In an April 2025 decision, the Massachusetts Court of Appeals extended the commonwealth’s taxation of nonresident capital gains in a novel––and arguably aggressive––way. The ruling underscores the need for businesses to carefully evaluate how state income tax sourcing rules apply to equity sales. While the outcome may have surprised some under Massachusetts law, there is at least one other state that might attempt to impose tax under similar facts, although on different legal grounds: Ohio.
Welch v. Commissioner
The court in Welch v. Commissioner, No. 24-P-109, 105 Mass. App. Ct. 391 (Apr. 3, 2025), held that Massachusetts could tax a nonresident individual’s capital gain on his sale of stock in the company that he founded. The taxpayer sold the original corporate stock that he received upon the formation of the company. The court treated the resulting capital gain as “compensation” connected with a Massachusetts trade or business and allowed the tax to stand.
Facts
Craig Welch founded AcadiaSoft, Inc., a Massachusetts corporation, in 2003 while living in Massachusetts. Welch was the sole shareholder at the outset and worked full-time for AcadiaSoft from 2003 to 2015, serving in various roles such as CEO, president, and treasurer. The company was headquartered in Massachusetts and primarily conducted business in the commonwealth.[1]
Welch’s ownership stake declined over time due to a 2005 reorganization and multiple rounds of outside investment. By the time he ultimately sold his shares, Welch owned under 12% of AcadiaSoft stock. By January 2015, Welch no longer had a significant operational role at the company. In April 2015, he and his wife moved to New Hampshire and ended their Massachusetts residency.[2]
Two months later, in June, AcadiaSoft offered to buy back Welch’s shares, and Welch agreed. He reported a $4.7 million dollar capital gain on the sale for federal income tax purposes. However, he did not report the gain as taxable in Massachusetts, citing his nonresident status at the time of sale. The Massachusetts Department of Revenue determined that the gain was taxable in the commonwealth and assessed over $300,000 in tax. The Appellate Tax Board agreed, and Welch sought review in the Court of Appeals.[3]
Law
In Massachusetts, nonresidents are subject to tax on income connected with a trade or business, including employment, carried on in the commonwealth.[4] This includes income from the “sale of a business or of an interest in a business” in certain cases.[5] While regulations provide that “the sale of shares of stock in a C or S corporation” is generally not connected to a trade or business, they do recognize an exception for “case[s] where the stock is related to the taxpayer’s compensation for services.”[6]
Application
The court reasoned that, if Welch’s stock was related to his compensation for services performed in Massachusetts for AcadiaSoft, then his capital gain from selling the shares was taxable as income derived from a Massachusetts trade or business.[7] To analyze this, the court focused on the way Welch “dedicated himself to the success of AcadiaSoft” and “expected a payout for his sweat equity.”[8] It also pointed to a 2009 investment agreement that gave AcadiaSoft the right to purchase back Welch’s shares at a deep discount if he left the company within 18 months after an outside investor’s capital infusion. Additionally, the Court noted that Welch’s agreement to resign from the company was contingent upon the company repurchasing his shares. On this basis, the court determined that the stock was related to Welch’s compensation and, therefore, connected with a Massachusetts trade or business.[9]
While it is likely true that Welch’s employment at AcadiaSoft increased the value of the company’s stock, one might wonder how any of this evidence proves Welch received the stock as compensation for services. Welch received his shares when he formed AcadiaSoft and before it conducted any business. Further, there was no evidence that the compensation he did receive while employed at the company was not reasonable.
Welch argued that his stock ownership was more properly characterized as an investment, which had not been contingent on his employment. He pointed out that an employee of a Massachusetts corporation who purchases his employer’s stock would not be treated as having Massachusetts-sourced “compensation” if he sells the stock and recognizes gain.[10] The court, however, dismissed this analogy since Welch did not “purchase” his AcadiaSoft stock.[11]
Accordingly, the court upheld the tax. Welch may apply for further appellate review in the Massachusetts Supreme Judicial Court.
Beyond Massachusetts: Considering the Facts of Welch under Ohio Law
Whether or not Welch correctly applied Massachusetts law, at least one other state, Ohio, would likely have attempted to tax Welch’s capital gain under similar facts. But Ohio would probably rely on a different legal rationale. In contrast to Massachusetts, Ohio has specific statutes addressing similar fact patterns.[12]
In Ohio, individuals are generally not taxed on their sale of intangible property, including stock or other equity interests in a business, unless they are domiciled in Ohio at the time of sale.[13] However, a nonresident’s gain may become taxable in Ohio if it qualifies as “business income” or if it falls within the terms of another statute, O.R.C. § 5747.212.[14] Business income can include the sale of an ownership interest in a business in certain cases.[15]
Most relevant here, a sale of an ownership interest can constitute Ohio business income if the seller “materially participated” in the business’s activities during the year of sale or any of the five previous tax years.[16] Ohio defines material participation by reference to the temporary federal tax regulations contained in Treas. Reg. § 1.469-5T, which are part of the federal rules limiting passive activity losses (PALs).[17] The federal regulations list seven ways a taxpayer can materially participate in a business. These include various bright-line tests, such as over 500 hours of participation in the activity during the year, as well as a more flexible test based on “regular, continuous, and substantial” participation in the business.[18]
Due to his full-time employment at AcadiaSoft, Welch likely would have satisfied the material-participation test. Thus, if his case had instead taken place in Ohio, he might have been required to apportion capital gain to Ohio as taxable business income, notwithstanding his move to New Hampshire.
What About the Constitution?
Additionally, in some cases, constitutional challenges have prevented Ohio’s attempts to tax “business income” of nonresidents. However, those have, so far, been limited to circumstances, such as those in Corrigan v. Testa, where a nonresident was simply a passive investor in an Ohio entity rather than a “unitary” participant in the business.[19] That is a far cry from the facts of Welch.
In Corrigan, the Ohio Supreme Court drew a distinction between the state’s ability to tax a nonresident equityholder’s distributive share of a pass-through entity’s income and its ability to tax the same equityholder’s capital gain upon sale of his ownership interest.[20] The Court in Corrigan did not address the issue of whether the gain was “compensation” earned in Ohio, but it likely would have rejected that argument for the same reasons that it refused to analogize to the distributive share concept. The out-of-state equityholder was a passive investor. Although he did participate in a “stewardship” role akin to a corporate director, he was not a founder or officer of the Ohio company and not otherwise involved in its day-to-day business.[21] The Court held that it was unconstitutional for Ohio to tax a passive, nonresident investor on the gain from the equity sale under the facts of Corrigan.[22]
After Corrigan was decided, the Ohio General Assembly changed the law by enacting the “material participation” statute described above. Corrigan had, in fact, been a material participant in the business at issue for federal purposes.[23] He met the federal standard because, even though his involvement with the entity at issue was limited, the federal rules allow a taxpayer to establish material participation through involvement in a collection of smaller “significant” activities that are carried on separately by multiple entities.[24]
Ohio cannot grant itself constitutional authority to tax a nonresident like Corrigan by simply adding the material participation language into statute. After all, the Court recognized that Corrigan was a material participant, not subject to federal PAL limitations, yet still found the tax to violate due process as applied to him. Uncertainty remains as to when Ohio’s “material participation” standard would be constitutional as applied to nonresidents in other cases.
For example, the taxpayer in Welch had less than a 15% interest in AcadiaSoft for over 5 years.[25] The Ohio law at issue in Corrigan, which is still the law, only applied to ownership interests above 20%. But the “material participation” law sets no ownership threshold. Further, Welch had become “CEO in name only” by January 2015.[26] However, because Welch was previously involved in AcadiaSoft’s business for over a decade while working in the taxing state, he would be less likely to qualify for constitutional protection than the taxpayer in Corrigan. Indeed, Welch raised no constitutional arguments. It is unclear how the Ohio Supreme Court would conduct the constitutional analysis in light of his nonresident status and low level of equity ownership in C corporation stock, on the one hand, and his high level of historical in-state activity, on the other.
What about a taxpayer who only owned 1% of a C corporation’s stock? What about an employee who “purchased” an interest in an Ohio company while working in Ohio and, years later, sold the stock after establishing residency outside the state? The constitutional limits on Ohio’s “material participation” rule for taxing nonresident “business income” remain murky.
For discussion of another Ohio nonresident who raised constitutional arguments against the taxation of business income, click here. And for analysis of the unitary business principle’s role in the constitutional inquiry, as applied in Ohio and in other states, click here and here.
ZHF Insights
The decision in Welch serves as an important reminder for businesses to scrutinize how state taxes might apply to nonresidents, regardless of whether the state has adopted legislation that is directly on point. This requires a detailed understanding of state law, as well as the constitutional limitations that may protect certain nonresidents from taxation. Careful planning of a business’s ownership structure, compensation arrangements, and operations can help to minimize the risk of unexpected results.
* * *
If you have questions about Welch, state taxation of nonresidents, or other state and local tax issues, please contact Tommy Zaino, Deb McGraw, or one of our other ZHF professionals for further information.
[1] 105 Mass. App. Ct. at 392–93.
[2] Id. at 393–94.
[3] Id. at 394–95.
[4] See M.G.L. c. 62, § 5A(a).
[5] Id.
[6] See 830 Code Mass. Regs. § 62.5A.1(3)(c)(8).
[7] 105 Mass. App. Ct. at 397–98.
[8] Id. at 398.
[9] Id.
[10] Id. at 399.
[11] Id.
[12] See O.R.C. §§ 5747.01(B); 5747.212.
[13] See O.R.C. § 5747.20(B)(2)(c). Nonresidents are still subject to Ohio tax on capital gains resulting from the sale of real property or tangible personal property physically located in the state at the time of sale. See O.R.C. § 5747.20(B)(2)(a)–(b).
[14] See O.R.C. § 5747.21(B) (requiring all items of business income to be apportioned to Ohio based on certain apportionment factors). Under O.R.C. § 5747.212, nonresidents can be subject to Ohio tax even when they do not strictly have “business income” in certain cases. However, § 5747.212 would have no application to Welch’s facts because his interest in AcadiaSoft was diluted below 20% more than three years before the disputed sale. See O.R.C. § 5747.212(B); Welch, 105 Mass. App. Ct. at 393 (describing a 2009 transaction that left Welch with about a 13% ownership interest in AcadiaSoft).
[15] See O.R.C. § 5747.01(B).
[16] See O.R.C. § 5747.01(B)(2). In Ohio, business income also includes sales treated as asset sales for federal income tax purposes, such as the sale of a disregarded entity or a sale made subject to an election under Internal Revenue Code Sections 336(e) or 338(h)(10). See O.R.C. § 5747.01(B)(1).
[17] Id.
[18] See Treas. Reg. § 1.469-5T(a)(1)–(7).
[19] 2016-Ohio-2805, ¶¶ 51, 60. But see VAS Holdings & Investments LLC v. Commissioner of Revenue, 489 Mass. 669, 685 (2022) (finding no federal constitutional requirement to use the unitary business principle to determine whether a state may tax an out-of-state entity on its gain from the sale of an in-state operating company).
[20] 2016-Ohio-2805, ¶¶ 35–36.
[21] Id. at ¶¶ 6, 69 n.5.
[22] Id. at ¶ 5.
[23] Id. at ¶ 26 & n.2.
[24] See Treas. Reg. § 1.469-5T(a)(4), (c) & Ex. 4. (discussing rules for aggregation of more than one “significant participation activity”).
[25] See 105 Mass. App. Ct. at 393.
[26] Id. at 394.