During database upgrade checklist I was failed to connect with source database. I followed the suggested steps from upgrade guide as pasted below but these weren't enough in my case for successful connection.
Configure matching user permissions
Windows integrated security is used to connect to the source database from the target system. If the administrative user who is performing the upgrade on the target system does not have access to the source system database, the source system will reject the database connection. Open Microsoft SQL Server Management Studio on the source system and perform the following steps:
1. Grant Microsoft Dynamics AX database access to a domain user with administrative privileges on the target Microsoft Dynamics AX 2012 system.
2. Add the user to the db_owner and public roles.
Make sure you have assigned sysadmin role to the AOS service account from SQL management studio under this path SQLSERVERINSTANCE\Security\Logins\<AOSService Account>. Right click on AOSService account and choose Server Roles from left hand side panel and assign sysadmin role listed on right hand side.