Berkley v. Gavin

• Decision Date: 25 July 2000
• Docket Number: (SC 16142)
• Citation: 253 Conn. 761,756 A.2d 248
• Parties: WILLIAM R. BERKLEY ET AL. v. GENE GAVIN, COMMISSIONER OF REVENUE SERVICES
• Court: Connecticut Supreme Court

253 Conn. 761

756 A.2d 248

WILLIAM R. BERKLEY ET AL. v. GENE GAVIN, COMMISSIONER OF REVENUE SERVICES

(SC 16142)

Supreme Court of Connecticut.

Argued September 30, 1999.

Officially released July 25, 2000.

Borden, Norcott, Palmer, Sullivan, and Vertefeuille, Js.¹ Charles H. Lenore, with whom was Eric R. Jones, for the appellants (plaintiffs).

Robert L. Klein, assistant attorney general, with whom, on the brief, was Richard Blumenthal, attorney general, for the appellee (defendant).

Opinion

VERTEFEUILLE, J.

The plaintiffs, William Berkley and Marjorie Berkley, appeal from the judgment of the trial court dismissing their appeal from the assessment by the defendant, the commissioner of revenue services, against the plaintiffs of an additional $393,263.01 in state income taxes for the 1994 taxable year. The principal issues in this appeal are: (1) whether the federal tax benefit rule is incorporated into the definition of "adjusted gross income" contained in General Statutes § 12-701 (a) (19);² and (2) if so, whether the plaintiffs are entitled to claim a deduction under the tax benefit rule due to the pass-through of certain losses incurred by subchapter S corporations of which William Berkley was a shareholder, even though the plaintiffs previously had avoided paying $1,297,189.63 in Connecticut capital gains, dividends and interest taxes as a result of those same passed-through losses.

We conclude that the federal tax benefit rule is incorporated into the definition of adjusted gross income contained in § 12-701 (a) (19). We further conclude that the plaintiffs had already received a tax benefit due to the aforementioned losses by virtue of the resultant reduction in their 1988, 1989, and 1990 federal adjusted gross income, which allowed them to avoid paying $1,297,189.63 in Connecticut capital gains, dividends and interest taxes. Therefore, they were not entitled to claim such a benefit a second time on their 1994 Connecticut income tax return. We therefore affirm the judgment of the trial court.

The parties in this case have stipulated to the following relevant facts. The plaintiffs are a married couple residing in Greenwich. William Berkley was a shareholder in three S corporations:³ Farm Acquisition Corporation (Farm Acquisition), Interlaken Grove Investors, Inc. (Interlaken Grove), and Caring Communities, Inc. (Caring Communities). Two of those corporations, Farm Acquisition and Caring Communities, reported ordinary losses on their 1988, 1989, and 1990 federal income tax returns and the third corporation, Interlaken Grove, reported ordinary losses on its 1989 and 1990 tax returns. Pursuant to 26 U.S.C. § 1366 (a) (1),⁴ the plaintiffs deducted William Berkley's pro rata share of the losses reported by Farm Acquisition and Caring Communities on their federal income tax returns for those three years, and his pro rata share of the losses reported by Interlaken Grove for the 1989 and 1990 tax years. William Berkley's bases in the stock of those three corporations then was reduced by the amount of the deductions. See 26 U.S.C. § 1367 (a) (2).

During 1988, 1989 and 1990, Connecticut imposed a tax on capital gains, dividends and interest income (capital gains tax) pursuant to General Statutes §§ 12-505 through 12-522, but did not tax any other income. For each of those years, the tax rates on capital gains, dividends and interest income were tied to the taxpayer's federal adjusted gross income.⁵ If, however, a taxpayer's federal adjusted gross income fell below a certain level, that taxpayer had no obligation to pay Connecticut's capital gains tax.

As a result of the losses passed through the three S corporations in which William Berkley was a shareholder, the plaintiffs' federal adjusted gross income for the tax years 1988, 1989 and 1990 was negative. Accordingly, the plaintiffs paid no state capital gains tax for those three years. If the plaintiffs' federal adjusted gross income for those years had not been reduced by their deduction of the pass-through losses from the three S corporations, the plaintiffs would have owed a total of $1,297;189.63 in state capital gains taxes for those three years.

For the 1994 tax year, the plaintiffs reported "worthless stock" losses for federal income tax purposes with respect to William Berkley's stock in all three S corporations. At that time, his bases in the stock of the three S corporations had been reduced to $3,623,671. The federal tax code allowed the plaintiffs to deduct the adjusted bases of $3,623,671 from their 1994 long-term capital gains reported in their 1994 federal income tax return. The plaintiffs' federal adjusted gross income for the 1994 tax year was $8,342,817.

In October, 1995, the plaintiffs timely filed a "Form CT-1040 Connecticut Resident Income Tax Return" for the 1994 tax year, on which they reported an overpayment of $496,123. In computing their 1994 Connecticut taxable income, the plaintiffs subtracted from their federal adjusted gross income of $8,342,817, the sum of $9,743,387, representing the aggregate reductions to the bases of the stock held by William Berkley in the three S corporations in 1988, 1989 and 1990. The plaintiffs subsequently agreed to limit the contested basis adjustment to $6,541,489, representing the total basis adjustment excluding depreciation and amortization.⁶ If the plaintiffs' deduction of the basis adjustment from the Connecticut basis in William Berkley's S corporation stock in computing their Connecticut adjusted gross income for 1994 were permissible, the plaintiffs would be entitled to a refund of $294,367, plus interest, for the 1994 tax year.

In addition, the record reveals the following other relevant facts. In February, 1996, the defendant notified the plaintiffs of a proposed recalculation of their 1994 Connecticut income tax, under which the defendant intended to assess against the plaintiffs an additional liability of $393,263.01. In April, 1996, the defendant sent a notice of the additional assessment to the plaintiffs. On May 17, 1996, the plaintiffs appealed the defendant's assessment to the Tax Session of the Superior Court.

The trial court issued a written memorandum of decision in favor of the defendant. In that memorandum, the trial court initially concluded that "[t]he tax benefit rule is alive and well in Connecticut." The trial court further concluded, however, that "the [plaintiffs] avoided paying a Connecticut [capital gains tax] on a substantial amount of income because ... the pass-through losses of the three S corporations were used in the determination of their federal adjusted gross income for 1989-90. They are not now entitled to a double benefit by excluding the losses in the determination of the basis of the three S corporations for capital gains purposes in determining their adjusted gross income under the Connecticut personal income tax." Accordingly, the trial court rendered judgment dismissing the plaintiffs' appeal. Thereafter, the plaintiffs appealed the trial court's judgment to the Appellate Court, and we granted the defendant's motion to transfer the appeal to this court pursuant to General Statutes § 51-199 (c) and Practice Book § 65-2.

On appeal, the plaintiffs argue that, although the trial court properly concluded that the federal tax benefit rule applies to Connecticut's personal income tax, the trial court improperly concluded that the plaintiffs' S corporation losses could not be excluded, pursuant to the tax benefit rule, from the plaintiffs' Connecticut adjusted gross income. We affirm the judgment of the trial court in both respects.

I

At the outset, a brief explanation of the federal tax benefit rule is warranted. The tax benefit rule is "a judicially developed principle that allays some of the inflexibilities of the annual accounting system. An annual accounting system is a practical necessity if the federal income tax is to produce revenue ascertainable and payable at regular intervals. Burnet v. Sanford & Brooks Co., 282 U.S. 359, 365, [51 S. Ct. 150, 75 L. Ed. 2 383] (1931). Nevertheless, strict adherence to an annual accounting system would create transactional inequities. Often an apparently completed transaction will reopen unexpectedly in a subsequent tax year, rendering the initial reporting improper. For instance, if a taxpayer held a note that became apparently uncollectible early in the taxable year, but the debtor made an unexpected financial recovery before the close of the year and paid the debt, the transaction would have no tax consequences for the taxpayer, for the repayment of the principal would be recovery of capital. If, however, the debtor's financial recovery and the resulting repayment took place after the close of the taxable year, the taxpayer would have a deduction for the apparently bad debt in the first year under § 166 (a) of the [Internal Revenue] Code, 26 U.S.C. § 166 (a). Without the tax benefit rule, the repayment in the second year, representing a return of capital, would not be taxable. The second transaction, then, although economically identical to the first, could, because of the differences in accounting, yield drastically different tax consequences. The Government, by allowing a deduction that it could not have known to be improper at the time, would be foreclosed from recouping any of the tax saved because of the improper deduction. Recognizing and seeking to avoid the possible distortions of income, the courts have long required the taxpayer to recognize the repayment in the second year as income." Hillsboro National Bank v. Commissioner of Internal Revenue, 460 U.S. 370, 377-79, 103 S. Ct. 1134, 75 L. Ed. 2d 130 (1983).

The tax benefit rule may be illustrated further by the following hypothetical example: If a taxpayer is owed $100 in connection with his trade or business and the debtor fails to pay the debt when it is due, the taxpayer may deduct the $100 loss as a bad debt. See 26 U.S.C. § 166 (a...