Leonard v. Commissioner of Revenue Services

• Decision Date: 10 June 2003
• Docket Number: (SC 16735).
• Citation: 823 A.2d 1184,264 Conn. 286
• Court: Connecticut Supreme Court
• Parties: STEWART J. LEONARD, SR. v. COMMISSIONER OF REVENUE SERVICES.

264 Conn. 286

823 A.2d 1184

STEWART J. LEONARD, SR. v. COMMISSIONER OF REVENUE SERVICES.

(SC 16735).

Supreme Court of Connecticut.

Argued March 18, 2003.

Officially released June 10, 2003.

Borden, Norcott, Katz, Vertefeuille and Zarella, Js.

Richard K. Greenberg, assistant attorney general, with whom, on the brief, were Richard Blumenthal, attorney general, and Eliot D. Prescott, assistant attorney general, for the appellant (defendant).

Nathan M. Silverstein, with whom was Kurt F. Zimmermann, for the appellee (petitioner).

Opinion

KATZ, J.

The defendant, the commissioner of revenue services, appeals¹ from the judgment of the trial court sustaining the appeal by the plaintiff, Stewart J. Leonard, Sr., doing business as Stew Leonard's Dairy (Dairy), from the defendant's decision imposing a deficiency assessment for sales and use tax, interest and a 25 percent penalty. The defendant claims that the trial court improperly construed the requirements for proving fraud and intent to evade under General Statutes (Rev. to 1991) § 12-415² when the court concluded that: (1) the exception to the three year statute of limitations under § 12-415 (7) had not been established and, accordingly, that pre-1989 assessments were time barred; and (2) the 25 percent penalty under § 12-415 (5) could not be imposed. The defendant further claims that the trial court improperly sustained the plaintiff's appeal with respect to the post-1989 deficiency assessments on the ground that those assessments were arbitrary and unsupported by the evidence. We conclude that the trial court improperly concluded that pre-1989 assessments were time barred. We further conclude, however, that the trial court properly concluded that the post-1989 deficiency assessments were improper. Accordingly, we reverse in part the judgment of the trial court.

A joint stipulation of facts submitted to the trial court provides much of the largely undisputed factual basis for this appeal. Since at least July 1, 1981, the plaintiff has owned and operated the Dairy, a partnership that engaged in a retail dairy and grocery sales business with its principal place of business in Norwalk. In July, 1991, the Internal Revenue Service (IRS) commenced an investigation of the plaintiff and the Dairy and, as a result, discovered that the plaintiff and certain Dairy employees had devised a scheme by which they systematically diverted cash receipts from the Dairy's bank deposits and altered financial records, including gross sales figures, to correspond with the diverted cash receipts. As part of this scheme, the participants instituted a computer software program at the Dairy, dubbed "Equity" (Equity program) by the scheme participants, which reduced the record of gross sales and corresponding inventory data by the amount of cash diverted each week. The Equity program wrote over the original data, including gross sales, and replaced that data with false data, which then was used to prepare the weekly financial report. Consequently, the original data was irretrievable. Gross receipts altered by the Equity program were then recorded in the Dairy's books and records.

As a result of its investigation, the IRS instituted criminal proceedings against the plaintiff and other scheme participants, alleging that the diversion of receipts and the alteration of records caused the Dairy's gross receipts to be understated substantially on its federal partnership tax returns for 1981 through 1990 and that the plaintiff similarly had underreported income on his personal federal income tax returns. The plaintiff and three other Dairy employees pleaded guilty to having conspired illegally to defraud the federal government by impeding and impairing the lawful functions of the IRS in violation of 18 U.S.C. § 371. The plaintiff and the IRS agreed that the plaintiff would pay $15 million in taxes, interest and penalties in settlement of all federal tax liabilities for the years 1981 through 1991. This amount was calculated based, in part, on an arbitrary figure, agreed to by the parties, of $12,500,000 in unreported gross sales.

As a result of the IRS actions, in February, 1992, the state department of revenue services (department) commenced an audit of the sales and use tax returns of the Dairy. On February 27, 1996, an audit examiner for the department issued a final tax determination report, proposing increases of $511,821.15 in the Dairy's sales and use tax liabilities for the taxable periods of July, 1983, through March, 1992. As the basis for the assessment, the examiner relied on the $12,500,000 gross sales figure contained in the plaintiff's settlement with the IRS, allocated among the fiscal years at issue. On March 15, 1996, the defendant issued a notice of assessment in accordance with the examiner's report for a total assessment of $1,402,514.24—$511,821.15 in sales and use tax liability, $742,278.10 in interest and $148,414.99 in penalties. The plaintiff agreed that $172,984 of the total assessment was valid for certain expenses improperly deducted on its returns and for additional sales and use tax owed. The plaintiff issued payment in that amount, but contested the balance of the tax assessment and the penalty, filing a petition for reassessment to the department's appellate division. After hearings on the matter, the defendant issued notice of his decision denying the plaintiff's petition.

Thereafter, the plaintiff appealed, pursuant to General Statutes § 12-422, from the defendant's decision to the Superior Court. The plaintiff raised two issues on appeal: (1) whether the three year statute of limitations under § 12-415 (7) barred deficiency assessments for the periods prior to February, 1989;³ and (2) whether the assessment and the penalty were valid. The parties submitted a stipulation of facts and stipulated exhibits to Hon. Arnold W. Aronson, judge trial referee, acting as a trial court. By agreement of the parties, the court bifurcated the trial to address separately the two time periods at issue.

The plaintiff submitted as stipulated exhibits the depositions of Jeffrey Pirhalla, the computer specialist who designed and implemented the Equity program, John M. Peters, the Dairy's comptroller, and Stephen Guthman, the Dairy's former chief executive officer, on the issues of the Dairy's sales tax collection and reporting methods and the effect of the Equity program on those methods. Each testified that the Equity program had no effect on sales tax. Specifically, Pirhalla testified that the program was designed to alter certain fields of information in order to conceal the cash diversions, but that the sales tax data that had been transmitted from the cash registers at the time it was collected had not been altered. He further testified that the Equity program software and computer printouts reflecting the data manipulation had been taken and retained by the IRS.

The plaintiff also presented testimony by Kevin Faustine, Lawrence Marini and Doreen Schulze, current and former IRS agents who had been involved in investigating the plaintiff's federal tax fraud case. The agents testified that they had no information leading them to conclude that the Equity program had an effect on sales tax. Specifically, Schulze, an IRS computer specialist, testified that, in conducting her investigation, she would have noticed and reported if the sales tax figures had been affected by the program. All three agents indicated on cross-examination that they had not taken any measures to verify the sales tax when investigating the Equity program.

Two department employees testified for the commissioner. Angela White, the department revenue examiner who issued the Dairy's tax determination report, testified that the deficiency assessment was based primarily on the IRS settlement figure, due to the limited availability of other records with which to verify sales tax.⁴ In addition, White relied on two "current week activity reports" reflecting the Dairy's sales data for the same week, one reflecting data before application of the Equity program, and the other reflecting data after the Equity program had run, altering data. Both White and Michael O'Sullivan, a tax appellate officer, testified that their analysis of the two reports, based on certain calculations O'Sullivan had made, indicated a discrepancy between the sales tax that should have been collected for that week and the sales tax reflected in the financial report. O'Sullivan attributed this discrepancy to the Equity program, although he stated that he did not know how the program operated. He had tried to obtain a copy of the program from the IRS, but it denied his request.

In his trial brief, the defendant contended that pre-1989 assessments were not barred by the statute of limitations under § 12-415 (7), because the fraud and intent to evade exceptions set forth therein were applicable. See footnote 2 of this opinion. Specifically, the defendant contended that fraud against the federal government and the false statement of gross sales on the state returns demonstrated fraud and that the plaintiff's wilful destruction of records demonstrated an intent to evade under § 12-415. In its memorandum of decision in the first phase of the proceedings, the trial court concluded that the pre-1989 assessments were time barred because the defendant had failed to satisfy his burden of proving "by clear and convincing evidence that the plaintiff ... committed fraud ... by wilful wrongdoing with the specific intent to deprive the state of taxes known by the plaintiff to be owed." The trial court acknowledged that the defendant's audit was "hampered by the unavailability of [certain] records," as a result of the Equity program's erasure of certain computer generated data and by the retention of certain records by the IRS. The trial court concluded, however, that the evidence demonstrated that the program had been designed only to understate...