Michael J. & Ann M. McTygue v. Commissioner of Revenue (April 20, 2010)

COMMONWEALTH OF MASSACHUSETTS

APPELLATE TAX BOARD


MICHAEL J. MCTYGUE & 	 v.	     COMMISSIONER OF REVENUE
ANN M. MCTYGUE

Docket No. C287781				Promulgated:
							April 20, 2010
        						

	This is an appeal filed under the formal procedure pursuant to G.L. c. 58A, § 7 and G.L. c. 62C, § 39, from the refusal of the Commissioner of Revenue ("Commissioner" or "appellee") to abate personal income tax assessed to Michael J. McTygue ("Mr. McTygue") and Ann M. McTygue (jointly, "appellants"), for tax years 2002, 2003, 2004, and 2005 ("years at issue").
Commissioner Scharaffa heard this appeal.  Chairman Hammond and Commissioners Egan, Rose, and Mulhern joined him in a decision for the appellee.
	These findings of fact and report are made pursuant to requests by the appellants and the appellee under G.L. c. 58A, § 13 and 831 CMR 1.32.

	Roger J. Brunelle, Esq., for the appellants.

	Celine E. Jackson, Esq. and Sean M. Fontes, Esq., for the appellee.

FINDINGS OF FACT AND REPORT
On the basis of a Statement of Agreed Facts and exhibits offered by the parties, the Appellate Tax Board ("Board") made the following findings of fact.  
As a result of an audit that was initiated during April of 2005, the Commissioner issued a Notice of Intent to Assess personal income tax to the appellants on December 20, 2005 for tax years 2002, 2003 and 2004.  The Commissioner subsequently issued a Notice of Assessment dated August 22, 2006, notifying the appellants that she had assessed tax, plus interest, in the amounts of $3,725.19, $6,953.78, and $5,959.88 for the 2002, 2003 and 2004 tax years, respectively.  On September 14, 2006, the appellants filed an Application for Abatement for tax years 2002, 2003, and 2004 with the Commissioner.  On December 1, 2006, the Commissioner denied the appellants' abatement application.  
On December 23, 2006, the Commissioner issued a Notice of Intent to Assess personal income tax for tax year 2005.  By Notice of Assessment dated February 7, 2007, the Commissioner notified the appellants that she had assessed tax, plus interest, in the amount of $15,059.95 for tax year 2005.  The appellants filed an abatement application for tax year 2005 with the Commissioner on December 28, 2007, which the Commissioner denied on June 13, 2008.  
On January 26, 2007, the appellants timely filed an appeal with the Board relating to tax years 2002, 2003, and 2004.  The appellants filed a motion for leave to amend their petition to include tax year 2005, which the Board allowed on August 5, 2008.  On the basis of the foregoing, the Board found that it had jurisdiction to hear and decide this appeal.
In 1974, Mr. McTygue, then a Massachusetts resident, founded a construction/real-estate development business, which was organized as a Massachusetts subchapter C corporation called Builders Systems, Inc. ("BSI").  Mr. McTygue was the sole shareholder of BSI, owning all 500 outstanding shares of the corporation.  
Having owned and operated BSI in Massachusetts for almost thirty years, Mr. McTygue sold his entire ownership interest in the company to three of his employees ("Buyers") pursuant to an agreement between Mr. McTygue and the Buyers dated June 28, 2002 ("Agreement"). The Agreement provided that Mr. McTygue would receive $2,500,000 in exchange for his 500 shares, $500,000 of which the Buyers paid in a lump sum at the time of the closing to redeem 100 shares. The $2,000,000 balance, representing payment for the remaining 400 shares, was to be made by the Buyers pursuant to a promissory note also dated June 28, 2002 ("Note"), which provided for payment of principal and accrued interest over a period of ten years.  Mr. McTygue maintained a security interest in all of the shares acquired by the Buyers until the Note was paid in full.  
On the same day that the Agreement and the Note were executed, Mr. McTygue entered into an employment agreement with BSI ("Employment Agreement"), which explicitly provided that "as a condition to the consummation of the Acquisition, [Mr. McTygue] is to remain employed by the Company." (emphasis added).  Pursuant to the Employment Agreement, Mr. McTygue reported directly to BSI's Board of Directors and was responsible "for the development and implementation of business plans, business development, providing management advice and developing budgets for the Company's business."  The Employment Agreement also provided that Mr. McTygue would work for BSI for five years, starting June 28, 2002, with a base annual salary of $50,000, and that Mr. McTygue would receive bonus compensation at a rate of 50% of any bonus compensation paid to the Buyers.  Further, Mr. McTygue was eligible to participate, at the company's expense, in any medical or health plan that may have been provided by the company for its executive employees.  He was entitled to sick leave, sick pay and disability benefits, and he was provided with "furnished suitable office and conference facilities with secretarial and drafting help as needed," as well as a company car.  Moreover, Mr. McTygue was granted "full and complete access to the financial books, records, statements and materials" pertaining to BSI until the Note was paid in full.  
At issue in this appeal is the taxation of interest on the Note received by Mr. McTygue during the years at issue.  For federal tax purposes, the appellants elected to pay tax on the capital gain from the sale of BSI on an installment basis over the term of the Note, pursuant to Internal Revenue Code § 453(b).  The appellants included the interest income from the Note as ordinary income on their federal income tax returns for the years at issue.  
For Massachusetts purposes, the appellants did not elect installment sale treatment, effectively realizing the capital gain on the sale of BSI stock in the year of sale.  However, the appellants owed no Massachusetts tax on the capital gain under then-prevailing law because Mr. McTygue had owned the stock for more than six years at the time of sale.  See G.L. c. 62, § 2(b)(3), as amended by St. 1994, c. 195, §§ 10 and 20; see also Peterson v. Commissioner of Revenue, 441 Mass. 420 (2004).  For each of the years at issue, the appellants filed Massachusetts Nonresident/Part Year Resident Income Tax Returns as nonresidents, including the income received pursuant to the Employment Agreement in Massachusetts source income, but excluding the interest income from the Note.  
On the basis of all of the evidence, the Board made the following additional findings of fact. Pursuant to the Employment Agreement, Mr. McTygue actively participated in the operation of BSI's business in Massachusetts during the years at issue.  Given that the Employment Agreement was executed "as a condition to the consummation of the Acquisition," the Board also found that the sale of Mr. McTygue's stock was contingent upon his continued employment with BSI. Moreover, the responsibilities borne by Mr. McTygue under the Employment Agreement, including "development and implementation of business plans, business development, providing management advice and developing budgets for the Company's business," were central to the successful operation of BSI's business.  Accordingly, the Board found that BSI's financial success and ability to fulfill its obligations under the Note were dependent, at least in part, upon Mr. McTygue's ongoing provision of services to the company.  
The Board further found that the interest income at issue was directly and solely traceable to Mr. McTygue's sale of his 100-percent ownership interest in BSI.  Based on the foregoing, and for the reasons more fully explained in the following Opinion, the Board found and ruled that the interest income at issue was derived from or effectively connected with Mr. McTygue's Massachusetts trade or business and therefore was subject to taxation as gross income from sources within the Commonwealth.  
Accordingly, the Board issued a decision for the appellee in this appeal.  

OPINION                 
The issue in the instant appeal is the taxability of interest income which Mr. McTygue received during the years at issue according to the terms of the sale of his ownership interest in his Massachusetts business.  The sale was completed while the appellants were domiciled in the Commonwealth, but Mr. McTygue received the interest at issue when the appellants were Florida domiciliaries.

Tax Year 2002 
General Laws c. 62, § 5A(a), in effect for tax year 2002, limited the taxation of nonresidents' income to "items of gross income from sources within the commonwealth."  Section 5A further provided that "[i]tems of gross income from sources within the commonwealth are 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." Such income is also known as Massachusetts source income. See 830 CMR 62.5A.1 (2). 
On June 28, 2002, Mr. McTygue sold his interest in his Massachusetts business, BSI, to the Buyers.  On the same day, Mr. McTygue entered into the Employment Agreement, which by its own terms established that the sale was contingent upon Mr. McTygue's ongoing employment with the company.  More specifically, the Employment Agreement provided that "as a condition to the consummation of the Acquisition, [Mr. McTygue] is to remain employed by the Company." (emphasis added). 
Pursuant to the Employment Agreement, Mr. McTygue would, for a period of five years, receive base compensation, bonuses, and various executive-level benefits.  Moreover, in his new role, Mr. McTygue was "responsible for the development and implementation of business plans, business development, providing management advice and developing budgets for the Company's business."  By their very nature, these duties were central to the operation of BSI's business and its continued financial success.  Mr. McTygue filled this role throughout the years at issue, and as the appellants' Massachusetts nonresident income tax returns for these years reflect, was compensated for his efforts.  In light of these facts, the Board found that Mr. McTygue actively participated in BSI's business during the years at issue and that BSI's ability to fulfill its obligations under the Note was dependent, at least in part, on this participation.  Accordingly, the Board found and ruled that for tax year 2002, the interest at issue qualified as "gross income from sources within the commonwealth" within the meaning of § 5A because it was "derived from or effectively connected with . . . [a] trade or business" conducted by Mr. McTygue in Massachusetts. The Board thus found and ruled that the income was taxable to the appellants pursuant to § 5A. 
The appellants do not dispute that Mr. McTygue remained employed by BSI during the years at issue, nor do they dispute that the interest income paid pursuant to the terms of the Note was part of the proceeds of the sale of BSI.  Rather, the appellants contend that the interest income was not sufficiently connected to Mr. McTygue's ongoing involvement in the business of BSI to qualify as Massachusetts source income within the meaning of § 5A.  In support of their position, the appellants cite Department of Revenue Letter Ruling 83-23 and Commissioner of Revenue v. Dupee, 423 Mass. 617, 621 (1996).
In Dupee, the Supreme Judicial Court considered the taxability of a nonresident taxpayer's capital gain realized from the disposition of his interest in the Boston Celtics.  The Court agreed with the Board's prior holding that the income was not subject to tax in Massachusetts where the taxpayer "‛did not actively, regularly, or continuously participate in any capacity in the activities constituting the regular operations of [the corporation],' nor did he maintain any offices, employees, or place of business in Massachusetts, or purchase goods or services in connection with a trade or business in Massachusetts." Dupee, 423 Mass. at 618 (citing Paul R. Dupee, Jr. and Lizbeth Schiff v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1994-103, 107).  Similarly, in Letter Ruling 82-23, the Commissioner found that a nonresident's long-term capital gain realized from the sale of stock in a Massachusetts corporation was not taxable by the Commonwealth where the taxpayer had performed no services for the corporation.
Consistent with Dupee and Letter Ruling 82-23, the Board and the Supreme Judicial Court have, on several occasions, ruled that income generated from the disposition of an interest in, or otherwise received from, a Massachusetts corporation is not includible in the Massachusetts source income of a nonresident if the nonresident did not actively participate in the corporation's business when the income was received.  See Gaston v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1997-332, 352-53 (ruling that gain from a nonresident's sale of shares in a Massachusetts subchapter S corporation was not Massachusetts source income where the taxpayer did not perform employment services in Massachusetts in connection with ownership of the shares); Gersh v. Commissioner of Revenue, Mass. ATB Findings of Fact and Reports 1997-502, 522-23 (ruling that a nonresident's income under a non-competition agreement related to the sale of a Massachusetts corporation was not Massachusetts source income where the taxpayer no longer acted as an officer or director of the company and did not perform any other services in Massachusetts for the company); Commissioner of Revenue v. R. Bruce Oliver, 436 Mass. 467 (2002) (affirming the Board's ruling that a nonresident was not subject to tax on nonqualified pension payments made by his former Massachusetts employer where the taxpayer did not carry on a trade or business in Massachusetts during the years he received the payments).
By contrast, Mr. McTygue founded and built a Massachusetts business, and when he sold that business agreed, as a condition of the sale, to continue to participate in its operation in a strategic role that was central to the company's ongoing success.  The interest income at issue, which comprised part of the proceeds of the sale, was paid to Mr. McTygue while he performed this service.  The Board thus found that Mr. McTygue's continued participation in BSI's business rendered Letter Ruling 83-23 and Dupee, as well as Gaston, Gersh and Oliver, inapplicable to the instant appeal.  
	Finally, any argument that the interest income at issue did not bear an adequate connection to Mr. McTygue's sale of his interest in BSI is simply not supported by the record in this appeal.  In Horst v. Commissioner of Revenue, 389 Mass. 177 (1983), a nonresident sold Massachusetts real estate at a gain, receiving as consideration cash and an interest-bearing note.  In concluding that "the interest on the note was derived from an interest in ownership in real property within the meaning of § 5A" (Horst, 389 Mass. at 181) and viewing the interest as "income directly and solely traceable to the sale of such property" (id. at 183), the Court stated that:
[t]he taxpayer seeks to divorce his interest income from the category of "such income as is derived from those sources."  He asserts that its intangible nature as interest on a note takes it out of the realm of income taxable to nonresidents.  The taxpayer . . . would have the interest viewed as somehow disembodied from the sale transaction.  We think that such a view strains the definition of income derived from the ownership of property.  

Id. at 182-83.
	While the Court in Horst considered whether interest income received in connection with the sale of real property was "derived from" Massachusetts property for purposes of § 5A, the reasoning in Horst is equally applicable to the interest income received in connection with Mr. McTygue's sale of his Massachusetts business.  As in Horst, the appellants' interest income is "derived from" one of the three sources delineated in § 5A; in this case, a trade or business carried on in Massachusetts. 
Accordingly, for all of the forgoing reasons, the Board found and ruled that the interest income which Mr. McTygue received under the note was derived from or effectively connected with a Massachusetts trade or business personally conducted by Mr. McTygue.  The Board therefore ruled that the interest income at issue was taxable to the appellants pursuant to § 5A(a) for tax year 2002.

Tax Years 2003 through 2005
Section 5A was amended, effective for tax years beginning on or after January 1, 2003, to expand the definition of Massachusetts source income.  Section 5A, as amended, provides in part that: 
[i]tems of gross income from sources within the commonwealth are 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. (emphasis added).

Section 5A was further amended to explicitly define "gross income derived from or effectively connected with any trade or business" as follows:
[f]or 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, 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. (emphasis added).


As a preliminary matter, the Board found and ruled that the amended version of § 5A determined the taxability of the interest income received by the appellants after January 1, 2003.  While the sale of Mr. McTygue's interest in BSI occurred in 2002, prior to the effective date of the amendment to § 5A, applying the statute to interest income recognized in tax years 2003 through 2005 is appropriate and does not constitute retroactivity.  See Johnson v. Department of Revenue, 387 Mass. 59, 64 (1982) (citing, inter alia, DuBois v. Director, Div. of Taxation, 4 N.J. Tax 11 (Tax Ct. 1981), aff'd, 470 A.2d 446 (1983) ("The taxable event is receipt of the installments.  Since this is a current event, there is no retroactivity.") (other citations omitted). 
Under the version of § 5A effective for tax year 2002, the appellants were taxable on the interest income at issue because, as detailed above, the interest income was derived from or effectively connected with the Massachusetts trade or business Mr. McTygue was conducting at the time he received the income.  Although Mr. McTygue would still be taxable on the disputed interest income for the subsequent tax years under this version of § 5A for the same reason, the amendment to § 5A provides further grounds for taxing the income.  
	First, amended § 5A removes the requirement, developed through case law, that a nonresident individual be actively engaged in a trade or business in Massachusetts in a year in which income is received for that income to be derived from or effectively connected with a trade or business.  Further, unlike the prior version of § 5A, which did not define "derived from or effectively connected with any trade or business," the amended statute incorporates an exceedingly broad definition of the phrase.  This definition includes income "that results from, is earned by, is credited to, accumulated for or otherwise attributable to" a trade or business in the Commonwealth and specifically enumerates several sources of taxable income including "gain from the sale of a business or of an interest in a business."    
Rather than attempt to argue that the disputed interest income somehow did not "result from" or was not "otherwise attributable to" Mr. McTygue's trade or business under amended § 5A, the appellants argue that income resulting from the sale of Mr. McTygue's BSI stock is not Massachusetts source income because BSI was a subchapter C corporation.  The appellants cite for this proposition the Commissioner's regulation interpreting taxation of the "[s]ale of a business or an interest in business." 830 CMR 62.5A.1 (3)(c)(8) provides that:
[t]his rule generally applies to the sale of an interest in a sole proprietorship, general partnership, limited liability partnership, a general or limited partner's interest in a limited partnership (subject to the exception in the following sentence), or an interest in a limited liability company.  It generally does not apply to the sale of a limited partner's interest in a publicly traded limited partnership, or 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.  (emphasis added).

The meaning of "generally," as it applies to the present appeal can be inferred from the regulation's illustrative examples, and in particular the example that relates to acquisition and sale of shares in a C corporation.  More specifically, example (3)(c)(8.4) depicts a hypothetical investor who is an employee of "NationalCorp," a C corporation that does business in Massachusetts.  The investor, who works in the corporation's Massachusetts offices, purchased stock of the corporation "as an ordinary investment unrelated in any way to his compensation."  The example concludes that the gain on the investor's sale of stock is not Massachusetts source income.  
From this example, the Board inferred that the Commissioner intended to exclude from Massachusetts source income those items of income which were 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.  The Board found, therefore, that given the statutory language of § 5A, 830 CMR 62.5A.1(3)(c)(8) could not be read to exclude gains such as those at issue in the present appeal from Massachusetts source income.
	The Board is also guided by the familiar principle that tax statutes are to be construed according to their plain meaning.  Commissioner of Revenue v. Franchi, 423 Mass. 817, 822 (1996). See also Massachusetts Broken Stone Co. v. Weston, 430 Mass. 637, 640 (2000)("Where the language of a statute is clear, courts must give effect to its plain and ordinary meaning and the courts need not look beyond the words of the statute itself.").  The plain and unambiguous nature of the statute in question, which includes in Massachusetts source income "gain from the sale of a business or of an interest in a business," compels the conclusion that the interest income at issue, which was part of the gain realized by Mr. McTygue from his sale of BSI, is subject to taxation under amended § 5A.  Further, as previously noted, amended § 5A removes the requirement that a nonresident individual be actively engaged in a trade or business in Massachusetts in a year in which income is received for that income to be effectively connected with a trade or business.  Thus, even had the Board found that Mr. McTygue was not so engaged during tax years 2003 through 2005, the income at issue would have been taxable under amended § 5A.    


Conclusion
Mr. McTygue actively participated in a Massachusetts trade or business during the years at issue.  For tax year 2002, the Board found and ruled that Mr. McTygue actively participated in the business of BSI such that the interest income he received, which comprised part of the proceeds of the sale of BSI, was income derived from or effectively connected with a Massachusetts trade or business and was therefore Massachusetts source income taxable to the appellants pursuant to § 5A.  
For tax years 2003 through 2005, the Board found and ruled that § 5A, as amended, determined the taxability of the interest income at issue.  For these tax years, the Board further found and ruled that amended § 5A was substantially more inclusive than its predecessor and provided additional bases on which to conclude that the disputed interest income was taxable as income derived from or effectively connected with a Massachusetts trade or business.

Accordingly, the Board issued a decision for the appellee in this appeal. 


 APPELLATE TAX BOARD


				By:				______	undefinedundefined_____
				   Thomas W. Hammond, Jr., Chairman




A true copy,


Attest:	______		_____
	    Clerk of the Board

 Consistent with their claimed nonresident filing status for the years at issue, the appellants asserted that they had changed their domiciles from Massachusetts to Florida as of January 1, 2002.  During the course of her audit of the appellants and until sometime after the filing of their appeal with the Board, the Commissioner disagreed, maintaining that the appellants remained domiciled in the Commonwealth throughout the years at issue.  Prior to the hearing of this appeal, the appellants and the Commissioner executed a "partial settlement agreement" reflecting their agreement that the appellants remained domiciled in Massachusetts until September 11, 2002, when they became Florida domiciliaries.
   The parties agreed that the income received by Mr. McTygue pursuant to the Employment Agreement qualified as Massachusetts source income and was subject to tax. 
 As discussed, infra, § 5A was amended effective for tax years beginning on or after January 1, 2003.
 The version of § 5A in effect for the tax years at issue in Horst, like the version applicable to the appellants' appeal for tax year 2002, taxed nonresidents on income "derived from or effectively connected with (1) any trade or business, including any employment carried on by the taxpayer in the commonwealth; (2) the participation in any lottery or wagering transaction within the commonwealth; or (3) the ownership of any interest in real or tangible personal property in the commonwealth."

ATB 2010-329