Drapkin v. Commissioner of Revenue

• Decision Date: 16 May 1995
• Citation: 420 Mass. 333,649 N.E.2d 1094
• Parties: Melvin B. DRAPKIN v. COMMISSIONER OF REVENUE.
• Court: United States State Supreme Judicial Court of Massachusetts Supreme Court

Page 1094

649 N.E.2d 1094

420 Mass. 333

Melvin B. DRAPKIN v. COMMISSIONER OF REVENUE.

Supreme Judicial Court of Massachusetts Suffolk.

Submitted Oct. 6, 1994.

Decided May 16, 1995.

Ann Marie Cannistraro and David R. Andelman, Boston, for the taxpayer.

Rosemary S. Gale, Asst. Atty. Gen., for Com'r of Revenue.

Before LIACOS, C.J., and WILKINS, ABRAMS, NOLAN, LYNCH, O'CONNOR and GREANEY, JJ.

LIACOS, Chief Justice.

Melvin B. Drapkin (taxpayer) appeals from a decision of the Appellate Tax Board (board) affirming the refusal of the Commissioner of Revenue (commissioner) to abate taxes paid by the taxpayer. We granted his application for direct appellate review. We affirm the board's decision.

The taxpayer was a fifty per cent shareholder of two Massachusetts corporations Eagle Mortgage Corp. (Eagle) and Bayside Funding, Inc. (Bayside), which had as their principal business activity the making of loans secured by mortgages on real property. The taxpayer worked full time in the corporations' lending business throughout 1987 and 1988, the years at issue. Eagle was a Subchapter S corporation for tax purposes under §§ 1362 and 1366 of the Internal Revenue Code and G.L. c. 62, § 17A (1992 ed.), during both years at issue and Bayside was a Subchapter S corporation in 1988, its first year of active operation. The income, deductions, and losses of a Subchapter S corporation are taxed to its shareholders under G.L. c. 62, § 17A, "as if ... realized or incurred directly by [them] in the same manner as incurred by the corporation." G.L. c. 62, § 17A(c ). Consequently, the taxpayer reported on his individual income tax return his proportionate share of the interest income from loans made by the two Subchapter S corporations. He reported this interest income as Part B income (income other than interest, dividends, or net capital gain). See G.L. c. 62, § 2 (1992 ed.).

Based on audits of the taxpayer's returns for 1987 and 1988, the commissioner assessed additional taxes and interest for each year. The assessments resulted from a reclassification of the interest income from Part B income to Part A income, which is taxed at a higher rate. In addition, the commissioner required the taxpayer to deduct his share of the business expenses of Eagle and Bayside from his Part B income, pursuant to G.L. c. 62, § 2(d )(1), and allowed him to deduct the expenses from interest income (Part A income) only to the extent that they exceeded the amount of the taxpayer's Part B income pursuant to G.L. c. 62, § 2(c )(1).

In response to the commissioner's actions, the taxpayer filed applications for abatement. The commissioner disallowed those applications, and the taxpayer then appealed to the board under the formal procedure as provided in G.L. c. 62C, § 39. The appeal was denied and the taxpayer appealed.

The taxpayer asserts two interrelated arguments in his appeal. First, he argues that the classification of interest income derived by him through Eagle and Bayside as Part A gross income violates article 44 of the Amendments to the Massachusetts Constitution and, further, that the exception provided for pawnbrokers provided in G.L. c. 62, § 2(b )(1)(B), violates art. 44 of the Amendments to the Massachusetts Constitution, art. 10 of the Massachusetts Declaration of Rights, and the equal protection clause of the Fourteenth Amendment to the United States Constitution. Second, the taxpayer argues that the ordering of deductions provided in G.L. c. 62, § 2(c ), violates art. 44 in that it precludes him from fully deducting the expenses incurred in producing the interest income from his Part A gross income.

1. Classification of interest income. In Massachusetts, gross income is divided into Part A income and Part B income. During the years at issue, Part B income was subject to tax at the rate of five per cent and Part A income was subject to tax at the rate of ten per cent. G.L. c. 62, § 4, as appearing in St.1973, c. 723, § 2; and as amended by St.1975, c. 684, § 41. The two classes are defined by G.L. c. 62, § 2(b ):

"(1) Part A gross income shall be the total interest, dividends and capital gain net income included in Massachusetts gross income, other than:--

"(A) Interest and dividends from savings deposits ...

"(B) Interest from loans made in the course of business by persons subject to the provisions of sections seventy to eighty-five, inclusive, of chapter one hundred and forty [i.e., pawnbrokers].

"(2) Part B gross income shall be the remainder of the Massachusetts gross income."

According to this statutory scheme, interest income derived from loans is Part A income, unless the loans are made in the course of business by persons subject to G.L. c. 140, §§ 70-85 (1992 ed.) (pawnbrokers). The interest earned by the taxpayer in the instant case does not qualify for the exemption for savings deposits or the exemption for pawnbrokers.

The taxpayer argues that the interest derived from lending businesses such as Eagle and Bayside should not be classified as "interest" within the meaning of G.L. c. 62, § 1(i ), but instead should be treated as ordinary business income. The Legislature's failure properly to classify this income, he argues, violates art. 44.

Article 44, ratified in 1915, allows the Legislature to impose an income tax on Massachusetts residents. The article provides: "Full power and authority are hereby given and granted to the general court to impose and levy a tax on income in the manner hereinafter provided. Such tax may be at different rates upon income derived from different classes of property, but shall be levied at a uniform rate throughout the commonwealth upon incomes derived from the same class of property." The taxpayer's claim centers on his assertion that the interest income of Eagle and Bayside is of the "same class" as ordinary business income and as such should be taxed at five per cent, under Part B of c. 62, § 2(b ).

The Legislature, under art. 44, may designate income from different classes of property to be taxed at differing rates. The Legislature has broad discretion in setting the perimeters of these classes. However, in order for varying tax rates on income derived from different types of property to be upheld under art. 44, the distinction between different classes must be based on "actual underlying differences" in the kinds of property from which the income was derived. Barnes v. State Tax Comm'n, 363 Mass. 589, 594, 296 N.E.2d 510 (1973). See Commissioner of Revenue v. Lonstein, 406 Mass. 92, 94, 546 N.E.2d 157 (1989); Salhanick v. Commissioner of Revenue, 391 Mass. 658, 662, 463 N.E.2d 1163 (1984). We have, in recent years, struck down several classifications enacted by the Legislature as violative of art. 44. ¹ The taxpayer relies on several of these cases in arguing that the interest income of his lending businesses should be classified as Part B gross income because it is of the same kind as other business income. However, none of these cases supports the taxpayer's position or refutes the presumption of validity enjoyed by G.L. c. 62, § 2(b ). See Commissioner of Revenue v. Lonstein, supra 406 Mass. at 94 n. 4, 546 N.E.2d 157, quoting Aronson v. Commonwealth, 401 Mass. 244, 254, 516 N.E.2d 137 (1987), cert. denied, 488 U.S. 818, 109 S.Ct. 58, 102 L.Ed.2d 36 (1988).

In Salhanick v. Commissioner, supra, we struck down a statute which provided for a varying tax rate on income received from certificates of beneficial interest in iron ore. The classification of the income as Part A or Part B gross income depended only on the amount of time the taxpayer held the property. There was no question that the property at issue was identical. We held that such a classification violated art. 44 because it provided for differing tax rates on income from the same class of property.

The taxpayer also cites Commissioner of Revenue v. Lonstein, supra, and Daley v. State Tax Comm'n, 376 Mass. 861, 383 N.E.2d 1140 (1978). However, these cases provide no support for the taxpayer's case. In Lonstein, we invalidated a tax classification which taxed savings deposits at different rates depending on the amount of the deposit. In Daley, we held invalid differing tax rates on income from employee trusts depending on the date of the contributions by the employer. Like Salhanick, these cases involved property which was in all respects identical and thus, under art. 44, of the "same class."

In contrast to the property involved in Salhanick, Lonstein, and Daley, income received in the form of interest has a long history in Massachusetts of being treated separately from income not derived from interest. Pursuant to the mandate of art. 44, the first income tax enacted by the Legislature arranged income into separate classes of property taxed at different rates. This arrangement essentially differentiated between "earned" and "unearned" income, with the former taxed at a lower rate. Interest income was categorized as "unearned" income. This basic classification principle survives in modified form today through the separation of Part A gross income (interest, capital gains, and dividends) and Part B gross income (all other gross income) in c. 62, § 2(b ). Historically, there has been a clear legislative intent to tax interest income at a higher rate, even if it is derived through a trade or business. Ingraham v. State Tax Comm'n, 368 Mass. 242, 247 & n. 3, 331 N.E.2d 795 (1975); Commissioner of Corps. & Taxation v. Adams, 316 Mass. 484, 486-487, 55 N.E.2d 697 (1944); Markell v. State Tax Comm'n, 2 Mass.Appellate Tax Bd.Rep. 75, 78, 1983 WL 15326 (1983).

By St.1971, c. 555, the Massachusetts system of taxation was brought closer to the Federal model. However, Massachusetts, under art. 44, retained the separation between different classes of income, and corresponding uniform rates within those classes. Markell v. State Tax Comm'n, supra at 77-78. The changes enacted through St.1971, c. 555, were further...