Massachusetts aggressively pursues tax revenue from its former residents. As high-net-worth residents seek refuge in tax-friendly states like New Hampshire and Florida, they should consider carefully whether Massachusetts might attempt to tax income they receive after having moved out of the Commonwealth. The purpose of this article is to summarize key tax considerations for people leaving Massachusetts and their advisors.
General Rules of Residence and Source. The relevant law distills down to two issues: residence and source. Generally, Massachusetts residents are subject to Massachusetts income tax on all of their income, regardless of source. However, Massachusetts nonresidents are subject to Massachusetts income tax only on their income from Massachusetts sources. Therefore, the first issue to consider is whether a taxpayer is a Massachusetts resident or nonresident. That is a fact-intensive analysis (e.g., day-counting of physical presence, indicia of subjective intent regarding where one’s true “home” is, locations of personal and professional connections, etc.), outside the scope of this article. For simplicity, this article assumes that a taxpayer who was formerly a Massachusetts resident has successfully severed that residency and moved to another state. Therefore, the second issue arises: what income received by the former resident is still subject to Massachusetts tax because it is from Massachusetts sources? The answer varies with the nature of the income.
The regulations defining Massachusetts source income of nonresidents are expansive. They start from the position that Massachusetts source income includes essentially all income derived from activities carried on by the nonresident in Massachusetts. This makes intuitive sense for many items of income. For example, say Nancy lives in Boston, where she works for Hospital. Nancy becomes a resident of New Hampshire, but she continues to work for Hospital, commuting to the same Boston location. Her compensation earned from that Massachusetts-based employment is taxable as Massachusetts source income, even after she becomes a New Hampshire resident. At the opposite end of the spectrum, assume instead that when Nancy leaves Boston she also leaves Hospital for a new job in New Hampshire. Her compensation earned from that New Hampshire-based employment is not subject to Massachusetts income tax because it is not Massachusetts source income and it is paid to a nonresident.
Exceptions to the General Rules. Real facts are often trickier. Say Nancy was an executive at Hospital for many years, and she moved to New Hampshire upon retirement. She retired with robust benefits, including both qualified and non-qualified deferred compensation plans (e.g., respectively, a defined-benefit pension plan and a “SERP” supplemental executive retirement plan). Can Massachusetts tax payments under these plans to Nancy, a nonresident? Under the general rule, yes. Regardless of Nancy’s New Hampshire residence, payments to her under the deferred compensation plans are Massachusetts source income because they are derived from her former employment in Massachusetts.
However, exceptions to that general rule likely protect Nancy from Massachusetts taxation. 4 U.S.C. § 114 is a federal statute that prohibits states from imposing tax on specific types of retirement income received by nonresidents. Massachusetts yields to this federal protection for nonresidents, not only via the general supremacy of federal law, but also explicitly within the relevant Massachusetts regulations and in various administrative rulings and guidance. Some of the federal protection is straightforward. For example, nonresident Nancy’s defined-benefit pension plan likely is not subject to Massachusetts taxation, along with other qualified plans, generally. Nancy’s non-qualified SERP requires further analysis. The federal statute may or may not prevent Massachusetts taxation, depending on the specific terms of the SERP and Nancy’s participation in it (e.g., timing of payments to Nancy, relationship between the non-qualified SERP and a separate qualified plan, etc.).
Down the Rabbit Hole. Away from retirement income and its potential federal statutory protection, things get stranger. Imagine Nancy’s husband, Nathan, also completes the move from Massachusetts and becomes a New Hampshire resident. They both worked in healthcare but followed different paths. Nathan’s career involved stints with Boston-based private investment funds and their portfolio companies in medical technology. Nathan’s income post-move may create a kaleidoscopic analysis. Does he have carried interest from the investment funds, classified as partnerships for tax purposes? If so, did he make a timely § 83(b) election? Does he have stock in the med-tech companies? If so, how are those companies classified for tax purposes? And how did he receive that stock, as compensation for services performed in Massachusetts when he was employed there (e.g., a stock bonus), or did he purchase it as a passive investor? What about stock options? If he has options, are they qualified “incentive stock options”? Any IPOs or other liquidity events on the horizon?
On and on it goes. Answers to these questions and more determine whether a particular item of income is or is not Massachusetts source income to a nonresident, subject to Massachusetts tax. Note that income source is not an all-or-nothing analysis. Nathan could pay zero, full, or partial (“apportioned”) Massachusetts tax on different items of income within any given tax year.
Practical Considerations. Practical considerations can upend the legal analysis, causing a Massachusetts income tax liability for a former resident who technically should not be liable. First, the Massachusetts Department of Revenue (“DOR”) can take very aggressive positions in this area. Former residents at times must decide whether to defend a correct legal position that no Massachusetts tax is due versus simply pay the incorrect tax to avoid legal/accounting fees and hassle. That decision typically is a cost-benefit analysis based on the amount of the alleged tax liability and the strength of the taxpayer’s legal position. Second, Massachusetts courts can uphold aggressive DOR positions. For example, in Welch v. Commissioner, the Massachusetts Appeals Court upheld the DOR’s assessment of tax where a Massachusetts resident founder moved to New Hampshire and then sold his C corporation stock in the business, which stock he had obtained at formation. Commentators have widely criticized the court’s analysis and conclusion in Welch as illustrative of a troubling trend: not only may DOR aggressively pursue a former resident, but Massachusetts courts may do legal gymnastics to agree with the DOR. The Massachusetts Supreme Judicial Court denied the taxpayer’s request for further review, leaving Welch in place to cast a long shadow over former Massachusetts residents. Third, sometimes unforced errors on the taxpayer’s side thwart an otherwise strong position. For example, say Nancy fails to update her address or communicate with her former employer following her move to New Hampshire. Her employer or the payroll company likely would withhold and remit to Massachusetts tax on pension and SERP payments to Nancy that should not be subject to Massachusetts tax. Once DOR has that money, prying it away from them may be next to impossible, even if technically correct. Fourth, taxpayers should seize low-hanging fruit where available. Updated driver’s licenses, voter registrations, bank statements, and the like are typically easy to obtain and bolster change-of-residence positions.
Conclusion. Massachusetts residents can and do successfully leave the Commonwealth and enjoy substantial tax savings. However, they and their advisors must plan proactively to not only sever Massachusetts residency, but also to minimize what remains taxable as Massachusetts source income.