Two Camps
Last month, Bloomberg carried an article about a “small but growing trend” of states that are either cutting their individual income taxes or phasing them out entirely.[i]
According to the article, the states adopting these measures have determined that, by reducing income taxes, they will enhance their ability to attract and retain people and businesses.[ii]
Other states, however, seem to be oblivious or indifferent to the competitive disadvantage at which their own income tax regimes have placed them.[iii]
Indeed, some of the states in this second group are facing budget deficits that they are hoping to shrink, not by reducing spending, but by increasing taxes.[iv]
The Bay State
Among these states is the Commonwealth of Massachusetts.[v]
Don’t get me wrong, the Bay State[vi] has come a long way from when it was known as “Taxachusetts.”[vii] Over the last few years, however, it has taken measures that, at best, may be interpreted as ambivalent toward successful businesses and their owners.
Millionaire’s Tax
For example, in 2022, Massachusetts approved the imposition of a 4% surtax on the taxable income of individuals – including nonresidents and part-year residents – to the extent it exceeds a specified threshold.[viii]
Single Sales factor
For tax years beginning on or after January 1, 2025,[ix] corporations doing business in Massachusetts[x] and at least one other jurisdiction are required to use a single sales factor apportionment formula to determine how much of their net income should be sourced to and taxed in Massachusetts,[xi] notwithstanding the corporation’s not having any employees or property in the State.[xii] Thus, any corporation with sufficient sales into Massachusetts will be required to apportion some of its net income to the State, and to pay income tax thereon.[xiii]
Investee Apportionment
In her proposed budget for the FY 2026, introduced in January of this year, the State’s governor included a provision that would apply the so-called “investee apportionment” method to tax the gain realized by a nonresident owner from the sale of an interest in a pass-through entity[xiv] doing business in the State.[xv]
Under this method, the gain from such a sale would be sourced to Massachusetts[xvi] based upon the passthrough entity’s “business attributes” – particularly, the extent of its activities within the State.[xvii]
Basic Principles?
The governor’s proposal contradicts what may be described as a longstanding general principle of state income taxation; specifically, that the gain realized by a nonresident of a state from the sale or exchange of intangible personal property[xviii] is not treated as taxable income from sources within the state except to the extent such property was used in carrying on a business in the State.[xix]
It also provides a segue into the subject of today’s post, which concerns a State court decision that may give pause to some entrepreneurs seeking to start or relocate a business in the State.
Nonresident’s Sale of Stock
Earlier this month,[xx] the Massachusetts Appeals Court[xxi] affirmed the decision of the Appellate Tax Board[xxii] in favor of the State’s Commissioner of Revenue, holding that the gain from the sale of stock by a nonresident individual was Massachusetts source income,[xxiii] which may be taxed by the State.
Before delving into the facts of this case, it may be helpful, at least for those of us who do not regularly work with the Massachusetts income tax laws (me included),[xxiv] not to lose sight of the lens through which the Appeals Court considered the issue when it framed it as follows:
“. . . whether the [Commissioner] may treat as Massachusetts source income the gain realized by [a nonresident] from the sale of stock in [the nonresident’s] former employer . . .”[xxv]
In other words, the employer-employee relationship – as opposed to that of a shareholder and the corporation in which they were invested – was going to figure prominently in the Court’s decision.
A Successful Entrepreneur
The State’s Commissioner of Revenue sought to tax a nonresident individual (“Taxpayer”) on the gain realized from Taxpayer’s sale of stock in a corporation (“Corp”) – an intangible – of which Taxpayer was a founder, and which was treated as a C corporation for tax purposes.
The Business
Corp developed and marketed software for institutional investors (the “Business”). At all relevant times, Corp was headquartered in Massachusetts and filed Massachusetts corporate tax returns apportioning 100 percent of its income to Massachusetts.[xxvi]
In 2003, Taxpayer organized the Business as a Massachusetts corporation. He was its sole stockholder, director, and officer. That corporation was voluntarily dissolved, and in 2005, another Massachusetts corporation (Corp) by the same name was organized. Taxpayer was Corp’s CEO and treasurer, while another individual (“Engineer”) was its chief technology officer, president, and secretary. These two were also Corp’s only directors.
Taxpayer and Engineer each owned 50 percent of Corp’s issued and outstanding common stock. It was not clear whether Taxpayer paid for his shares of Corp stock by way of a capital contribution[xxvii] to Corp, or whether the shares were issued to Taxpayer as compensation for organizing Corp and the Business, or for services to be provided to or on behalf of the corporation.
It Wasn’t Easy
Between 2003 and 2015, Taxpayer worked exclusively for Corp. In the early years of the Business, Taxpayer’s main focus was sales. He described himself as Corp’s “chief evangelist” in that he “created the desire for [Corp’s] product with the potential customers,” “designed what the product needed to do,” “sold it,” and “financed it.”[xxviii]
During 2003 through 2009, Taxpayer worked about eighty hours each week. However, he reported no wage income for 2003 through 2005 and reported only minimal income in 2006 and 2007. As the years passed, Taxpayer’s wages increased but he was frustrated with not being Corp’s highest paid person employee.[xxix]
According to Taxpayer, he expected Corp would eventually be worth much more than when he started the Business, and he looked forward to the payout from his hard work, “[w]henever that came.”
New Investors
In 2006 and 2007, Corp raised funding from a group of investors to whom Taxpayer promised “a handsome return” on their investment. As a result of this recapitalization, Taxpayer’s share of Corp stock was diluted to 35.9 percent.
Taxpayer worked primarily in Massachusetts; he travelled elsewhere, albeit infrequently, only to solicit funding for the Business.
In 2009, Corp reincorporated in Delaware,[xxx] then obtained funding from certain financial services firms, resulting in the dilution of Taxpayer’s share of Corp stock to approximately 13 percent.
At the same time, Taxpayer became bound by an agreement that identified him as a “[k]ey [h]older” of Corp stock and provided him with a financial incentive to remain employed by Corp; specifically, if Taxpayer left Corp’s employment under certain circumstances, Corp would have an option to purchase his shares for one cent per share.
Beginning in 2010, Taxpayer was the CEO of Corp, and focused on operations, management, and sales. All Corp personnel reported to Taxpayer, and he was involved in matters including hiring, assessing legal claims, formulating business plans, and seeking equity financing.
He continued to work exclusively from Massachusetts.
In 2013, Corp obtained funding from certain financial services firms, as a result of which Taxpayer’s share of Corp stock was diluted to 11.86 percent, where it remained until he left the Business.
I’m Outta Here
Beginning around 2014, Taxpayer’s relationship with certain Corp directors deteriorated to the point he became concerned that his “sweat equity” was in jeopardy.
By January 2015, Taxpayer was CEO in name only. He no longer had an operational role in the Business but retained the CEO title at the request of Corp’s board because he was “high profile” in the industry.
Taxpayer moved to New Hampshire on or about April 30, 2015.[xxxi]
In June 2015, Corp offered to purchase Taxpayer’s shares, contingent on all the holders of common stock agreeing to sell their shares. Taxpayer accepted the offer and, on June 26, signed a letter resigning as an officer and director of Corp,[xxxii] but he conditioned his resignation on the sale of his shares so he could retain some leverage in case the sale did not occur.
Corp then had another round of financing,[xxxiii] following which it purchased the entirety of Taxpayer’s shares.
Tax Status
From 2003 through 2014, Taxpayer had filed Massachusetts resident income tax returns.
Taxpayer moved to New Hampshire[xxxiv] on or about April 30, 2015, which was the last day of his Massachusetts residency.[xxxv]
Corp issued Taxpayer a 2015 IRS Form 1099 reporting Taxpayer had received cash proceeds of approximately $4.745 million on June 29, 2015, in exchange for the sale of his Corp shares, for which Taxpayer had no cost or other basis.
For 2015, Taxpayer filed a Massachusetts nonresident/part-year resident income tax return, on which he indicated that the amount received for his shares had been reported as capital gain on his federal income tax return. However, Taxpayer did not include this gain as Massachusetts source income.
Audit and Appellate Tax Board
After an audit of Taxpayer’s Massachusetts 2015 nonresident/part-year resident return, the Commissioner notified Taxpayer that he owed additional State income tax (including interest and penalties) of approximately $336,000, based on the gain from his sale of Corp stock. Taxpayer’s protest was denied;[xxxvi] Taxpayer appealed the denial to the Appellate Tax Board (the “Board”).[xxxvii]
The Board observed that Taxpayer’s shares of Corp stock were issued to him as a founder of the Business and noted there was no indication he had paid for the shares. The Board focused on Taxpayer’s active involvement in the Business, including the many positions in which Taxpayer had served Corp, and the many business functions for which he had been responsible. According to the Board, Taxpayer’s continued employment with Corp contributed to the corporation’s value.
Correspondingly the Board pointed out that Taxpayer “expected a payout for his years of sweat equity, which came in the form of a stock gain, a compensatory amount under the unique circumstances presented in this matter – a remuneration that derived from and was effectively connected with his [Corp] employment.”[xxxviii]
Strangely, at no point did the Board state that Taxpayer’s continued ownership of Corp stock was conditioned on his continued employment with Corp.
Moreover, following its conclusory statements that Taxpayer’s Corp stock was compensatory, the Board added that “[o]f importance is not the character and timing of the income but rather whether Massachusetts has a right to tax it based on the income’s provenance.”
The Board ruled that Taxpayer’s gain from the sale of his Corp shares was Massachusetts source income because it was effectively connected with his employment in Massachusetts.
As if to clarify its ruling, the Board distinguished Taxpayer’s situation from that of a hypothetical investor who was an employee of a C corporation that did business in Massachusetts. The investor, who worked in the corporation’s Massachusetts offices, paid an arm’s length price to purchase stock of the corporation as an ordinary investment unrelated in any way to his compensation. In that case, the gain on the investor’s sale of stock in his employer was not Massachusetts source income.[xxxix]
By contrast, Corp was “not a passive venture for [Taxpayer], but one . . . to which he made crucial contributions that added to, and were critical to, [Corp’s] value.” The stock gain, the Board continued, was of a compensatory nature that resulted from, was earned by, and was credited to or otherwise attributable to his employment; thus, it was derived from and effectively connected with Taxpayer’s employment in the State.[xl]
Taxpayer appealed to the Appeals Court.[xli]
The Court’s Analysis
The Appeals Court examined the plain language of the statute which empowered the Commissioner to tax nonresidents on their Massachusetts source income, which it defined to include:
“items of gross 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 in which the income is received.”[xlii]
The Court explained that the State Legislature sought to define the phrase “derived from or effectively connected with any trade or business” by adding the following language:
“For purposes of this section, gross income derived from or effectively connected with any trade or business, including any employment, carried on by the taxpayer in the commonwealth shall mean the income that results from, is earned by, is credited to, accumulated for or otherwise attributable to either the taxpayer’s trade or business in the commonwealth in any year or part thereof, regardless of the year in which that income is actually received by the taxpayer and regardless of the taxpayer’s residence or domicile in the year it is received. It shall include, but not be limited to, gain from the sale of a business or of an interest in a business . . .”
According to the Court, the statute “incorporates an exceedingly broad definition” of the phrase “derived from or effectively connected with any trade or business,” including the list of phrases “results from, is earned by, is credited to, accumulated for or otherwise attributable to,” and specifically enumerates sources of taxable income as including what occurred in Taxpayer’s case – “gain from the sale of . . . an interest in a business.”
The Court then turned to the regulation[xliii] promulgated under the statute, which stated:
“Income from a trade or business may include income that results from the sale of . . . an interest in a business. 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 . . . Such 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) . . .”[xliv]
The Court dismissed Taxpayer’s argument that the regulation prohibited the Commissioner from treating Taxpayer’s gain from the sale of his shares in Corp as Massachusetts source income. The Court explained that, read as a whole, the regulation made clear that the gain from the sale of stock in a C corporation may constitute Massachusetts source income if “the stock is related to the taxpayer’s compensation for services.”
Against the foregoing statutory and regulatory framework, the Court observed that Taxpayer’s case turned on whether the gain from the sale of his shares of Corp stock was “derived from or effectively connected with” his trade or business or employment,[xlv] or “related to [his] compensation for services.”[xlvi]
The Court’s Opinion
Next, the Court reviewed the Board’s statement that Taxpayer “was not a passive investor in [Corp], but a founder whose continued employment with the company – in prominent, powerful, and crucial roles – contributed to its value.” Taxpayer, the Court added, “exclusively devoted his life for more than a decade” to Corp, “to which he made crucial contributions that added to, and were critical to, the company’s value.”
The Court considered several events that, according to the Board, emphasized the connection of Taxpayer’s ownership of Corp stock to his compensation. Taxpayer acquired that stock soon after he founded Corp, dedicated himself to the success of Corp, and expected a payout for his sweat equity. In connection with the 2009 refinancing, Taxpayer became bound by an agreement that tied his status as a key holder of Corp stock to his continued employment with the company. Finally, Taxpayer made his resignation from Corp contingent on the sale of his shares.
Next, the Court rejected Taxpayer’s arguments that (i) his shares of Corp stock were not compensation for his employment because Corp had not yet conducted any business when Taxpayer acquired the stock in 2005, (ii) there was no evidence of an explicit agreement that the shares were issued as compensation, and (iii) Corp paid him a salary.
The absence of a formal designation of compensation, the Court stated, was not determinative of the issue before it. Because Taxpayer (i) obtained the stock soon after founding Corp, (ii) expected that in the future Corp would be worth a lot more than it was when he started it, and (iii) was looking forward to the payout from his hard work, there was substantial evidence to support a determination that Taxpayer’s gain from the sale of the Corp stock was derived from his employment.
Finally, the Court dismissed Taxpayer’s contention that he held the Corp shares as an investment. The Court pointed out that the example in the regulation[xlvii] on which Taxpayer based his position, involved a nonresident employee who purchased shares of stock in his Massachusetts employer corporation “as an ordinary investment unrelated in any way to his compensation.”[xlviii] That example, the Court stated, was not relevant because Taxpayer did not “purchase” his Corp shares.
In any case, the Court added, Taxpayer’s acquisition of the stock was related to his compensation.[xlix]
Court’s Conclusion
With that, the Court concluded that Taxpayer’s gain from the sale of his shares of Corp stock was “derived from and was effectively connected with” his trade or business or employment and, therefore, was taxable as Massachusetts source income.
Framework for Analysis
It remains to be seen whether Taxpayer will ask the SJC to review the decision of the Appeals Court.[l]
Setting aside that possibility for now, we should next consider the potential ramifications of the Court’s affirmance of the Board’s holding and the Commissioner’s interpretation. Before doing so, however, let’s briefly review some principles and sourcing rules generally applicable to the taxation of nonresidents, and which may be relevant to Taxpayer’s situation.[li]
Sourcing Gain
In general, nonresidents of a state are subject to the state’s personal income tax on their state-source income. This is generally defined as the sum of income, gain, loss, and deduction derived from or connected with sources within the state. For example, where a nonresident sells real property or tangible personal property located in the state, the nonresident’s gain from the sale is taxable by the state.
By contrast, the gain derived from a nonresident’s disposition of intangible personal property constitutes income derived from state sources only to the extent that the property is employed in a business carried on in-state.[lii]
Thus, for example, unless a nonresident shareholder holds the stock of a corporation for use in the nonresident’s in-state business, the gain realized by the nonresident on the sale of such stock is not treated as state-source income – the gain from the sale of the intangible is sourced outside the state.[liii]
Business Income
In general, a nonresident’s state-source income will include their income from a business carried on by the nonresident in the state.[liv] Similarly, it will include the nonresident’s share of state-sourced partnership/LLC and S corporation business income.
In addition, any income a nonresident receives that is related to a business, trade, profession, or occupation previously carried on in the state, including, but not limited to, a payment received in exchange for a covenant not to compete, is sourced in the state.
Sourcing Compensation
The compensation earned by the nonresident for services performed in the state, including as an employee of a business, is sourced to the state.[lv] If the nonresident provides services to a state-based employer during a tax year, the nonresident will generally allocate their compensation to the state based upon the number of days worked in the state as compared to their total number of days worked that year, subject to the state’s “convenience” rule, if any, for nonresident employees whose assigned or primary office is in the state.[lvi]
Compensatory Stock
When a nonresident employee receives a compensatory grant of stock in their employer corporation, and the employee’s rights in the stock are substantially vested,[lvii] the employee will include the fair market value of the stock in their federal income in the year the stock is received.[lviii]
The state-source portion of such compensation is computed by multiplying the fair market value of the stock on the date of grant by a fraction equal to the number of days worked in the state for the year the stock was received divided by the total number of days worked during such year.
In the case of restricted stock – i.e., employer stock that is awarded to an employee as compensation for their services to the employer, but in which the employee’s rights are restricted until the shares vest[lix] – the amount of compensation is equal to the fair market value of the stock at the time the stock becomes substantially vested. The amount treated as sourced in the state is determined by reference to the number of days worked in the state during the period beginning with the date the stock was received and ending with the date the stock became substantially vested.[lx]
Free-Flowing Thoughts
Now let’s consider some alternative theories that may have been applicable to Taxpayer’s situation. Let’s also take a closer look at the reasoning and implications of the Court’s decision as well as.
Accrual and Change of Domicile?
The application of the statute and regulations described above, as interpreted by the Commissioner, the Board, and the Court, caused the gain from the stock of sale – the sale of an intangible – to be sourced in Massachusetts and, therefore, subject to the State’s income tax notwithstanding that Taxpayer seemed to have successfully changed his domicile to New Hampshire prior to the sale.[lxi]
Is it possible that, prior to Taxpayer’s departure from Massachusetts, all the events occurred to fix his right to receive the gain, and could the amount thereof have been determined with reasonable accuracy?
Was there any indication that the gain from the stock sale had accrued prior to Taxpayer’s leaving Massachusetts and becoming a New Hampshire resident.[lxii] Specifically, by the time Taxpayer headed north, was there an agreement for the sale of his shares of Corp stock?
Stated differently, was the sale a foregone conclusion?
Consider the following: the first capital raise included an understanding that if Taxpayer ceased working in the Business, his shares would be acquired; Taxpayer moved to a low-tax state shortly after he ceased to have any operational role in the Business, and shortly before the sale of his Corp stock; the delay in acquiring Taxpayer’s shares was attributable to Corp’s having to raise the necessary funds; such capital raise likely included a valuation of Corp.
Character?
Taxpayer reported the gain from the sale of his Corp stock as long-term capital gain for federal tax purposes.
The Court determined that this gain was “derived from and was effectively connected with” Taxpayer’s employment with Corp in Massachusetts. However, it appears that the Court did not recharacterize the nature of the income as ordinary compensation income for purposes of the Massachusetts income tax. Instead, only the source of the nonresident’s gain was affected by virtue of its “relationship” to Taxpayer’s former employment in the State.[lxiii]
Still, the fact that Taxpayer did not acquire his shares of stock from Corp in exchange for full and adequate consideration in the form of money or other property, but instead received them in exchange for his services in organizing, and then managing and operating, Corp’s business – i.e., sweat equity – favored the Court’s conclusion that Taxpayer’s gain was attributed to his services and was not consistent with the status of an investor.
What if Taxpayer had not been a founder, and that Corp had issued restricted stock to Taxpayer? Or say he was a founder but, in connection with the admission of institutional investors (and at their insistence), Corp issued restricted shares to Taxpayer. By definition, the restricted stock would have been issued in connection with the employee’s performance of services. Assume the risk of forfeiture was tied to the successful sale of the business within, say, five years of issuance, or to an increase in Corp’s value by some targeted amount within that timeframe?
What if Taxpayer had timely elected under Section 83(b) of the Code to include in gross income the fair market value of such Corp stock? This election would have cut off the compensation element of the issued stock for tax purposes (notwithstanding the continued risk of forfeiture), started Taxpayer’s holding period for the stock, and allowed Taxpayer to treat the gain from the subsequent sale of the stock as capital gain. Would this have influenced the Court’s decision? Probably not. The Court’s and the Board’s focus was not on the character of the income per se but, rather, on the source of such income as determined by reference to the importance of the shareholder-employee’s role in the Business, as subjectively determined by the trier of fact.
Undercompensated?
One scenario with which the Massachusetts sourcing rule seems to be reasonably concerned is the following: the resident or nonresident founder of an in-State business is undercompensated by the business for their services throughout the startup and growth periods of the business; these are the periods during which the founder’s compensation would have been included in the founder’s Massachusetts gross income; the business grows into a potentially attractive target for some strategic or financial buyer; prior to selling their interest in the business – an intangible asset – the resident founder leaves the State and establishes domicile in a low tax jurisdiction; the founder subsequently sells their interest and realizes gain from the sale as a nonresident of the State; thus, the gain from the sale is sourced outside the State for purposes of its income tax.
The Court alluded to Taxpayer’s having been undercompensated relative to the value of the services he rendered to Corp. For example, the Court stated that Taxpayer did not receive any compensation during the first couple of years of the business, and little compensation in the immediately succeeding years.
Although Taxpayer’s salary increased over time, nowhere did the Court state that the aggregate compensation Corp paid to Taxpayer for all his years of service to Corp was or was not reasonable for such service.[lxiv]
Provenance
Taxpayer testified that he was not the most highly compensated employee in the business – a fact that irked him to no small degree. Still, he found solace[lxv] in the fact that, ultimately, he would realize “the payout from his hard work” on his share of the net proceeds from the sale of the business or of his interest in the business.
The Court appears to have interpreted Taxpayer’s statements as supporting the conclusion that the gain from the stock sale was tied to his employment. That does not mean the Court treated the gain as compensation – it did not recharacterize its nature for tax purposes; rather, it relied upon the “connection” between the in-State services and the gain realized on the sale to conclude that the gain was sourced in Massachusetts.
In the words of the Court, “[o]f importance is not the tax character and timing of the income” – whether ordinary compensation income or long-term capital gain – “but rather whether Massachusetts has a right to tax it based on the income’s provenance”; i.e., its origin or source.
Similarly, the Court cited the Commissioner’s regulation, which states, in part, that “[a]ll types of income, including investment income, derived from or effectively connected with the carrying on of a trade or business within Massachusetts are Massachusetts source income: ”[lxvi]
“Income from a trade or business may include income that results from the sale of a business or an interest in a business. 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. Nevertheless, gain from the . . . disposition of shares of corporate stock will be considered Massachusetts source income if it is treated as compensation for federal income tax purposes. Such gain may also 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) or if the organizational form of a business is changed in anticipation of the disposition of one or more interests therein for the purpose of avoiding Massachusetts tax. Depending on the facts and circumstances of the case, gain from the sale of such corporate stock . . . will be taxable to non-residents if it is determined that the taxpayer has engaged in a transaction or multiple transactions, the purpose of which is the avoidance of tax upon the gain (e.g. sham or step transaction, or prohibited assignment of income).”[lxvii]
Setting aside the stock that Corp issued to Taxpayer at inception – when Corp was a start-up with an idea but little capital, few (if any) non-founder service providers, and a speculative value – how likely is it that the outcome would have been different if Taxpayer had received compensation that was reasonable for the services rendered? Would that have sufficed to treat him as an investor with respect to his shares of Corp stock? Or were Taxpayer’s Corp-related activities/services such that they were inextricably tied to the value of the stock?
Doesn’t the founder’s receipt of reasonable compensation for services performed in Massachusetts eliminate the risk that part of his gain from the sale of his Corp stock is actually disguised compensation income that should have been sourced to and taxed by Massachusetts?
What if the compensation paid was less than an arm’s length rate? Would it have been appropriate to treat part of the sale consideration – an amount equal to the aggregate compensation shortfall over the years – as compensation that should have been taxed in the State? The balance of the sale proceeds may be treated as received by Taxpayer (a nonresident) in his capacity as an investor of Corp.
Then again, does it matter if the rule in question is intended only as a means for sourcing to Massachusetts some or all of the gain realized by a nonresident shareholder-employee? In that case, would the reasonableness of Taxpayer’s compensation matter? Wouldn’t the only relevant question be whether and when Taxpayer added value to Corp? Would it matter if the services of another shareholder-employee, or another non-owner employee, were more essential or critical to the success of the Business?
What if Corp’s value had increased between the time Taxpayer ceased to be CEO and the time of the redemption; for example, if Corp had delayed the redemption of Taxpayer’s shares of Corp stock? What if, instead of purchasing the shares contemporaneously with Taxpayer’s resignation as a director, officer, and employee of Corp less than two months after Taxpayer left Massachusetts, his shares were redeemed about one year later? Would it be fair to say that the change in value during that stretch was not attributable to Taxpayer’s employment? After all, how could he have earned it when he was effectively relegated to a non-participating position. Should Taxpayer have been treated as an investor as to this amount, such that it should have been excluded from his Massachusetts income? Would the post-resignation increase in Corp’s value have been treated as being other than derived from and effectively connected with Taxpayer’s in-State employment with Corp?
Earnout
Consider the sale of a business where part of the consideration is in the form of an earnout. An earnout is a form of contingent, deferred consideration that is often utilized to reconcile a difference of opinions between the buyer and the seller regarding the fair market value of the target business as of the date of the closing.
An earnout, at least in theory, is a form of contingent consideration that relates back to the date of the sale of the business; it represents the “corrected” closing date purchase price as derived from the post-closing performance of the business notwithstanding that it may be paid between, say, one to three years after completion of the sale.
Assume the founder employee-shareholder remains with the business post-closing to increase the odds of satisfying the earnout criteria. He is paid reasonable compensation by the buyer. Of course, he is no longer an owner of the target business. Should the gain attributable to the earnout be allocated to the founder’s Massachusetts sourced income?
What If?
Imagine other states decide to adopt the Massachusetts rules discussed above in order to capture more of a nonresident’s income from the sale of equity in an in-state, resident employer.
At this point, I’m content to wait for Taxpayer’s appeal to the SJC – perhaps that court will push back on the Commissioner’s interpretation.
Sign up to receive my blog at www.TaxSlaw.com.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] “States Eye Income Tax Phaseouts to Draw, Keep Residents,” by David Hood, April 11,2025. See also “Michigan Income Tax Cut Passes House, Heads to State Senate,” by David Hood, Daily Tax Report, March 20, 2025.
At the same time, these states are trying to address the resulting loss of income tax revenue, whether by levying different taxes or by reducing the size of government.
[ii] There may be something to that – witness the significant population losses experienced by California, New York and Illinois over the last few years, as compared to the gains shown by Florida and Texas.
Across the Atlantic, the U.K. is experiencing quite an exodus of wealth I response to the Labour government’s tax hikes.
[iii] See The Tax Foundation’s 2025 State Tax Competitiveness Index: https://taxfoundation.org/research/all/state/2025-state-tax-competitiveness-index/ . Note the bottom ten, beginning with Massachusetts at 41 and ending with New York at 50. (Query how the eventual introduction of Canada and/or Greenland into the Union will affect the rankings. . . Crickets.)
[iv] For example, New York. Last week, Gov. Hochul (D) signed an eighth budget extension as she continues to negotiate with the State’s veto-proof legislature (controlled by her own party). Legislators have been pushing for income tax increases for wealthy individuals and for corporations. The governor has stated that she is opposed to the first – fearful of driving folks out of the State – but may be open to the second. However, both the executive and legislative branches of the State appear amenable to an increased “payroll mobility” tax on certain employers. We’ll know soon enough.
[v] Apologies to the Commonwealth, but I will refer to it as “the State” in this post. I don’t intend any disrespect. I have loved the Commonwealth my entire life. I grew up visiting family in Southbridge, Dorchester, and Canton. I attended law school in Cambridge and lived in Somerville – it was almost painful returning to New York. Fast forward, the first place I visited with my wife outside New York was MA. Our eldest attended dental school in Boston and lived in Brookline; she married a guy from MIT. Our middle one married a BU grad, and my youngest (who hates the cold) rowed twice at The Head of the Charles.
[vi] Or the Codfish State, the Baked Bean State, the Pilgrim State, etc.
[vii] In the 1970’s, when its personal income tax was second only to New York’s.
[viii] $1,053,750 for 2025.
[ix] H. 4104, “An Act to Improve the Commonwealth’s Competitiveness, Affordability, and Equity”; enacted in late 2023.
[x] And having at least $500,000 in sales in the State.
[xi] Truth be told, most States have enacted similar rules.
[xii] This follows from the U.S. Supreme Court’s decision in Wayfair, as a result of which the economic nexus doctrine effectively supplanted the long-standing physical presence requirement for purposes of establishing sufficient nexus with a state for income tax (and sales tax) purposes. South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018).
[xiii] Of course, this rule may also benefit certain businesses that have a physical presence in the state but significant out-of-state sales. That said, today’s e-commerce-based/digital economy will continue to grow.
[xiv] Basically, S corporations, partnerships, and LLCs treated as partnerships for tax purposes.
[xv] It does this by ascribing the business activities of the passthrough to its nonresident owners for purposes of apportioning income to the State; in other words, the business conducted in the State by the passthrough entity is treated as the business of its nonresident owners. See Sections 33 and 38 of Bill H.1. https://malegislature.gov/Bills/194/H1 .
The governor’s budget was issued in January 2025. According to the Boston Herald, the Massachusetts House recently released its own budget proposal, which does not include the governor’s tax increases. “Mass. House Democrats roll out $61B state budget that ditches Gov. Healey’s tax policies,” by Chris Van Buskirk (April 16, 2025).
Think along the lines of IRC Sec. 864(c)(8)’s anti-Grecian Magnesite provision, enacted as part of the 2017 Tax Cuts and Jobs Act (“TCJA”; P.L. 115-97), which may treat the gain realized by a nonresident alien individual or foreign corporation on the sale of an interest in a partnership which is engaged in any U.S. trade or business as effectively connected with the conduct of such trade or business and, thus, taxable by the U.S.
[xvi] Sourcing is the key here, as it is in the Welch case described later in this post. A capital gain from a nonresident’s sale of an interest in a business entity, that would otherwise escape taxation by the State, is brought back within the State’s reach by connecting it to the in-State activities of the business entity.
[xvii] In VAS Holdings & Investments LLC v. Commissioner of Revenue, 489 Mass. 669 (2022), 186 N.E.3d 1240 (Mass. 2022), the States’s Supreme Judicial Court (“SJC”) determined that the Commissioner did not have the authority to tax the capital gain realized by a nonresident S corporation on the sale of its membership interest in an in-State partnership where the partnership was not engaged in a unitary business with the seller-corporation, and the corporation’s shareholders were not actively engaged in the partnership’s business or management. The Commissioner tried to allocate the gain to Massachusetts based upon the partnership’s apportionment of its business income to the State – 100%. That said, the SJC seemed to have otherwise accepted the apportionment method – the gain in question arose from the nonresident’s sale of an equity interest in an entity conducting business in the State and benefitting from the State’s laws.
[xviii] As distinguished from intangible real property. At least for purposes of IRC Sec. 1031, see Reg. Sec. 1.1031(a)-3(a)(5)’s definition, promulgated following TCJA, which limited Sec. 1031’s tax deferral to exchanges of real property.
[xix] This issue often arises in connection with the sale of equity in a business by a former resident of the state. See https://www.taxslaw.com/2023/05/can-you-be-sure-youve-left-new-york-before-the-sale-of-your-business-will-it-matter/#_ednref5 .
In general, under NY’s Tax Law, gains derived from the disposition of intangible personal property constitute income derived from NY sources only to the extent that the property is employed in a business, trade, profession, or occupation carried on in NY.
An exception is made for gain derived from the disposition of intangible personal property (say, shares of stock in a corporation) to the extent attributable to the ownership of any interest in real property located in NY.
For purposes of this rule, the term “real property located in” NY was defined to include an interest in a partnership, LLC, S corporation, or non-publicly traded C corporation with one hundred or fewer shareholders, that owns real property located in NY and has a fair market value (“FMV”) that equals or exceeds 50% of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity.
The gain derived from NY sources from a nonresident’s disposition of an interest in an entity that is subject to this rule is the total gain for federal income tax purposes from that disposition multiplied by a fraction, the numerator of which is the FMV of the real property located in NY on the date of the disposition and the denominator of which is the FMV of all the assets of the entity on such date.
[xx] A couple of weeks shy of the 250th anniversary of the Battles of Lexington and Concord (April 19). Always reminds me of the song, “Momma , Look Sharp” (from the musical, 1776), which refers to that day.
The phrase, “The shot heard round the world,” from Emerson’s “Concord Hymn,” refers to these battles.
[xxi] The Appeals Court is the State’s intermediate appellate court. It is a court of general appellate jurisdiction.
[xxii] A quasi-judicial agency that hears taxpayer appeals from decisions by State taxing authorities regarding income tax and other State tax matters.
[xxiii] It should be noted that Massachusetts taxes long-term capital gain at the same 5% tax rate as applies to ordinary income. (Short-term capital gains are taxed at 8.5%.)
[xxiv] Title XI, Chapters 62 and 63.
[xxv] Emphasis added.
[xxvi] Another reminder of investee apportionment?
[xxvii] Whether of money or other property.
[xxviii] According to the Appellate Tax Board, Taxpayer failed to establish the amount of his personal financial contribution.
[xxix] As we’ll see, Taxpayer’s testimony supported the State’s assertions.
[xxx] By merger into a Delaware corporation of the same name – an F Reorg described in IRC Sec. 368(a)(1)(F) and Reg. Sec. 1.368-2(m).
[xxxi] I don’t know the town to which Taxpayer moved, but I can tell you Nashua is only about 45 miles, and Manchester about 50 miles, respectively from Boston, MA. There are plenty of commuters.
[xxxii] As Taxpayer put it, he was “forced to voluntarily resign.”
[xxxiii] Its fifth: 2006, 2007, 2009, 2013, and 2015. Is it safe to say the Business was capital intensive?
[xxxiv] New Hampshire has a flat 3.0% individual income tax rate, which is levied only on interest and dividend income. It does not have a sales tax. It does not have an estate tax. Massachusetts has all the above.
[xxxv] The State did not argue that Taxpayer remained domiciled in Massachusetts. I’m certain New York would have acted differently.
[xxxvi] Actually, it was deemed denied after months of inaction.
[xxxvii] Welch v. Comm’r, Commonwealth of Massachusetts Appellate Tax Board, Administrative Decision No. C339531.https://www.mass.gov/doc/welch-craig-natalia-v-commissioner-of-revenue-november-29-2023/download.
[xxxviii] Emphasis added.
Mind you, Taxpayer reported the gain from the sale as long-term capital gain on his federal return. Neither the Board nor the Court criticized Taxpayer’s treatment of the gain on his federal return.
[xxxix] Query, whether the Board’s conclusion would change if the employee was an officer, or was in charge of a division of Corp’s business? What if his annual bonus was determined by reference to Corp’s profits or to an increase in its value?
[xl] The Board added: that “items of income that are essentially passive in nature and unrelated to an individual’s employment by or active participation in the entity that was the source of the income” are excluded from Massachusetts source income.
[xli] Welch v. Comm’r, Appeals Court, No. 24-P-109; https://www.mass.gov/files/documents/2025/04/03/l24P0109.pdf.
[xlii] G. L. c. 62, § 5A (a).
[xliii] 830 Code Mass. Regs. § 62.5A.1(3)(c)(8).
[xliv] The State did not argue that the gain should be treated as compensation for federal income tax purposes.
[xlv] G. L. c. 62, § 5A (a).
[xlvi] 830 Code Mass. Regs. § 62.5A.1(3)(c)(8).
[xlvii] Example (3)(c)(8.4).
[xlviii] The example concluded that gain from the sale of that stock would not be treated as Massachusetts source income.
[xlix] Taxpayer also argued that the gain from the sale of his Corp shares was not “derived from or effectively connected with” his trade or business or employment within the meaning of the statute.
According to Taxpayer, it was Corp that conducted the trade or business of developing and marketing the software, not him personally.
The Court rejected this assertion, noting that the gain would have been taxable if it had derived from Taxpayer’s trade or business of working for Corp.
[l] I have to be believe that he will.
[li] Other deferred compensation principles are likely not relevant tom Taxpayer’s case, but are described here for “completeness” (as if possible):
Nonqualified Retirement Compensation
Under Federal law (the “Pension Source Law”), no state may impose an income tax on any retirement income of an individual who is not a resident or domiciliary of such state. 4 USC Sec. 114.
In general, the term “retirement income” means any income from qualified plans. However, it also includes income from any nonqualified plan if such income (i) is part of a series of substantially equal periodic payments, made not less frequently than annually, made for the life or life expectancy of the recipient, or for the joint lives or joint life expectancies of the recipient and the designated beneficiary of the recipient, or for a period of not less than 10 years, or (ii) is a payment received after termination of employment and under a plan, program, or arrangement (to which such employment relates) maintained solely for the purpose of providing retirement benefits for employees in excess of the limitations on contributions or benefits imposed by the Code with respect to qualified plans.
Nonqualified Deferred Compensation
Any nonqualified deferred compensation payable to a nonresident of a state, and that is not treated as retirement income under the Pension Source Law, may be taxed by the state to the extent allocable to services performed in the state.
State-source income includes income that is related to a business previously carried on in the state, including that of an employee. This income includes nonqualified deferred compensation (including all appreciation and earnings related to such deferrals) that is required to be included in federal adjusted gross income in a tax year if such compensation is related to a business, trade, profession, or occupation previously carried on in the state, whether or not as an employee.
The amount of such nonqualified deferred compensation that must be included in a nonresident’s state-source income is determined as follows: (i) if the business was carried on wholly in the state in the tax year the services were performed, the entire amount of nonqualified deferred compensation must be included in state-source income; (ii) if the business was carried on wholly outside the state in the tax year the services were performed, none of the nonqualified deferred compensation is included in state-source source income; and (iii) if the business was carried on partly in and partly outside the state during the tax year the services were performed, the amount of nonqualified deferred compensation to be included in state-source income is determined using the rules for allocating the compensation of a nonresident employee.
Severance/Termination
Income from state sources includes income received by a nonresident that is related to an occupation previously carried on within the state. This income includes, but is not limited to, income related to termination agreements. Assuming this income is related to past employment , the amount of income related to such past employment in the state is determined by multiplying the amount of such income includable in the former employee’s federal adjusted gross income by a fraction based upon the amount of income treated as state-source employment income during the termination year and a specified number of preceding years relative to total employment income during such period.
[lii] The gain from the sale of such intangible property is treated as income received from carrying on a business in the state; for example, the goodwill associated with the business, which is realized on a sale (or deemed sale, as pursuant to IRC Sec. 338(h)(10)) of the assets of the business.
[liii] In some cases, however, “real property located in” the state is defined to include an interest in a closely held business entity that owns real property located in the state and has a fair market value equal to at least 50 percent of all the assets of the entity on the date of the sale or exchange of the taxpayer’s interest in the entity (subject to “anti-stuffing” rules).
[liv] Which may require apportionment between the state and other taxing jurisdictions in which the business is conducted.
[lv] This includes bonuses paid in the year following the year in which the services were rendered.
[lvi] The convenience of the employer rule will source compensation to the state in which the employer is located, regardless of where the employee is located when the services are performed. Massachusetts’s convenience rule was the subject of a suit brought by New Hampshire in 2021 against Massachusetts in the U.S. Supreme Court. The Court refused to exercise its original jurisdiction under the Constitution to hear and resolve the conflict between the two states. https://www.supremecourt.gov/docket/docketfiles/html/public/22o154.html. Justices Thomas and Alito would have granted the motion. Four of the nine Justices must vote to accept a case.
[lvii] They are transferable and not subject to substantial risk of forfeiture; in other words, the employee’s rights in the stock are not conditioned upon the future performance of substantial services, or upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial. Treas. Reg. Sec. 1.83-3(c).
The same result follows when the employee timely elects to include the fair market value of the stock in income for the year the stock is received. IRC Sec. 83(b); Treas. Reg. Sec. 1.83-2.
[lviii] Although not relevant to Taxpayer’s case, when a nonresident employee exercises a nonqualified stock option, and the stock acquired is vested, the excess of the fair market value of the stock on the exercise date over the exercise price is treated as compensation that will be allocated to the state based on the relative days worked within and without the state from the grant date to the exercise date. That said, it should be noted that appreciation in the value of the stock after the exercise date, that is realized on the later sale of such stock, generally represents investment income, which is not taxable by the state.
[lix] I.e., when the shares become transferable or are no longer subject to a substantial risk of forfeiture. IRC Sec. 83.
[lx] Assuming the nonresident’s services were not terminated sooner, and the stock was not sold prior to the vesting date. The allocation period may span two or more years.
[lxi] There was no indication that the State had challenged Taxpayer’s assertion of having abandoned his Massachusetts domicile and having established a new domicile in the Granite State.
Indeed, footnote 4 of the Appeals Court’s Opinion notes that “The commissioner does not argue that when [Taxpayer] sold his [Corp] shares on June 29, 2015, his domicile was Massachusetts, and so we do not consider that issue.”
[lxii] Taxpayer left MA on April 30; in June, Corp offered to redeem his shares; the sale was contingent on all the common stockholders agreeing to sell their shares of Corp stock; the sale closed June 29.
[lxiii] Though some of the Board’s statements could lead one into thinking that Massachusetts was going to tax as ordinary income the same gain that the federal government was going to treat as long-term capital gain. Think on that a bit.
[lxiv] The “catch-up” payments would be tested on this holistic basis.
[lxv] My words. Literary license.
[lxvi] 830 CMR 62.5A.1(1)((a). The regulation continues, “The term may include gain from the sale of a business or of an interest in a business, distributive share income, separation, sick or vacation pay, deferred compensation and nonqualified pension income not prevented from state taxation by the laws of the United States, and income from a covenant not to compete.”
[lxvii] 830 CMR 62.5A.1(3)(c)8.