A critical question for tax practitioners advising nonresident clients arises when those clients sell stock in a Massachusetts-based entity they were involved with, particularly if they were also employees. The Massachusetts Appeals Court recently affirmed the Appellate Tax Board’s decision in Craig H. & Natalia I. Welch v. Commissioner of Revenue, concluding that the gain from a founder’s sale of stock in his former employer was Massachusetts source income. The appellants, Craig H. & Natalia I. Welch, are seeking further appellate review from the Supreme Judicial Court of Massachusetts. This case presents a significant issue of first impression impacting countless Massachusetts entrepreneurs and key employees.

This article examines the facts, the appellant’s request for relief, the relevant legal framework, and the appellant’s arguments regarding the application of the law, drawing directly from the appellants’ application for further appellate review and the Appeals Court opinion.

Factual Background

The case centers on Craig H. Welch ("Mr. Welch"), an entrepreneur who founded AcadiaSoft, Inc. ("AcadiaSoft"), a business focused on derivative and collateral management solutions. AcadiaSoft was initially formed in Massachusetts in 2003, dissolved, and reincorporated in Massachusetts in 2005. In return for his contributions to the business, Mr. Welch received shares of stock and became a 50/50 owner with co-founder Mr. Danny Moyse in 2005. Mr. Welch served in various roles, including CEO and Treasurer, directing efforts primarily at sales and marketing. The business was run from their homes in Massachusetts. AcadiaSoft initially elected to be treated as a subchapter S corporation for federal and Massachusetts tax purposes.

Over the following years, AcadiaSoft received multiple rounds of investment from angel investors and financial services firms, resulting in recapitalizations and the dilution of Mr. Welch’s ownership percentage. In 2009, AcadiaSoft reincorporated in Delaware and elected C corporation status for federal and state tax purposes. Mr. Welch remained involved in prominent roles, though his operational role was reduced by 2014.

Mr. Welch did not have a formal employment agreement but received wage income from AcadiaSoft for his services from 2006 through 2015. This wage income significantly increased over the years, totaling over $2 million from 2009 to 2015. Mr. Welch reported and paid Massachusetts personal income tax on this wage income. Mr. Welch received his initial 750 shares in 2005 and was not issued any additional shares, stock options, or stock awards during his time with the company. He held this same stock until he sold it in 2015.

Mr. Welch, a Massachusetts resident from 2003 through 2014, moved to New Hampshire on or about April 30, 2015. On June 29, 2015, while a resident of New Hampshire, Mr. Welch sold his AcadiaSoft stock back to the company as part of a recapitalization. He reported the gain from this sale as long-term capital gain for federal income tax purposes. On their 2015 Massachusetts Part-Year Resident Income Tax Return, the Welches reported the gain as not taxable in Massachusetts because they were New Hampshire residents at the time of the sale.

Following an audit, the Commissioner of Revenue ("Commissioner") assessed a tax liability of $335,968.62 against the Welches, taking the position that the gain from the stock sale was income taxable in Massachusetts. The Commissioner argued the gain was effectively connected to Mr. Welch’s trade or business as an employee of AcadiaSoft. The Welches appealed to the Appellate Tax Board ("Board"), which upheld the assessment, concluding the gain "was of a compensatory nature" tied to his employment. The Appeals Court affirmed the Board’s decision, concluding the gain was income effectively connected with Mr. Welch’s trade or business of working for AcadiaSoft, though the court stated it was limiting the scope of its decision to the unique facts of this case.

Appellant’s Request for Relief

The appellants respectfully request that the Supreme Judicial Court grant further appellate review of the Appeals Court decision. The core issue presented is whether the gain from the sale of Mr. Welch’s AcadiaSoft stock constitutes compensation for services performed in Massachusetts subject to personal income tax under G.L. c. 62, § 5A, or is capital gain income from his investment in AcadiaSoft stock allocable to his state of residence at the time of sale (New Hampshire).

The appellants emphasize the importance of this issue, stating it impacts countless Massachusetts entrepreneurs and key employees and the jobs they create. They argue that allowing the Appeals Court decision to stand would represent a significant change in how Massachusetts has historically taxed such transactions and would negatively impact entrepreneurial ventures and their economic benefits in the Commonwealth.

Legal Framework and Analysis

The taxation of a nonresident’s income in Massachusetts is governed by G.L. c. 62, § 5A. Applicable to the period at issue, the statute states that gross income from sources within the Commonwealth includes items "derived from or effectively connected with: (1) 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".

The phrase "gross income derived from or effectively connected with any trade or business" is further defined in § 5A as 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". The statute explicitly states this includes, but is not limited to, "gain from the sale of a business or of an interest in a business".

The Appeals Court noted that the 2003 amendment to § 5A added the language clarifying that taxability is not dependent on the nonresident being actively engaged in the Commonwealth in the year the income is received, nor on the taxpayer’s residency or domicile in the year of receipt. This amendment, according to the Supreme Judicial Court in VAS Holdings & Investments, LLC v. Commissioner, 489 Mass. 669, 688 fn. 23 (2022), addressed only the questions of timing of receipt and residency at the time of receipt.

The Board and the Appeals Court interpreted the statutory definition of "derived from or effectively connected with any trade or business" as "exceedingly broad".

The relevant administrative rule, 830 CMR 62.5A.1(3)(c)(8), explains when income from the sale of a business interest by a nonresident is considered taxable under § 5A. The rule generally considers income from the sale of interests in entities like sole proprietorships or partnerships as taxable under § 5A. However, the rule specifically states that income from the "sale of shares of stock in a C or S corporation" is generally not subject to tax in Massachusetts "to the extent that the income from such gain is characterized for federal income tax purposes as capital gains". As noted, it is undisputed that Mr. Welch reported the gain as capital gain for federal purposes.

The rule contains a crucial qualification: 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)". The Appeals Court focused on the word "generally" qualifying the exclusion for C or S corporation stock gain, concluding that the rule allows for the taxation of such gain if "the stock is related to the taxpayer’s compensation for services".

The Appeals Court relied on the Board’s conclusion that Mr. Welch was "not a passive investor" but a founder whose "continued employment" and "crucial contributions" in prominent roles added critical value to the company. The Appeals Court cited specific events linking Welch’s stock ownership to compensation: he acquired the stock soon after founding AcadiaSoft, expected a payout for his "sweat equity," was bound by a 2009 agreement tying his "key holder" status to continued employment, and made his resignation contingent on the stock sale. Based on these facts, the Appeals Court concluded the gain was "derived from" his employment.

Appellant’s Arguments and Suggested Conclusions

The appellants present several arguments challenging the Appeals Court’s decision and advocating for reversal by the Supreme Judicial Court:

Separateness of Entity and Shareholder Trade or Business: The appellants contend that Massachusetts caselaw clearly establishes that the trade or business of a C or S corporation is separate and distinct from the trade or business of its shareholders for purposes of G.L. c. 62, § 5A. They cite:
- Commissioner of Revenue v. Dupee, 423 Mass. 617 (1996): Held that § 5A requires the nonresident taxpayer to personally conduct the Massachusetts business giving rise to the income.
- Commissioner of Revenue v. Oliver, 436 Mass. 467 (2002): Reaffirmed that the taxpayer must "personally conduct the Massachusetts business giving rise to the income". The Appeals Court found Oliver inapposite due to the 2003 amendment.
- VAS Holdings & Investments, LLC v. Commissioner, 489 Mass. 669 (2022): Instructed that the activities of an LLC could not be attributed to nonresident owners under § 5A and rejected the Commissioner’s argument that the 2003 amendments altered Dupee and Oliver, stating the amendments only addressed timing and residency at receipt.
- The appellants argue that based on these holdings, the trade or business of AcadiaSoft is not imputed to Mr. Welch, and the only trade or business he conducted was that of an employee.
Stock Acquisition Not Attributable to Employment Services: The appellants argue that Mr. Welch’s stock was not "attributable to" the employment services he provided. They assert he received the stock in 2005 for his many contributions to the formation of the entity and as a legal consequence of forming AcadiaSoft as a Massachusetts S corporation. They state there is no evidence the stock was received in return for employment services in 2005 or any future year. The stock sold was the same stock received at formation; he never received additional stock or options as compensation.
Adequate Compensation for Employment: The appellants emphasize that Mr. Welch was handsomely compensated for his employment services through wage income from 2006 through 2015, reporting and paying Massachusetts personal income tax on this income. They argue the Appeals Court ignored or failed to mention his significant wage compensation, particularly from 2009-2015. The Commissioner’s position that the entire stock gain is also wage income taxable under § 5A disregards that Mr. Welch was already taxed on his wages.
Commissioner’s Regulation Supports Appellant’s Position: The appellants assert that the Commissioner’s own administrative rule, 830 CMR 62.5A.1(3)(c)(8), supports their position by generally excluding gain from the sale of C or S corporation stock from § 5A taxation. This rule, they argue, is consistent with Dupee, Oliver, and VAS Holdings and acknowledges that a nonresident can be both an employee and a shareholder and still receive capital gain treatment on a stock sale.
Applicability of Regulatory Example: The appellants highlight example (3)(c)(8.4) in 830 CMR 62.5A.1, which describes an out-of-state employee of a Massachusetts C corporation who "purchases stock" as an "ordinary investment unrelated in any way to his compensation," and where the gain is not Massachusetts source income. The appellants argue the facts of this example are substantively identical to their case. They challenge the Appeals Court’s dismissal of this example, arguing that acquiring shares for financial and other contributions leading to formation is akin to a "purchase". They also argue the Appeals Court erred by assuming the stock acquisition was related to compensation, which is the very issue the rule intends to clarify.
Strict Construction of Tax Laws: The appellants invoke the principle that tax laws are to be strictly construed, and any doubts resolved in favor of the taxpayer, citing Cabot v. Commissioner of Corps. & Taxation, 267 Mass. 338, 340 (1929). They argue that the Commissioner is bound by the clear language of 830 CMR 62.5A.1, or if ambiguous, doubts should favor the taxpayer.

Conclusion (Appellant’s View)

The appellants urge the Supreme Judicial Court to grant further appellate review and conclude that the gain from Mr. Welch’s sale of AcadiaSoft stock should be treated as capital gain from an investment, not compensation for services taxable under G.L. c. 62, § 5A. They argue that the Appeals Court’s decision erroneously blurs the distinction between the entity and the shareholder, which is inconsistent with Massachusetts caselaw and the Commissioner’s own regulation. They contend their situation fits within the general rule and the regulatory example that gain from the sale of C corporation stock held for investment is not Massachusetts source income for a nonresident, particularly given that Mr. Welch was separately compensated for his employment services. They characterize the Appeals Court decision as an expansive and dangerous interpretation of § 5A that would negatively impact entrepreneurship in the Commonwealth.

Prepared with assistance from NotebookLM.