigating Massachusetts Taxes after Relocation: Key Takeaways from Welch v. Commissioner of Revenue

Many Massachusetts residents have recently considered taking, or have undertaken, steps to relocate from Massachusetts to jurisdictions with lower or no state income taxes, especially in light of the recently enacted 2023 Massachusetts “Millionaire’s Tax.” While such a move could offer significant tax advantages, a recent Massachusetts Appeals Court decision, Welch v. Commissioner of Revenue, could reshape how nonresidents are taxed on capital gains from stock sales, emphasizing where the value was earned over where it is recognized. 

The case involved a company founder who worked mainly from his home and office, both in Massachusetts, over a twelve year period. In 2015, however, the founder established residency in New Hampshire, and then sold his company stock for a gain, but did not report it as Massachusetts-source income on his nonresident tax return. The Massachusetts Department of Revenue challenged the reporting decision and the Massachusetts Appeals Court ultimately held that the gain realized from the stock sale was Massachusetts source income because it was effectively connected with the founder’s trade, business, or employment within the meaning of G. L. c. 62, § 5A. 

The Court’s Reasoning

The Appeals Court emphasized the following points in upholding the Appellate Tax Board’s decision:

• Broad Scope of § 5A. The statute defines Massachusetts source income to include “income derived from or effectively connected with . . . any trade or business, including any employment carried on by the taxpayer in the commonwealth, whether or not the nonresident is actively engaged in a trade or business or employment in the commonwealth in the year the income is received.” (emphasis added). A 2003 amendment added the emphasized language, and further broadly defined what income qualifies as being “derived from or effectively connected with” a Massachusetts trade or business and includes “the gain from the sale of a business or of an interest in a business.” 

• Not an Ordinary Investment. Massachusetts Regulations provide that generally, gain from the sale of C or S corporation stock is not Massachusetts source income if it is characterized as capital gain for federal tax purposes. However, the court noted that such a gain may be Massachusetts source income if “the stock is related to the taxpayer’s compensation for services.”

• Compensatory Nature. The Court agreed with the Tax Board that the founder’s gain was not a passive investment return but rather was compensatory and connected with his continued employment at the company in prominent and crucial roles. The Tax Board emphasized that the founder acquired the stock after founding the company, dedicated himself to the company’s success, expected a payout for his “sweat equity,” and his resignation was contingent on the sale of his shares. Although the founder argued that there was no evidence of an explicit agreement that the shares were issued as compensation, the court noted that this was not determinative. 

Implications for Founders and Executives

The Welch decision could have a profound impact on founders and executives who were employed in Massachusetts and hold equity interests in their company but who are no longer residents. 

• Gains from Equity May Be Source Income to Non-Residents. Even if a taxpayer changes residency before a liquidity event, Massachusetts may assert taxing authority over resulting gains if the equity was earned through services in Massachusetts. This decision reinforces that Massachusetts emphasizes where you earn value outweighs where you recognize it in determining Massachusetts source income.

• Substance Over Form. The ruling underscores the Commonwealth’s ability to recharacterize what might seem like investment income as compensation for services rendered. The absence of an agreement explicitly labeling equity as compensation is not dispositive. Massachusetts taxing authorities may look at the facts and circumstances, including the taxpayer’s role within the company and the timing and circumstances of the equity acquisition, to determine whether the equity was compensatory. 

• Tax Planning Considerations. Executives and founders contemplating relocation or exit events should carefully evaluate the sourcing of equity-related income and consult with tax and legal advisors early in the process to mitigate unexpected state tax exposure.

Mintz’s Executive Compensation and Employee Benefits Practice and Private Client Practice will continue to monitor developments and remain available to assist in your business and personal tax planning. 

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