🔒Mass. tax ruling creates new risk for founders who move out of state

The recent Massachusetts Appeals Court ruling in Welch v. Commissioner of Revenue has sent shockwaves through the entrepreneurial community, potentially changing how founders think about their exit strategies. This landmark case creates significant tax implications for business founders who build companies in Massachusetts and later relocate to another state before selling their shares.

The case that's changing the game

Craig Welch, a founder of AcadiaSoft, moved from Massachusetts to New Hampshire before selling his shares in the company. Despite being a non-resident at the time of the sale, the Massachusetts Appeals Court upheld that Welch was liable for Massachusetts income tax on the capital gains from selling his stock, determining that the gain was derived from or effectively connected with his previous employment and business activities in Massachusetts.

The court's decision hinged on interpreting Welch's stock not as a passive investment but rather as a form of deferred compensation or reward for services performed in Massachusetts. The Appeals Court and Appellate Tax Board emphasized Welch's deep involvement in building AcadiaSoft, his expectation of a future payout for his sweat equity, and contractual provisions tying stock ownership to continued employment.

Why this ruling matters to entrepreneurs

This decision represents a significant departure from how most states treat the sale of corporate stock by former residents. Legal commentators have described it as a bombshell and a new direction for Massachusetts, warning that the state is now an outlier in taxing nonresidents on gains from selling stock in a corporation when the stock is connected to prior in-state employment.

For founders and executives, particularly those in Massachusetts' vibrant tech and biotech sectors, this ruling creates a complex new tax planning challenge. Moving to a lower-tax state like New Hampshire or Florida, a common strategy for entrepreneurs approaching a liquidity event, may no longer provide the expected tax benefits if Massachusetts can claim the stock gains are effectively connected to previous work performed in the state.

The legal reasoning behind the decision

The court's rationale focused on several key factors in Welch's case:

1. He acquired his stock soon after founding AcadiaSoft and worked exclusively for the company for over a decade
2. He expected a future payout for his sweat equity in the business
3. His stock ownership was tied to his continued employment through contractual provisions
4. He was deeply involved in building the company's value

The court distinguished Welch's situation from cases where stock is acquired purely as an investment, noting that Welch did not purchase his shares as an ordinary investor but received them in connection with his role as founder and executive.

Broader implications for business formation

The ruling signals a significant shift in how states may attempt to tax income with substantial ties to their jurisdiction, even after the taxpayer has left the state. This is especially relevant as more high-net-worth individuals and business owners consider changing residency to avoid state income taxes.
The case is being closely watched as it may influence tax policy and enforcement in other states, particularly those with significant numbers of company founders and executives.

Critical commentary and concerns

Critics argue that the decision blurs the line between a founder's investment and compensation and fails to fully respect the Department of Revenue's own regulation, which generally excludes capital gains from stock sales from Massachusetts source income unless directly tied to compensation for services.

There is growing concern that this precedent could deter entrepreneurs and executives from founding or building companies in Massachusetts, knowing that the state may seek to tax future stock sale proceeds even after they relocate. Some legal professionals warn that this could stymie innovation and discourage business formation in the state.

Potential estate tax complications

The Welch decision also raises questions about potential double taxation in certain scenarios. For instance, if a stockholder dies while a non-resident of Massachusetts, and a buy-sell agreement triggers the sale of stock upon death, there's a risk that Massachusetts could attempt to impose both income tax and estate tax on the same stock proceeds.

Since the Welch decision established that stock gains can be Massachusetts source income if effectively connected with Massachusetts business activities, the state could potentially argue that:

1. The gain from the sale should be subject to Massachusetts income tax under the Welch precedent
2. The value of the stock could simultaneously be included in the Massachusetts taxable estate

This creates an uncertain and potentially burdensome tax situation for founders and their estates. Estate planning professionals working with Massachusetts business founders should carefully consider these implications and develop strategies to minimize exposure to potential double taxation through thoughtful structuring of buy-sell agreements and comprehensive exit planning.

Recommended actions for VC and PE funders

Venture capital and private equity firms with Massachusetts portfolio companies should consider several strategies to protect founders from similar tax outcomes:

Structure equity differently. Consider structuring founder equity in ways that more clearly distinguish it from compensation for services, such as documenting that a founder purchased their shares as investments rather than receiving them as compensation, having a founder pay meaningful consideration for their equity to establish investment intent, and creating clear separation between equity ownership and employment agreements.

Review of operating agreements and employment contracts. Remove or modify clauses that tie stock ownership to continued employment, avoid provisions that will force founders to sell shares back to the company at minimal value if they leave employment, and separate founder equity agreements from employment agreements where possible.

Consider alternative corporate structures. Explore using holding companies outside Massachusetts to own the intellectual property, evaluate whether alternative entity structures (LLCs, partnerships) might provide different tax treatment, and consider domiciling new portfolio companies in more tax-friendly jurisdictions while maintaining operations in Massachusetts.

Modify investment agreement terms. Include tax gross-up provisions in acquisition agreements to protect founders from unexpected state tax liabilities, consider indemnification clauses related to state tax claims in investment agreements, and require portfolio companies to obtain tax opinions on founder stock sales as part of exit planning.

Encourage proactive founder planning. Advise founders to establish clear documentation on the investment nature of their stock, recommend establishing domicile changes well in advance of anticipated exits, and suggest creating clear separation between ending employment and selling shares.

Tax planning strategies post-Welch

For entrepreneurs and executives currently building businesses in Massachusetts, this ruling necessitates new approaches to tax planning:

• Timing considerations: The timing of relocation relative to stock acquisition, vesting, and sale becomes even more critical
• Stock structure analysis: How and when founders receive equity may impact future tax treatment
• Documentation practices: Clear documentation of whether stock is compensation or investment becomes increasingly important
• Multi-state tax planning: Comprehensive planning that accounts for potential taxation in multiple states is now essential
• Estate planning integration: Tax mitigation strategies must now coordinate both income and estate tax considerations

The bottom line

The Welch decision represents a significant shift in tax policy that founders and executives need to carefully consider in their business and personal planning. As other states watch this precedent, entrepreneurs nationwide would be wise to consult with tax professionals who understand the nuances of multi-state taxation before making significant decisions about residency changes prior to liquidity events.

While tax considerations shouldn't drive all business decisions, this case highlights the importance of including sophisticated tax planning in your overall exit strategy—ideally years before an anticipated sale or transaction.