J.H. McKnight Ranch v. Franchise Tax Bd.

• Decision Date: 22 July 2003
• Docket Number: No. A098729.,A098729.
• Citation: 110 Cal.App.4th 978,2 Cal.Rptr.3d 339
• Court: California Court of Appeals Court of Appeals
• Parties: J.H. McKNIGHT RANCH, INC., Plaintiff and Respondent, v. FRANCHISE TAX BOARD, Defendant and Appellant.

2 Cal.Rptr.3d 339

110 Cal.App.4th 978

J.H. McKNIGHT RANCH, INC., Plaintiff and Respondent, v. FRANCHISE TAX BOARD, Defendant and Appellant.

No. A098729.

Court of Appeal, First District, Division 5.

July 22, 2003.

As Modified on Denial of Rehearing August 19, 2003.

Bill Lockyer, Attorney General, Randall P. Borcherding, Supervising Deputy Attorney General, Jack Newman and David Lew, Deputy Attorneys General, for Defendant and Appellant.

Reed Smith Crosby Heafey, Donald P. Rubenstein, Paul D. Fogel, San Francisco, and Jayne E. Fleming, Oakland, for Plaintiff and Respondent.

GEMELLO, J.

In 1995, the Franchise Tax Board (Board) informed the J.H. McKnight Ranch, Inc. (McKnight) that it had underpaid state taxes by approximately $97,000. McKnight protested without success, then paid the disputed tax and filed a refund claim. In discussions with McKnight, the Board reiterated the view that the tax was owed, but offered to deny the refund claim summarily so that McKnight could proceed in court. McKnight accepted the offer and filed suit.

The Board now concedes that under the contested liability doctrine, no tax was ever owed. It nevertheless suggests that because of its summary denial of McKnight's refund claim, McKnight failed to exhaust its administrative remedies and the Board should be allowed to retain the excess tax.

Equity does not allow such a result. The common law rule that the government could not be estopped was abandoned in California more than a century ago. Where equity requires it, as where a government agent's actions have induced noncompliance with procedural requirements, the government may be estopped from asserting those procedural bars against a citizen's recovery. We affirm the trial court's grant of judgment in favor of McKnight.

FACTUAL AND PROCEDURAL BACKGROUND

McKnight operates a rice farm in Butte County. In 1980, Bank of America represented to McKnight that it had substantial farm management and marketing experience, and persuaded McKnight to consolidate its banking with Bank of America. Bank of America extended annual lines of credit to McKnight and exerted substantial influence over McKnight's farming operations over the next six years. Between 1980 and 1986, McKnight paid Bank of America more than $13,000,000 in principal and interest on approximately $12,600,000 in loans. As of 1989, Bank of America contended approximately $2.4 million was still owed. McKnight disputed this amount.

In 1989, McKnight sued Bank of America for breach of fiduciary duty, misrepresentations, misappropriation of funds, and assorted other malfeasance resulting in significant losses to McKnight. The parties settled in 1990, with Bank of America discharging the purported $2.4 million debt for a payment of $150,000 and dismissal of the suit. McKnight did not report the discharge as income on its 1990 income tax return.

The Board audited McKnight's 1990 return. In June 1995, it determined that $991,445 of the debt discharged by Bank of America was taxable income and assessed $97,258 in additional taxes.

In November 1995, McKnight filed a protest of the assessment. McKnight's protest contended that the $991,445 was not taxable income under the tax benefit rule and the contested liability doctrine. In 1996, the Board's Protest Unit denied McKnight's protest.

McKnight attempted to resolve the dispute with the Board's Settlement Bureau. That effort failed.

In 1997, McKnight paid the disputed $97,258 in additional taxes and filed an amended 1990 return and refund claim. In February 1999, the Board denied McKnight's refund claim. McKnight thereupon filed suit for refund in superior court.

The parties submitted a set of stipulated facts and documents. After a one-day trial, the court issued a statement of decision ruling in favor of McKnight. On March 14, 2002, it entered judgment for McKnight, awarding it the $97,258 in overpaid taxes plus pre- and post-judgment interest.

The Board has timely appealed. On appeal, it contends that the trial court ignored McKnight's failure to exhaust its administrative remedies in proceedings before the Board.

DISCUSSION

I. Standard of Review

When the parties have submitted a tax matter on stipulated facts and documentary evidence and there is no conflict in that evidence, this court is confronted with questions of law rather than fact. We independently review the record and are not bound by the trial court's determination. (Wilson v. Franchise Tax Bd. (1993) 20 Cal.App.4th 1441, 1450, 25 Cal.Rptr .2d 282.) However, when the trial court makes factual findings on disputed issues, we review those findings under the substantial evidence test. (Tenneco West, Inc. v. Franchise Tax Bd. (1991) 234 Cal. App.3d 1510, 1521, 286 Cal.Rptr. 354.)

The Board contends that the trial court erred by failing to draft its own statement of decision, and that we should therefore review de novo even those findings that hinged on disputed evidence. (Estate of Larson (1980) 106 Cal.App.3d 560, 567-568, 166 Cal.Rptr. 868.) In Estate of Larson, the appellate court reversed because the record demonstrated that the trial court had misapprehended the legal standards governing a particular factual finding. In such circumstances, the appellate court declined to apply a substantial evidence standard of review because the trial court never weighed the evidence with the correct standard in mind. (Ibid.)

Estate of Larson does not support a departure from the substantial evidence standard here. In order to free time to consider the merits of parties' disputes, state trial courts routinely solicit draft statements of decision. "The preparation of a statement of decision should place no extra burden on the trial courts. A party may be, and often should be, required to prepare the statement." (Whittington v. McKinney (1991) 234 Cal. App.3d 123, 129, fn. 5, 285 Cal.Rptr. 586.) A trial court may then select which findings it agrees with as supported by the evidence and adopt them, rather than having to prepare a statement of decision from scratch. That a court does so creates no inference that it has failed to engage in a thoughtful weighing of the evidence, and does not license us to ignore its findings of fact. (See Western Aggregates, Inc. v. County of Yuba (2002) 101 Cal.App.4th 278, 310-311, 130 Cal.Rptr.2d 436.) Here, the trial court adopted virtually all of McKnight's proposed statement of decision, but struck the portion with which it disagreed, a finding that the Board's position was without substantial justification and that McKnight was entitled to attorney fees. We decline to displace the trial court from its role as fact finder and review its findings de novo. Instead, we adhere to the traditional substantial evidence test.

II. As a Matter of Substantive Tax Law, McKnight Owed No Tax Under the Contested Liability Doctrine

After eight years, the Board offers no substantive rebuttal to McKnight's argument that it owed no tax under the contested liability doctrine. Under that doctrine, the purported debt discharged by the Bank of America was not taxable.

Ordinarily, the discharge of a loan will give rise to taxable income. "The discharge-of-indebtedness doctrine applies when a taxpayer who has incurred a financial obligation is thereafter relieved of liability, in whole or in part. When that happens, the taxpayer recognizes taxable income equal to the difference between the initial obligation and the amount, if any, paid to discharge that obligation." (Estate of Smith v. C.I.R. (5th Cir.1999) 198 F.3d 515, 530.)¹ This is so because "[b]orrowed funds are excluded from income in the first instance because the taxpayer's obligation to repay the funds offsets any increase in the taxpayer's assets; if the taxpayer is thereafter released from his obligation to repay, the taxpayer enjoys a net increase in assets equal to the forgiven portion of the debt and the basis for the original exclusion thus evaporates." (United States v. Centennial Savings Bank FSB (1991) 499 U.S. 573, 582, 111 S.Ct. 1512, 113 L.Ed.2d 608.)

However, an exception arises when the "discharge" results from a dispute over whether the greater amount actually was owed. "Under the contested liability doctrine, if a taxpayer, in good faith, disputed the amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt cognizable for tax purposes. The excess of the original debt over the amount determined to have been due is disregarded for both loss and debt accounting purposes." (Zarin v. C.I.R. (3d Cir.1990) 916 F.2d 110, 115.) The law thus accepts the parties' fixing of the amount of the debt and treats the greater asserted amount as a nullity.

Here, McKnight contends that it disputed in good faith the amount it owed the Bank of America. Consequently, under the contested liability doctrine, the Bank of America's cancellation of $2.25 million of the purported $2.4 million debt owed by McKnight would not be taxable income, but simply a bookkeeping consequence of the parties' liquidation of the amount of the disputed debt. At the close of trial, the trial court agreed with McKnight, adopted McKnight's proposed statement of decision, and held that under contested liability principles McKnight owed no tax on the cancelled portion of the Bank of America debt.

On appeal, the Board does not dispute this conclusion. At oral argument, it expressly conceded that the contested liability doctrine exempted the cancelled portion of the debt from taxation. We thus treat it as established that McKnight did not owe the $97,258 it paid when it filed its amended 1990 return.²

III. The Board Had Actual Notice of McKnight's Contested Liability Argument in the Course of Resolving the Refund Claim

Notwithstanding the fact that substantively, no tax was owed, the Board contends that McKnight should be barred from a refund for procedural reasons. It argues that the trial court lacked jurisdiction to order a refund...