Massachusetts Income Tax Case Impacts Nonresident Stock Sales

The Massachusetts Appellate Tax Board’s decision in Welch v. Commissioner of Revenue last fall is gaining attention as it proceeds through the judicial appeals process. The case, and the Department of Revenue’s application of its holding, could impact certain taxpayers who have changed their residency to another state but receive certain items of income that retain a connection to Massachusetts.

The case may ultimately be reviewed by the Massachusetts Supreme Judicial Court, where a direct review application is pending. A decision may come by June 30. A minor factual comment in the board’s decision may impact the taxation of income earned by nonresidents and has already been raised by the Department of Revenue during audits of former residents.

Welch presented a simple issue on its face—whether gains realized by a nonresident on the sale of stock in a corporation he had founded was subject to personal income tax in Massachusetts pursuant to Massachusetts General Law Chapter 62, Section 5A.

The board held that the gain was effectively connected to his former employment in Massachusetts and ruled in favor of the Commissioner of Revenue. The taxpayer has appealed.

A law approved by Massachusetts voters that became effective for tax years beginning Jan. 1, 2023, imposes an additional income tax on high earners. The Massachusetts Department of Revenue began to beef up its residency audit program in response.

Determining whether a person has established a new residency involves a detailed analysis of numerous “domicile factors” that have evolved from Massachusetts case law over the past several decades. However, successfully proving the residency change doesn’t necessarily mean a taxpayer is home free. The audit review will then turn to whether the taxpayer received income that is derived from Massachusetts sources.

For the income of a nonresident to be taxable in Massachusetts, it must be derived from or effectively connected with a trade or business, including any employment carried on by the taxpayer in state.

It doesn’t matter if the nonresident isn’t actively engaged in a trade or business or employment in the commonwealth in the year in which the income is ultimately received. However, gains from the sale or exchange of intangibles aren’t taxable when purely of a passive investment character.

The board found that Craig Welch wasn’t a passive investor in the company as he claimed, but a founder whose continued employment with the company—in prominent, powerful, and crucial roles—was key to the company’s success.

The stock gain was determined by the board to be compensation for his years of service. As such, it was attributable to employment carried on by Welch in Massachusetts and therefore taxable.

The decision’s potential impact on other residency cases is derived from an alternative argument raised by Welch, who claimed that he traveled extensively for the corporation to the point that he wasn’t engaged in a trade or business in Massachusetts. The board dismissed this argument, noting that during the time that Welch was a resident of Massachusetts, he didn’t file tax returns in other states nor claim a credit for taxes paid to other jurisdictions.

This was a relatively minor comment from the board, but the Department of Revenue appears to be citing it when determining whether all or part of gain from a stock option exercise may be taxable.

In general, former Massachusetts residents must recognize income derived from the exercise of nonqualified stock options. In most instances, there is no dispute over the income’s connection to employment in Massachusetts.

The amount of income that is taxable to Massachusetts is determined by applying an apportionment percentage for the period between the option grant date and option exercise date. The apportionment percentage is derived from a fraction—the number of days worked in Massachusetts over total working days.

The resolution of the Welch appeal will likely turn on whether the court considers stock granted to a corporation’s founder as an intangible—a passive investment that doesn’t generate taxable income to a nonresident. Welch’s insistence on extolling his contributions to the corporation and lamenting his low compensation over the years may doom his chances of convincing the court that the stock was unrelated to his overall compensation.

Nonresidents who have stock options related to their time working in Massachusetts should be interested in the outcome of the Welch case. The Department of Revenue’s regulation requires nonresidents who derive income from the exercise of stock options to either allocate or apportion the income to Massachusetts.

Apportionment is allowed when the taxpayer has performed services both within Massachusetts and elsewhere during the option period. The regulation says nothing about the taxpayer having to file returns in other states, and it shouldn’t be a relevant consideration when considering if a taxpayer derived income from sources outside Massachusetts during the option grant period.

Nevertheless, the Department of Revenue posits that claiming a credit for taxes paid to other jurisdictions is not only relevant, but also possibly a determining factor in a taxpayer’s ability to apportion gain from a stock option exercise. Some guidance, or even a comment on this point, from the court would be welcome.

The case is Welch v. Commissioner of Revenue, Mass. App. Tax Bd., C339531, 11/29/23.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Philip S. Olsen is a tax attorney at Davis Malm, focused on state and local tax consulting and litigation.

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