Tarrant v. Department of Taxes

Citation733 A.2d 733
Decision Date09 April 1999
Docket NumberNo. 96-608.,96-608.
PartiesRichard and Amy TARRANT v. DEPARTMENT OF TAXES.
CourtUnited States State Supreme Court of Vermont

Robert B. Luce, William Roger Prescott and Christopher D. Roy of Downs, Rachlin & Martin, P.C., Burlington, for Plaintiffs-Appellees.

Jeffrey L. Amestoy, Attorney General, J. Wallace Malley, Jr., Acting Attorney General, and John M. Bagwell, Special Assistant Attorney General, Montpelier, for Defendant-Appellant.

Stephen S. Ostrach, Boston, Massachusetts, for Amicus Curiae New England Legal Foundation.

Present JOHNSON and SKOGLUND, JJ., and ALLEN, C.J. (Ret.), GIBSON, J. (Ret.) and KATZ, Supr. J., Specially Assigned.

SKOGLUND, J.

The Vermont Department of Taxes appeals a superior court decision holding that taxpayers Richard and Amy Tarrant are entitled to an income tax credit on their 1989 joint income tax return for their pro rata share of taxes paid by their S corporation to states that did not recognize the pass-through taxation treatment of such corporations. The Department contends the court erred by construing the newly enacted 32 V.S.A. § 5916, which explicitly disallows the credit at issue, as an amendment to 32 V.S.A. § 5825 rather than as a clarification of preexisting law. We affirm. The parties stipulated to the facts of this case. IDX Systems Corporation, formerly known as IDX Corporation, has its headquarters in South Burlington, and taxpayers are Vermont residents. In 1989, Mr. Tarrant was president of IDX and owned 48.23% of its shares.1 Previously, IDX had made a valid federal S corporation election, also recognized by Vermont. By virtue of this election, IDX did not pay either federal or Vermont corporate income taxes in 1989. That is, as explained in more detail below, rather than the corporation paying taxes on distributions to shareholders and the shareholders then paying personal taxes on the distributions received, IDX's income, whether or not distributed, was attributed to its shareholders in proportion to their percentage of ownership. Thus, in 1989 taxpayers reported and paid taxes on 48.23% of IDX's net income — allocable to Mr. Tarrant as a shareholder — as personal income for federal and Vermont tax purposes. This is known as pass-through taxation. See I.R.C. § 1366 (1986).

During the year at issue, IDX conducted business in a number of states beyond Vermont. In those states that accorded IDX pass-through tax treatment, taxpayers were required to pay personal income taxes on their pro rata share of IDX's net income attributable to IDX's business activities in those states. Since taxpayers paid personal income taxes to those states, they were permitted to claim a credit pursuant to § 5825 for those taxes. IDX conducted business, however, in several other states2 that either did not recognize IDX's S corporation status3 or, while recognizing IDX as an S corporation, nonetheless imposed a state, corporate-level tax on IDX's net income attributable to the corporation's activities within the state.4

In 1991, taxpayers timely filed an amended Vermont income tax return for 1989, claiming a credit under § 5825 against their 1989 Vermont personal income taxes for a pro rata share of taxes that IDX paid to such non-pass-through-taxation states. Pursuant to the version of § 5825 in effect for 1989:

A taxpayer of this state ... shall receive credit against the tax imposed, for that taxable year, by section 5822 of this title for taxes imposed by and paid to, another state or territory of the United States or the District of Columbia, upon his income earned or received from sources within that state, territory, or district.

32 V.S.A. § 5825 (Cum.Supp.1989).5 The Department denied the credit. Taxpayers appealed the denial to the Commissioner of Taxes, maintaining that because Vermont passes S corporation income through to the shareholders the tax imposed by other states on IDX's income constituted a tax imposed on taxpayers' income. The Commissioner denied the claim on the grounds that § 5825 only afforded the credit where taxpayers were personally liable to pay the taxes to the other state. Taxpayers then appealed the Commissioner's adverse determination to the superior court.

On May 15, 1996, prior to hearing but after the parties had filed memoranda of law with the superior court, the Legislature passed Act No. 169, entitled "An Act Relating to Miscellaneous Tax Changes." Whereas Vermont's tax code had previously contained only de minimis coverage of S corporation taxation, § 21 of the Act created a new taxation subchapter dealing specifically with the tax treatment of S corporations. See 1995, No. 169 (Adj.Sess.), § 21; Title 32, chapter 151, subchapter 10A. Section 5916 of this new subchapter provides:

For purposes of section 5825 of this title, no credit shall be available to a resident individual, estate or trust for taxes imposed by another state or territory of the United States, the District of Columbia or a Province of Canada upon an S corporation or the income of an S corporation.

This section applies to tax years beginning on or after January 1, 1997. See 1995, No. 169 (Adj.Sess.), § 27. The Legislature also provided a sunset provision for this section; it lapses as of January 1, 2000. See id.

The court allowed both parties to file supplemental memoranda to address the Commissioner's decision in light of this new legislation. Taxpayers did not dispute that, if § 5916 had been in effect in 1989, they could not have received the § 5825 credit they seek. They argued, however, that § 5916 constituted an amendment, altering the meaning of § 5825. By contrast, the Department contended that § 5916 only confirmed and restated the existing law of § 5825. The court, agreeing with taxpayers' interpretation of § 5916 and noting that this interpretation was the "most significant" factor in its decision, reversed the Commissioner's determination and allowed the credit. This appeal followed.

Before addressing the specific issue on appeal, we first set forth, by way of background, a brief overview of the S corporation business form. "One of the disadvantages of doing business in [traditional] corporate form is the phenomenon of `double taxation.'" Wolff v. Director of Revenue, 791 S.W.2d 390, 391 (Mo.1990). A traditional corporation, also known as a C corporation because its governing provisions are found in Subchapter C, Chapter 1, Subtitle A of the United States Internal Revenue Code (I.R.C.), is treated as a separate taxable entity by the federal government and is required to pay corporate income taxes based on or measured by its net income. When a C corporation distributes its earnings and profits to its shareholders, these distributions generally are taxable to the shareholders as dividends. Thus, a C corporation's income that is distributed to its shareholders is taxed twice: once at the corporate level and once at the personal level.

In 1958, Congress adopted Subchapter S of the I.R.C. primarily to curtail the impact of double taxation on small businesses. See generally P. McDaniel, et al., Federal Income Taxation of Partnerships and S Corporations, at 383-87 (2d ed.1997) (discussing legislative history and purpose of S corporations); 14A W. Fletcher, et al., Fletcher Cyclopedia of the Law of Private Corporations §§ 6970.191-6970.215 (perm. ed. rev.vol.1991) (discussing S corporation characteristics). Subchapter S permits small businesses, or S corporations, to receive the "non-tax advantages of incorporation such as continuity of existence, insulation from personal liability, and ease of transferability of ownership," Cohen v. Colorado Dep't of Revenue, 197 Colo. 385, 593 P.2d 957, 959 (1979), which are also available to C corporations. There are, however, differences between S corporations and C corporations, most notably their tax treatment.6

S corporations and their shareholders are for the most part statutorily exempt from double taxation. See I.R.C. § 1363(a) (1986). But see id. § 1374 (S corporation is taxable on gain recognized from disposition of appreciated assets or income items acquired while corporation was a C corporation, or from a C corporation in a nonrecognition transaction). Instead, S corporations and their shareholders are treated for tax purposes much like partnerships and their respective partners. See S.Rep. No. 97-640, 97th Cong., 2nd Sess., at 15 (1982) U.S.Code Cong. & Admin. News 1982 at pp. 3253, 3266 ("These rules generally follow the . . . rules governing the taxation of partners with respect to items of partnership income and loss."); see also Beard v. United States, 992 F.2d 1516, 1518 (11th Cir.1993) ("The S corporation is, in effect, a Code-created hybrid combining traits of both corporations and partnerships."). A small business can thus "select the form of business organization desired, without . . . taking into account major differences in tax consequence." S.Rep. No. 85-1983, at 87 (1958).

At the federal level, S corporations are required to file only an informational return, reporting for the taxable year gross income (or loss), deductions, credits, the identity of its shareholders, and the shareholders' pro rata shares of each item. See I.R.C. § 6037(a). The taxable income of an S corporation is typically computed in the same manner as that of an individual. See id. § 1363(b). Certain deductions, however, are not available to the S corporation, but may be claimed by the individual shareholders. These include deductions for taxes paid to foreign countries or United States possessions. See, e.g., id. § 1363(c)(1), (2). The S corporation's income (or loss), deductions, and credits are passed through on a pro rata basis to the shareholders, who report them on their personal income tax returns. See id. § 1366(a)(1)(A) (items of income, including tax-exempt income, loss, deduction, or credit — separate treatment of which could affect any shareholder's tax liability — are...

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