                          T.C. Memo. 1997-283



                        UNITED STATES TAX COURT



         REAVES LIVESTOCK, INC., ET AL.,1 Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 6594-94, 6630-94,                Filed June 23, 1997.
                 11155-95.



     Ocie F. Murray, Jr., for petitioners Reaves Livestock, Inc.,

and George K. Reaves.

     Matthew Bates, for petitioner Linda L. Reaves.

     Frank C. McClanahan, for respondent.




     1
       The cases of George K. and Linda L. Reaves, docket Nos.
6630-94 and 11155-95, were consolidated for purposes of trial,
briefing, and opinion.
                                - 2 -

             MEMORANDUM FINDINGS OF FACT AND OPINION


     COLVIN, Judge:    Respondent determined deficiencies and

additions to tax in petitioners' Federal income tax as follows:

                        Reaves Livestock, Inc.

                                  Additions to Tax
Year Deficiency    Sec. 6653(b)(1)  Sec. 6653(b)(1)(A) Sec. 6661
1984 $39,374          $28,835                           $14,418
1985   79,218          42,459                            21,229
1986   95,420                          $91,216           30,405
1987   85,092                           74,947           24,982

     Respondent also determined that Reaves Livestock, Inc.

(Reaves Livestock) is liable for additions to tax for fraud of 50

percent of the interest due on $57,670 for 1984 and $84,918 for

1985 under section 6653(b)(2), and 50 percent of the interest due

on $121,621 for 1986 and $99,929 for 1987 under section

6653(b)(1)(B).

                 George K. Reaves and Linda L. Reaves

                                 Additions to Tax
Year Deficiency    Sec. 6653(b)(1) Sec. 6653(b)(1)(A) Sec. 6661
1984 $40,883          $20,552                          $10,221
1985   66,787          34,452                           16,697
1986 130,741                              $98,056       32,685
1987 112,224                               84,168       28,056

     Respondent also determined that George K. Reaves (Mr.

Reaves) and Linda L. Reaves (Mrs. Reaves) are liable for

additions to tax for fraud of 50 percent of the interest due on

$40,883 for 1984 and $66,787 for 1985 under section 6653(b)(2),

and 50 percent of the interest due on $130,741 for 1986 and

$112,224 for 1987 under section 6653(b)(1)(B).
                                   - 3 -

                   George K. Reaves and Linda L. Reaves

                                  Additions to Tax
Year Deficiency       Sec. 6653(a)(1)   Sec. 6661    Sec. 6662
1988   $22,746            $1,137          $5,687
1989     1,148                                           $230

        Following concessions, we must decide the following issues:2

     1.        Whether Mr. and Mrs. Reaves received constructive

dividends of $93,460 in 1984, $144,287 in 1985, $270,200 in 1986,

and $273,889 in 1987, as respondent contends; $13,814 in 1984,

$19,551 in 1985, $89,150 in 1986, and $68,556 in 1987, as

petitioners contend; or some other amount.       We hold that they

received constructive dividends of $93,410 in 1984, $130,551 in

1985, $270,200 in 1986, and $222,982 in 1987.

     2.        Whether Mr. and Mrs. Reaves are liable for the

additions to tax for fraud under section 6653(b)(1) and (2) for

1984 and 1985 and section 6653(b)(1)(A) and (B) for 1986 and

1987.       We hold that they are to the extent stated below.

     3.        Whether respondent timely issued a notice of deficiency

to Mr. and Mrs. Reaves for 1984 and Reaves Livestock for all of

the years in issue.       We hold that respondent did.

     4.        Whether petitioners are liable for the addition to tax

for substantial understatement of tax under section 6661(a) for

        2
       Spouses who sign a joint return are jointly liable for the
addition to tax for negligence. See Pesch v. Commissioner, 78
T.C. 100, 128-129 (1982). Mrs. Reaves is liable for the addition
to tax for negligence under sec. 6653(a)(1) for 1988 because Mr.
Reaves concedes liability and, as discussed below at par. F of
the opinion, Mrs. Reaves does not qualify as an innocent spouse
under sec. 6013(e).
                                  - 4 -

1984, 1985, 1986, and 1987.    We hold they are for the years for

which the understatement is substantial.

     5.     Whether Reaves Livestock is liable for the additions to

tax for fraud under section 6653(b)(1) and (2) for 1984 and 1985

and section 6653(b)(1)(A) and (B) for 1986 and 1987.    We hold

that it is to the extent stated below.

     6.     Whether Linda L. Reaves qualifies as an innocent spouse

under section 6013(e).    We hold that she does not.

     Unless otherwise indicated, section references are to the

Internal Revenue Code.    Rule references are to the Tax Court

Rules of Practice and Procedure.

                          FINDINGS OF FACT

A.   Petitioners

     1.     Mr. and Mrs. Reaves

     Mr. and Mrs. Reaves are married and lived in Rowland, North

Carolina, when they filed the petition in this case.

     Mr. Reaves has an eighth grade education.    In 1971, he

formed Reaves Livestock, a North Carolina corporation, the

principal place of business of which is in Rowland, North

Carolina.    Mr. Reaves has been the president and sole shareholder

of Reaves Livestock since 1971.     Mr. Reaves has no experience or

formal training in bookkeeping or tax matters.

     Mrs. Reaves graduated from high school and attended business

school for 3 months.    She had no formal training in bookkeeping
                                 - 5 -

or accounting.    She kept her and Mr. Reaves' personal accounts

and records.

     Mr. and Mrs. Reaves had three children:    Sandra, born in

1962; Tina, born in 1966; and Mike, born in 1967 or 1968.    Mike

Reaves raised and sold livestock.

     Mr. and Mrs. Reaves had two personal accounts at Southern

National Bank of North Carolina (Southern National) in Rowland,

North Carolina.    One was in the name of George K. and Linda L.

Reaves.   The other was in the name of Reaves Farm.   In 1986, Mrs.

Reaves inadvertently deposited a $10,197 payment to Reaves

Livestock for the sale of cattle in one of the Reaves' personal

accounts.

     Mr. and Mrs. Reaves had a conservative lifestyle during the

years in issue.    They generally took no vacations other than at

their beach house.    From 1986 to 1993, Mr. Reaves drove a 1986

Ford pickup truck that belonged to Reaves Livestock.    Mrs. Reaves

owned a 1983 Oldsmobile before 1986 until 1988.

     2.     Reaves Livestock, Inc.

            a.    General Business Activities

     Reaves Livestock bought livestock from farmers and sold it

to packing companies.

     Mr. Reaves usually arrived at work at the Reaves Livestock

barn at 7 or 7:30 a.m.    He often left the barn around 8 a.m. to

attend livestock sales.    He returned around 8 p.m. and usually
                                 - 6 -

went to the barn.    Mr. Reaves also worked in the office, but he

did no bookkeeping.

     During the years in issue, Reaves Livestock had about nine

truck drivers and five or six barn men.    The barn men loaded and

unloaded livestock, weighed them, and put them in pens.

     Samuel Ray Cummings (Cummings) worked for Reaves Livestock

during the 1980's.    He stole money from Reaves Livestock while he

worked there.

     Farmers sometimes asked Reaves Livestock to pay cash for

their livestock.

     From 1984 to 1987, Reaves Livestock reported gross receipts

and taxable income as follows:

          Year        Gross receipts       Taxable income

          1984        $17,565,725             $77,149
          1985         19,269,418              99,687
          1986         23,317,287              49,739
          1987         22,676,647              35,838
            Total     $82,829,077            $262,413

          b.     Reaves Livestock's Bookkeepers--Bonnie Wright and
                 Jeff Lawson

     Mr. Reaves met Bonnie Wright (Wright) in the late 1960's

when they worked at Powell Livestock Co.    Wright kept records and

wrote checks for Powell Livestock Co.    Wright worked for Reaves

Livestock from the early 1970's to 1987.    Wright was the

corporate secretary and treasurer for Reaves Livestock.

     Wright had a son, Jeff Lawson (Lawson).    At her request, Mr.

Reaves hired Lawson as a bookkeeper for Reaves Livestock around
                                - 7 -

June 1980.   Lawson has an associate's degree in accounting and

business administration and has completed 3 years towards his

bachelor's degree in accounting.   Lawson earned from $195 to $225

per week in 1984, $225 per week in 1985, from $245 to $300 per

week in 1986, and from $300 to $500 per week in 1987.    He

received more than $6,000 in bonuses from 1984 to 1987.    Lawson

became corporate secretary and treasurer for Reaves Livestock

after Wright stopped working there in 1987.

     Wright and Lawson were Reaves Livestock's only bookkeepers

during the years in issue.   Wright usually arrived at work

between 9:30 a.m. and 11 a.m. and stayed until late in the

evening.   Lawson usually arrived about 7:30 a.m. and left between

4 p.m. and 5 p.m.

     Wright and Lawson maintained Reaves Livestock's books and

records and knew about all of its transactions.    They wrote the

checks, balanced the checking account, reconciled the bank

statements, and made deposits in Reaves Livestock's account.

They wrote 6,000 to 7,000 checks per year.    They kept a double

entry set of books; i.e., they posted an entry once as a credit

and once as a debit.   They kept journals and ledgers for Reaves

Livestock.

     Reaves Livestock had a checking account at Southern National

(Reaves Livestock account) during the years in issue.    Mr. and

Mrs. Reaves, Wright, and Lawson were authorized to sign checks on

the Reaves Livestock account.   If Mr. Reaves arrived in the
                                 - 8 -

morning and Wright was not there, Mr. Reaves signed 15 to 30

blank checks to be used to buy livestock.    Wright signed

additional checks on the Reaves Livestock account as needed.      Mr.

Reaves did not usually prepare checks or review completed checks

after he signed them in blank.

     Lawson was not authorized to sign checks for Reaves

Livestock until he became an officer of the company early in

1987.   Before Lawson had check signing authority, he prepared

checks previously signed by Mr. Reaves if Mr. Reaves was away.

Lawson signed most of the checks after he had check signing

authority.

     Lawson used drugs in the 1980's and was convicted of

possessing marijuana in 1982.    Lawson went to a bowling

tournament in Las Vegas in 1985 and 1986 and to New England and

Canada for 5 days in 1987.   Lawson bought a 1985 Buick Regal in

1986 or 1987 for his sister.    He bought a new BMW automobile in

1987, which he kept for less than 6 months.    Lawson sometimes

played poker with Mr. Reaves and several other people.

           c.   Mr. Reaves' Involvement With Reaves Livestock's
                Books and Records

     Every Monday the bookkeepers told Mr. Reaves the amount of

Reaves Livestock's cash on hand, the bank balance, how much money

was owed to them, how much money they had spent to buy livestock,

the amount of money that they had spent to pay bills, and the

cash and livestock that they had on hand the previous Monday.
                                 - 9 -

Mr. Reaves could tell how well Reaves Livestock was doing

financially from the amount and the profit margin of inventory

that he bought and sold.    He could detect a mistake as small as a

few thousand dollars.    Mr. Reaves did not know what books and

records Reaves Livestock kept during the years in issue, nor did

he review its books and records.

            d.    Mrs. Reaves' Role at Reaves Livestock

     Mrs. Reaves was vice president of Reaves Livestock during

the years in issue.    From 1984 to 1988, she occasionally helped

in the office by writing invoices, weight tickets, bills, and

checks including payroll.    She also checked daily stockyard

bills.    She did no bookkeeping.   Mr. and Mrs. Reaves reported

that Mrs. Reaves received a salary from Reaves Livestock of

$4,067 in 1984, $4,071 in 1985, $3,000 in 1986, and $3,000 in

1987.

B.   The First Citizens Bank Accounts

     1.     Establishment and Control of The Accounts

     Reaves Livestock is about one mile from South of the Border,

South Carolina.    Mr. Reaves opened accounts at First Citizens

Bank & Trust Co. (First Citizens) at South of the Border and

maintained them during the years in issue in the names of S&J Hog

Farm (S&J) and George K. Reaves (First Citizens accounts).      Mr.

Reaves caused some unreported Reaves Livestock receipts to be

deposited in the First Citizens accounts.     He also caused some

Reaves Livestock checks (which Reaves Livestock deducted as
                                - 10 -

business expenses) to be deposited in the First Citizens

accounts.

     Only Mr. and Mrs. Reaves were authorized to sign checks and

make withdrawals from the First Citizens accounts.     The Social

Security number on the signature card for the S&J account was not

that of Mr. or Mrs. Reaves.

     Wright and Lawson knew about the First Citizens accounts.

They balanced the S&J account but not the George K. Reaves

account.    During the years in issue, Mr. and Mrs. Reaves, Wright,

and Lawson (in 1988) signed Reaves Livestock account checks which

were deposited in the First Citizens accounts.      Wright and Lawson

recorded those checks as purchases on Reaves Livestock's books.

     Wright and Lawson stored the checkbooks, canceled checks,

and bank statements for the Reaves Livestock account and the

First Citizens accounts in a filing cabinet in the storage room

at Reaves Livestock's office.    The filing cabinet doors were open

during the day.

     The deposits in the First Citizens accounts totaled as

follows:

                           Reaves           S&J
            Year           account        account

            1984           $29,010         $9,937
            1985            27,744        110,041
            1986            68,052        149,162
            1987           105,541        238,185
                              - 11 -

     2.   The S&J Account

          a.    Purpose of the S&J Account

     Wallace "Slick" Prevatte (Prevatte) formerly worked for Mr.

Reaves or Reaves Livestock.   Mr. Reaves' nickname is "Jackie".

"S&J" stood for Slick and Jackie.   Mr. Reaves created S&J Hog

Farm because some businesses wanted to deal with a farm, not

Reaves Livestock.   S&J bought and sold hogs and cattle.   Prevatte

received a commission for hogs that he sold.    He had no authority

over the S&J account.

          b.    Checks Written on S&J Account

     Mr. and Mrs. Reaves signed checks written on the S&J account

as follows:

                Hog farm               No. of checks signed by
Year   Personal related Disputed       Mr. Reaves   Mrs. Reaves
1984       $0      $845       $0            0            2
1985    5,006    61,225   4,750             2            2
1986    3,325   149,371  55,000            16            3
1987   10,600   230,364  23,800            44            5
1988   18,262   324,061    --              72           12
Total $37,193  $765,866 $83,550           134           24

     Lawson wrote some of the S&J checks which Mr. or Mrs. Reaves

signed.   We discuss the disputed checks below at pars. B-2-d, B-

2-e, and G.

          c.    Reaves Livestock Payments To S&J Hog Farms

     Reaves Livestock bought cattle from S&J with the following

seven checks, which were payable to S&J:
                                    - 12 -

       Date          Amount      Signed by     Endorsed by     Notation

Jan.   31, 1986       $242      Mr. Reaves         S&J       1 Hfr.-440#
Feb.   4, 1986         179      Wright             S&J       1 Bull-715#
Feb.   5, 1986       1,300      (not signed)       S&J       11 calves
Mar.   17, 1986      1,147      Mr. Reaves         S&J       2 Bulls-2,730#
Mar.   24, 1986      3,944      Wright             S&J       15 clfs-6635#
                                               Mr. Reaves
Sept. 22, 1986         950      Wright             S&J       2 Cattle-BH
                                               Mr. Reaves
Oct. 6, 1986         1,287      Wright             S&J       3 Cattle-3230#
                                               Mr. Reaves
       Total        $9,049

               d.   $4,750 Check Payable to Mrs. Reaves

       On December 16, 1985, Neil Lee (Lee), a farmer who sold

feed, offered to sell a load of corn to Mr. Reaves.            Mrs. Reaves

wrote a $4,750 check on the S&J account payable to herself with

the notation "feed".         Mrs. Reaves endorsed and cashed the check.

Mr. Reaves used the proceeds to pay Lee for the corn.

               e.   $23,800 Check Payable to Crook Motor Co.

       In 1987, Mr. Reaves wrote a $23,800 check on the S&J account

payable to Crook Motor Co., Inc.         Mr. Reaves lent the money to

Robert Martin, a former employee of Reaves Livestock, and his

partner, Hubert Kissam, to buy a dump truck for Martin's and

Kissam's business, Lumberton Paving and Grading Co. (Lumberton

Paving).       Lumberton Paving mortgaged the dump truck.       Lumberton

Paving went bankrupt in 1989.        The dump truck was sold at an

auction.
                               - 13 -

     3.    The George K. Reaves Account

     Mr. Reaves signed most of the checks in 1984, 1985, and

19883 drawn on the George K. Reaves account at First Citizens,

which totaled as follows:

                                      Business
                Year       Personal   Related    Disputed
                1984       $11,564          $0
                1985        11,545      55,075
                1986        17,628          50   $11,730
                1987        71,849      31,358    19,151
                1988        47,384      45,569
                  Total   $159,970    $132,052   $30,881

     We discuss the disputed checks next.

           a.   $11,730 Check Payable to Allstate Truck & Equip.,
                Inc.

     On December 26, 1986, Mr. Reaves wrote an $11,730 check on

the George K. Reaves account payable to Allstate Truck & Equip.,

Inc., to buy a lowboy trailer.   Lumberton Paving used the

trailer.   Lumberton Paving could not repay the $11,730.

           b.   $19,151 Check Payable to First Citizens

     On March 23, 1987, Reaves Livestock bought a small old house

in Dillon, South Carolina (Dillon house) for Doug Grant (Grant),

a Reaves Livestock employee.   Grant lived about 60 miles from

Rowland and wanted to live closer to work.

     Mr. Reaves wrote a $19,151 check on the George K. Reaves

account payable to First Citizens to buy the Dillon house.   Title

to the Dillon house was in Mrs. Reaves' name.    Grant did not want

     3
       The record does not show who signed the George K. Reaves
account checks in 1986 and 1987.
                                 - 14 -

title to the Dillon house to be in his name because he had some

judgments against him.

       Grant lived in the Dillon house, repaired it, and paid taxes

and insurance on it.     In March 1993, Reaves Livestock sold the

Dillon house to Grant for $20,000.        Mrs. Reaves transferred title

to him.    Grant paid $20,000 to Reaves Livestock.

C.     The 282 Checks

       A total of 282 checks were drawn on the Reaves Livestock

account and payable to fictitious persons from 1984 to 1987 (the

282 checks).     Reaves Livestock deducted the 282 checks as

business expenses.      The checks totaled the following amounts each

year:

                        Year      Amount
                        1984      $79,596
                        1985      111,000
                        1986      153,051
                        1987      154,426
                        Total    $498,073

       All but one of the 282 checks included notations such as "5

hogs - 2975#", "corn", or "3 cattle - 2200#".       Mr. Reaves and

Wright signed most of the 282 checks.       Lawson signed seven of the

checks totaling about $19,701 from November 17 to December 29,

1987.     Lawson cashed 273 of the 282 checks.    Mrs. Reaves endorsed

two of the checks, Mr. Reaves endorsed one, and Prevatte endorsed

one.    Lawson cashed four of the 282 checks, totaling $35,000, on

August 28 and 29, 1986.
                               - 15 -

     Lawson made up most of the names of the payees for the

checks that he wrote.    Wright or Lawson wrote most of the 282

checks that Lawson cashed.    Lawson usually endorsed the

fictitious names with altered handwriting, countersigned his name

with his normal signature, and then went to Southern National to

cash the checks.

     The bank did not always require Lawson to endorse the

checks, but he did so if asked.    Lawson told the bank tellers

that he was cashing the checks for people who had sold livestock

to Reaves Livestock and were waiting for him at the Reaves

Livestock barn, but were too busy or lacked the proper

identification to cash the checks.

     At a time not specified in the record, several of the

tellers became concerned about the fact that Lawson was cashing

Reaves Livestock account checks payable to third parties.     They

told Don Ballard (Ballard), bank manager for Southern National,

what Lawson was doing.    Ballard telephoned Mr. Reaves and told

him Lawson had been cashing checks which were not payable to

Lawson.   Mr. Reaves gave permission to Ballard for Southern

National to cash those checks.    Ballard then authorized the

tellers to cash the checks.

     Lawson initially tried to conceal the check cashing scheme

from respondent.   He told Thomas W. Bozeman (Bozeman),

respondent's agent, that he had not endorsed the checks, that he

could not recall that Mr. Reaves had asked him to endorse checks
                               - 16 -

written to Jim Butler or anyone else, and that he did not know

that Reaves Livestock had lent $55,000 (discussed below at par.

G) to Mr. and Mrs. Reaves.    Those statements were false.

     Mr. Reaves took no action against the bank or Lawson for

cashing the 282 nominee checks.

D.   The John Chavis Checks

     Mr. Reaves told Lawson to give money to Mrs. Reaves each

month by writing a Reaves Livestock check for $250.    For each of

the 36 months from December 1984 to November 1987, Lawson or

Wright wrote a $250 check with the notation "hay", except for one

that said "salary".    Thirty-four of the checks were payable to

John Chavis, one to Ray Hunt, and one to Ray Ofendine (John

Chavis checks).   The John Chavis checks were payable to

fictitious payees.    Mrs. Reaves signed 29 of the checks, Mr.

Reaves signed 5, Wright signed 1, and 1 was unsigned.    Mrs.

Reaves endorsed 35 of the checks by signing John Chavis or Linda

Reaves.   One was not endorsed.   She countersigned 7 of the 36

checks and cashed all of them.

     These payments totaled $2,250 in 1984, and $3,000 in 1985,

1986, 1987, and 1988.    These payments were deducted by Reaves

Livestock as a business expense and were not reported as income

by Mr. and Mrs. Reaves.

E.   The Lumberton Auction Checks

     Lumberton Auction Co., Inc. (Lumberton Auction) issued the

following checks, all of which were cashed:
                                   - 17 -

         Date                Payee              Amount     Endorser
     Mar. 9, 1984      Reaves Livestock           $50 Reaves Livestock
     Apr. 24, 1985     S&J Livestock            1,130 S&J Livestock
                                                       Jeff Lawson
     June 5, 1985      S&J Farms #2               298 S&J Reaves
                                                       Livestock
                                                       By Jeff Lawson
     June 5, 1985      S&J Farms                1,269 S&J Reaves
                                                       Livestock
                                                       By Jeff Lawson
     July 10, 1985     Mike Reaves                935 Mike Reaves
                                                       By Jeff Lawson
     Aug. 14, 1985     Slick Prevatte           1,526 Slick Prevatte
                                                       By Jeff Lawson
     Aug. 28,   1985   Slick   Prevatte         2,986 Slick Prevatte
     Sept. 4,   1985   Slick   Prevatte           284 Slick Prevatte
     Sept. 4,   1985   Slick   Prevatte           145 Slick Prevatte
     Oct. 30,   1985   Slick   Prevatte           121 Slick Prevatte
                                                       By Jeff Lawson
     Nov. 13, 1985     Slick Prevatte             293 Slick Prevatte
     Apr. 2, 1986      Jackie Reaves               95 Mr. Reaves
     Apr. 2, 1986      Reaves Livestock            63 Reaves L/S

     Prevatte and Mike Reaves received the cash from the checks

which were payable to them.

F.   Other Checks

     1.   Circle S Checks

     Circle S Livestock, Inc. (Circle S) issued checks payable to

Marlboro Farms on May 1, 1987, for $3,164 and $2,555 which Mr.

Reaves cashed.    Mr. Reaves used the proceeds to buy livestock.

Marlboro Farms was a pasture on which Reaves Livestock placed

livestock.

     2.   $9,300 Check to Mike Reaves

     On September 29, 1986, two individuals issued a check to

Mike Reaves for $9,300 to buy cows.         Mike Reaves endorsed and

cashed the check.
                                - 18 -

G.   The Beach House

     Mr. Reaves asked Kenneth Davis (Davis), a certified public

accountant and return preparer, if it would be proper for Reaves

Livestock to lend money to Mr. and Mrs. Reaves to buy a beach

house.    Davis said that it would.   Mr. Reaves told Mrs. Reaves

that they were going to borrow $55,000 from Reaves Livestock to

buy a beach house for themselves.

     On November 24, 1986, Reaves Livestock lent $55,000 to Mr.

and Mrs. Reaves.    Mrs. Reaves used that $55,000 and other money

to buy a beach house on November 25, 1986.

     On December 11, 1986, Mrs. Reaves repaid Reaves Livestock

with a $55,000 check drawn on the S&J account.

     In early 1987, Mrs. Reaves paid Allendale Furniture Co.

$6,000 from the George K. Reaves First Citizens account for beach

furniture.

H.   Petitioners' Tax Returns

     1.     Reaves Livestock's Tax Returns

     Davis prepared Reaves Livestock's income tax returns for the

years in issue.

     At the end of the year, Wright or Lawson gave Reaves

Livestock's ledgers and journals to Davis for him to prepare its

corporate income tax return.    Neither Mr. nor Mrs. Reaves gave

Davis any of Reaves Livestock's records.     Mr. Reaves gave

inventory information to Wright or Lawson to give to Davis to

include in the corporate tax return.     Davis could have reviewed
                               - 19 -

any of the records at Reaves Livestock, including First Citizens

records.    He sometimes visited the business to meet with Wright

or Lawson when Mr. Reaves was not present.    Mr. Reaves did not

know what information Wright or Lawson gave to Davis.     Davis used

Reaves Livestock's journals and ledgers to prepare its tax

returns, but he did not verify their accuracy.    He generally

asked Wright or Lawson any questions he had about journal

entries.    He did not review Reaves Livestock's bank account

statements or canceled checks to prepare its corporate tax

returns.    He sometimes did a quick net worth evaluation in

December.    He did not perform any monthly services for Reaves

Livestock or for Mr. and Mrs. Reaves.

     Each December, Davis and Mr. Reaves discussed Reaves

Livestock's performance and its likely tax liabilities.     After he

prepared the tax returns for Reaves Livestock and Mr. and Mrs.

Reaves, Davis brought the returns to Mr. Reaves.      Davis briefly

reviewed them with Mr. Reaves before Davis filed them.

     2.     Mr. and Mrs. Reaves' Income Tax Returns

     Mrs. Reaves decided which of her and Mr. Reaves' personal

records to give to Davis.    She searched their canceled checks for

potential income tax deductions.    She gave Davis bank statements,

Forms W-2 and 1099, and canceled checks which she believed

substantiated their deductions.

     The First Citizens accounts paid interest (in an amount not

stated in the record) which neither Mr. and Mrs. Reaves nor
                                - 20 -

Reaves Livestock reported on their income tax returns for the

years in issue.     Reaves Livestock overstated its deductions by

deducting payments to the First Citizens accounts as business

expenses.     Mr. Reaves caused amounts payable to Reaves Livestock

to be deposited in the First Citizens accounts.     Neither Reaves

Livestock nor Mr. and Mrs. Reaves reported those amounts as

income on the returns they originally filed for 1984, 1985, 1986,

and 1987.

     Davis prepared and filed Mr. and Mrs. Reaves' returns for

1984 on April 15, 1985, for 1985 on April 15, 1986, for 1986 in

April 1987, for 1987 on April 15, 1988, and for 1988 on April 17,

1989.     Davis first heard about the First Citizens accounts when

Bozeman told him about them in December 1988.

I.   Later Events

        1.   Criminal Investigation of Mr. and Mrs. Reaves

        Respondent began a criminal investigation of Mr. and Mrs.

Reaves in December 1988.     Mr. and Mrs. Reaves gave Bozeman Reaves

Livestock's Southern National account records, but not the First

Citizens records.     Bozeman obtained the First Citizens account

records from First Citizens in response to a summons.     Mr. and

Mrs. Reaves gave Bozeman their personal records.     Some of those

records did not cover all of the years in issue.     Mr. Reaves

voluntarily gave a handwriting exemplar.
                               - 21 -

     2.    Reaves Livestock's Amended Tax Returns

     In June 1989, after Bozeman told Davis about the First

Citizens accounts, Davis prepared amended corporate returns which

included the First Citizens accounts in the Reaves Livestock

records.

     3.    Respondent's Taped Telephone Conversation Between
           Lawson and Mr. Reaves

     On September 25, 1989, at respondent's request, Lawson

placed a telephone call to Mr. Reaves which respondent recorded

without Mr. Reaves' knowledge.   When Lawson agreed to make the

call, he feared that respondent would treat the cash from the 282

checks as his income.    When Lawson called Mr. Reaves' house, Mike

Reaves answered.   Lawson concealed from him that respondent was

recording the call.

     Mr. Reaves' recorded comments confirm that Lawson had been

giving him an unspecified amount of cash.   During the call, Mr.

Reaves said that if respondent's agents asked Lawson what Mr.

Reaves did with the money, Lawson should say that he did not know

because that was true.   Mr. Reaves said that Lawson should say

that Mr. Reaves needed cash for feed, cattle, or other business
                               - 22 -

expenses.    Mr. Reaves told Lawson that Davis would probably say

to tell the truth.

     Lawson stopped working for Reaves Livestock in January 1990.

     4.     Reaves Livestock's Second Amended Tax Return

     Davis filed a second amended corporate return for 1986 in

August 1990, because he had misclassified a $55,000 check.      In

it, Davis decreased the amount reported for purchases by $55,000.

     5.     Criminal Conviction of Mr. and Mrs. Reaves

     On April 1, 1991, petitioners were indicted for willfully

signing and filing false returns under section 7206(1) for 1984,

1985, 1986, and 1987.    On June 3, 1991, Mrs. Reaves pleaded

guilty to violating section 7206(1) for 1986 and Mr. Reaves

pleaded guilty to violating section 7206(1) for 1987.      The other

counts were dismissed.

     6.     Mr. and Mrs. Reaves' 1990 Tax Returns

     Davis prepared and filed Mr. and Mrs. Reaves' 1990 joint

individual Federal income tax returns on August 15, 1991.     Davis

included the previously unreported income as a constructive

dividend on Mr. and Mrs. Reaves' 1990 return.    As a result, they

reported that they had received a $171,928 dividend from Reaves

Livestock.    They intended that amount to represent unreported

income of $13,054 for 1984, $15,645 for 1985, $75,933 for 1986,

$49,802 for 1987, and $17,494 for 1988 from the First Citizens
                                - 23 -

accounts.   Davis included what he believed was income from the

First Citizens accounts.

                                OPINION

A.   Overview

     The primary issues for decision are whether Mr. and Mrs.

Reaves received constructive dividends from Reaves Livestock and

are liable for additions to tax for fraud, negligence, or

substantial understatement of tax for the years in issue, and

whether Reaves Livestock is liable for additions to tax for fraud

and substantial understatement of tax for the years in issue.

     Petitioners concede that petitioners received cash dividends

from the checks which were payable to fictitious payees (e.g.,

John Chavis) and endorsed and cashed by Mrs. Reaves, but contend

that petitioners' underpayments of tax related to those checks

were not due to fraud.     Petitioners concede that checks from the

First Citizens accounts used to buy personal items are

constructive dividends to them, but contend that petitioners'

underpayments of tax related to those checks were not due to

fraud.   Petitioners contend that the proceeds of the 282 checks

payable to fictitious persons and cashed by Lawson are not

constructive dividends to Mr. and Mrs. Reaves and that

petitioners' underpayments of tax related to those checks were

not due to fraud.
                              - 24 -

B.   Constructive Dividends

     The parties dispute whether the following items are

constructive dividends to Mr. and Mrs. Reaves:   (1) The 282

checks written on the Reaves Livestock account and payable to

fictitious persons; (2) two Circle S checks payable to Marlboro

Farms; (3) Lumberton Auction checks payable to Reaves Livestock,

S&J, Slick Prevatte, and Mike Reaves; (4) seven checks written on

the Reaves Livestock account payable to S&J and cashed by Lawson;

(5) a $4,750 check written on the S&J account dated December 16,

1985, payable to Mrs. Reaves; (6) an $11,730 check written on the

George K. Reaves account dated December 26, 1986, payable to

Allstate Truck & Equip., Inc.; (7) a $23,800 check written on the

George K. Reaves account dated December 28, 1987, payable to

Crook Motor Co., Inc.; (8) a $19,151 check written on the S&J

account dated March 23, 1987, payable to First Citizens Bank for

a cashier's check; and (9) seven Reaves Livestock checks payable

to S&J.4




     4
       Mr. and Mrs. Reaves concede that they received
constructive dividends from checks written on the First Citizens
accounts and the John Chavis checks in the following amounts:
$13,814 in 1984, $19,551 in 1985, $89,150 in 1986, $68,556 in
1987, and $58,646 in 1988.
                                - 25 -

     A sole shareholder receives a constructive dividend to the

extent of the corporation's earnings and profits5 if the

corporation pays a personal expense of its shareholder, or lets

the shareholder use corporate property for a personal purpose.

Secs. 301, 316; Falsetti v. Commissioner, 85 T.C. 332, 356-357

(1985); Henry Schwartz Corp. v. Commissioner, 60 T.C. 728, 744

(1973).   Whether a shareholder receives a constructive dividend

is a question of fact.   Hagaman v. Commissioner, 958 F.2d 684,

690-691 (6th Cir. 1992), affg. and remanding T.C. Memo. 1987-549;

Loftin & Woodard, Inc. v. United States, 577 F.2d 1206, 1214-1215

(5th Cir. 1978).

     1.    The 282 Checks Payable to Fictitious Persons

     Petitioners contend that the proceeds from the 282 checks

are not constructive dividends to Mr. and Mrs. Reaves because

Lawson embezzled them.   Mr. Reaves testified that Lawson

embezzled the cash.   Lawson testified that he gave the cash from

the 282 checks to Mr. Reaves.    Mr. Reaves' testimony on this

point was not credible for reasons stated next.

     We give more weight to the objective facts than to the

testimony about the 282 checks.    The objective facts show that



     5
       Petitioners do not contend that Reaves Livestock lacked
enough earnings and profits to pay the constructive dividends at
issue in this case.
                               - 26 -

Lawson did not embezzle the proceeds of the 282 checks from

Reaves Livestock.   First, Mr. and Mrs. Reaves did not act like

victims of a nearly $500,000 embezzlement.    They did not file

charges against Lawson or otherwise try to collect the funds from

Lawson or Southern National.   Mr. Reaves contends that he wanted

to pursue Lawson and the bank, but his attorneys advised against

it, and the statute of limitations had run.    He gave no

convincing reason why he waited after the period of limitations

had run to act.   Mr. Reaves testified that an unnamed law

enforcement official administered lie detector tests to Mr.

Reaves, Mrs. Reaves, and Lawson.   His explanation of his

purported efforts to recover the money lacked detail and was not

believable.

     Second, we do not believe that nearly $500,000 left Reaves

Livestock without Mr. Reaves' knowledge.   For example, Mr. Reaves

surely would have noticed that $35,000 was missing when Lawson

cashed four checks on August 28 and 29, 1986, based on Mr.

Reaves' testimony that he could detect errors of a few thousand

dollars in the weekly cash flow report.

     Third, there is no evidence that Wright or Lawson used

nearly $500,000 in funds embezzled from Reaves Livestock.

Petitioners point out some expenditures that Lawson and Wright

made during the years in issue, but not enough to show that they
                              - 27 -

lived beyond their means.   There is certainly no showing that

Lawson or Wright received nearly $500,000 from the 282 checks.

     Mr. Reaves' claim that Lawson never had authority to endorse

checks for Reaves Livestock is inconsistent with the fact that

Lawson endorsed some of the Lumberton Auction checks.   Mr. Reaves

authorized Ballard to permit Lawson to endorse third party

checks.   The recorded telephone conversation also shows that Mr.

Reaves authorized Lawson to endorse checks.

     Petitioners contend that the recorded telephone conversation

shows that Mr. Reaves did not receive the cash from the 282

checks and that Lawson embezzled it.   We disagree.   During that

conversation, Mr. Reaves acknowledged that he had received cash

from Lawson when he advised Lawson to say that Mr. Reaves needed

the cash for business purposes and that Lawson did not know what

Mr. Reaves did with the money.

     Petitioners contend that Lawson could not have given Mr.

Reaves the cash from the 282 checks because Mr. Reaves and Lawson

were rarely in the office at the same time.   We disagree.   Mr.

Reaves and Lawson were together sometimes, such as when Lawson

and Wright gave Mr. Reaves the weekly financial report of Reaves

Livestock, and when Lawson and Mr. Reaves played poker.

     Petitioners point out that Lawson initially misled Bozeman

about the 282 checks.   We believe Lawson adequately explained why
                               - 28 -

he did so; his prior statements were an ineffectual but

unsurprising attempt to conceal petitioners' check cashing scheme

from respondent.

     Cummings testified that he stole livestock from Reaves

Livestock with Lawson's help, sold the livestock, and split the

proceeds with Lawson.    Petitioners contend that Cummings'

testimony shows that Lawson was likely to embezzle.    We disagree.

Cummings' testimony is questionable because in 1991 he said that

Lawson was not involved in these thefts; he changed his story

shortly before the trial in this case.    Whether or not Lawson

helped Cummings steal from petitioners, we are not convinced that

he embezzled the cash from the 282 checks for reasons given

above.

     Petitioners contend that their conservative lifestyle and

their ability to live on their income shows that they did not

receive the proceeds from the 282 checks.    Mr. Reaves testified

that he used cash in his business, but he provided no records

showing how much cash he used or how he used it.    His vague

explanations do not persuade us that he used the proceeds of the

282 checks for business expenses.    Petitioners failed to keep

records that were sufficient to enable respondent to determine

their tax liabilities.   See sec. 6001; sec. 1.6001-1(a), Income

Tax Regs.
                              - 29 -

     We conclude that the proceeds of the 282 checks are

constructive dividends to Mr. and Mrs. Reaves.6

     2.   Two Circle S Livestock, Inc. Checks

     Mr. Reaves endorsed and cashed two Circle S checks dated May

1, 1987, payable to Marlboro Farms for $3,164 and $2,554.    Mr.

Reaves testified that he used the cash from these checks to buy

livestock.   Respondent offered no contrary evidence.   We may not

arbitrarily disregard testimony that is competent, relevant, and

uncontradicted.   Conti v. Commissioner, 39 F.3d 658, 664 (6th

Cir. 1994), affg. 99 T.C. 370 (1992) and T.C. Memo. 1992-616;

Demkowicz v. Commissioner, 551 F.2d 929, 931-932 (3d Cir. 1977),

revg. T.C. Memo. 1975-278; Banks v. Commissioner, 322 F.2d 530,

537 (8th Cir. 1963), affg. in part and remanding in part T.C.

Memo. 1961-237.   We conclude that the two Circle S checks are not

constructive dividends to Mr. and Mrs. Reaves.

     3.   The Lumberton Auction Co. Checks

     Respondent contends that the 13 checks from Lumberton

Auction, all of which were cashed, were constructive dividends to

Mr. and Mrs. Reaves.   We disagree, except for one check payable

to Mr. Reaves.


     6
       Because we conclude that Mr. Reaves' testimony is
unreasonable, we reject petitioners' contention that they may
meet a lesser burden of proof by reasonably denying receiving
unreported income.
                               - 30 -

     The $5,997 that Prevatte and Mike Reaves received from the

Lumberton Auction checks written to them are not constructive

dividends to Mr. and Mrs. Reaves.   The other Lumberton Auction

checks payable to Reaves Livestock and S&J are not constructive

dividends to Mr. and Mrs. Reaves because there is uncontradicted

evidence that the proceeds went to the payees and did not go to

Mr. and Mrs. Reaves.

     One Lumberton Auction check for $95 dated April 2, 1986, was

payable to and endorsed by Mr. Reaves.     We conclude that this

check is income to Mr. Reaves.

     Respondent contends that Mr. Reaves owned Lumberton Auction.

We disagree.   Mr. Reaves denied ownership, and respondent offered

no evidence to the contrary.

     Respondent contends that the First Citizens accounts are Mr.

and Mrs. Reaves' personal accounts.     Thus, respondent contends

that the Lumberton Auction checks are constructive dividends

because some of them were payable to S&J.     We disagree.   Mr.

Reaves used these accounts in part as Reaves Livestock accounts.

Reaves Livestock's bookkeepers wrote checks and kept the bank

records for the First Citizens accounts.     Most of the checks

written on the S&J account and many written on the George K.

Reaves account were for business purposes.     The Lumberton Auction

Co. checks payable to a First Citizens account are not
                              - 31 -

constructive dividends to Mr. and Mrs. Reaves unless they were

used for their personal benefit.   The Lumberton Auction Co.

checks were not paid for Mr. and Mrs. Reaves' personal benefit

except for the $95 check payable to Mr. Reaves.

     4.    Undecipherable Check Payable to Mike Reaves and
           Endorsed by Mike Reaves

     Respondent contends that Mr. Reaves received the cash from

an undecipherable check payable to Mike Reaves.   We disagree.

Mike Reaves endorsed the check and received the cash.   We

conclude that it is not a constructive dividend to Mr. and Mrs.

Reaves.

     5.    Disputed Checks Written on the First Citizens Accounts

     The parties dispute whether several checks (described next)

written on the First Citizens accounts are constructive dividends

to Mr. and Mrs. Reaves.   Respondent contends that they are,

because Mr. and Mrs. Reaves controlled the disposition of the

funds in the First Citizens accounts and petitioners used the

proceeds of these checks for personal purposes.   Petitioners

contend that they used the proceeds from these checks for

business purposes and that they did not receive any personal

benefit.
                               - 32 -

          a.   $4,750 Check Drawn on The S&J Account

     The $4,750 check written on the S&J account that Mrs. Reaves

endorsed and cashed is not a constructive dividend because she

used it to pay Lee for corn.

     Respondent contends that, if $4,750 was the price after

allowing a 10-percent discount, then the undiscounted selling

price for the corn would have been $5,277.77.    Respondent assumes

that Mr. Reaves and Lee would have calculated a discount equal to

exactly 10 percent and argues that the price of a load of corn

would be more in round numbers.   Respondent's point is purely

speculative and is an insufficient basis for us to disregard the

testimony on this point.

     Respondent points out that petitioners did not call Lee to

testify and contends that we should infer that his testimony

would have been adverse to petitioners.    Apparently either party

could have called Lee to testify.   We decline to apply an adverse

inference against petitioners here.     See Gaw v. Commissioner,

T.C. Memo. 1995-531.

          b.   Checks for $11,730 Drawn on the George K. Reaves
               Account and $23,800 Drawn on the S&J Account

     Respondent contends that the proceeds of the $11,730 check

drawn on the George K. Reaves account with the notation "1966

Rogers Trailer" and the $23,800 check drawn on the S&J account
                                - 33 -

payable to Crook Motor Co., Inc. are constructive dividends to

petitioners because they controlled the George K. Reaves account.

Mr. Reaves lent the funds to Lumberton Paving to buy the vehicles

in his capacity as an officer of Reaves Livestock.         Mr. Reaves

did not need or personally benefit from the dump truck or the

trailer.    Respondent offered no evidence to the contrary.

     We conclude that the $11,730 and $23,800 checks to buy the

dump truck and trailer were loans from Reaves Livestock to

Lumberton Paving, not constructive dividends to Mr. and Mrs.

Reaves.

            c.    George K. Reaves Account Check for the Dillon
                  House

     Respondent contends that the proceeds of the check drawn on

the George K. Reaves account to buy the Dillon house were a

constructive dividend to Mr. and Mrs. Reaves, primarily because

Mrs. Reaves took title to the house.       We disagree.    Reaves

Livestock used the proceeds from this check to buy a house for

Grant.     Reaves Livestock had a reasonable business interest in

helping Grant live closer to work.       Grant lived in the Dillon

house, paid for repairs, taxes, and insurance, and later paid

Reaves Livestock for and took title to the house.         Neither Mr.

and Mrs. Reaves nor Reaves Livestock made a profit from the

Dillon house.
                                - 34 -

     Respondent points out that title to the house was in Mrs.

Reaves' name until Grant bought the house from Reaves Livestock.

Respondent contends that this fact shows that Mr. and Mrs. Reaves

and not Reaves Livestock bought the house and contends that there

is no evidence that Reaves Livestock lent money to Grant.        We

disagree.    Mr. and Mrs. Reaves testified that Reaves Livestock

lent Grant the money to buy the house.       Reaves Livestock bought

the house.    Grant repaid Reaves Livestock, not Mr. and Mrs.

Reaves.   Mrs. Reaves took title as a corporate agent.      We

conclude that Reaves Livestock bought the Dillon house for Grant,

and that the purchase of the house was not a constructive

dividend to Mr. and Mrs. Reaves.

            d.    The $55,000 S&J Account Check To Repay Reaves
                  Livestock for the Beach House Loan

     Petitioners contend that the $55,000 Mr. and Mrs. Reaves

obtained from Reaves Livestock for the beach house in 1986 was a

loan, not a constructive dividend.       We agree.   However, Mr. and

Mrs. Reaves received a constructive dividend when Mrs. Reaves

used funds from the S&J account to repay $55,000 to Reaves

Livestock because that was a personal use of S&J account funds.

     6.      The Seven Reaves Livestock Checks Payable to S&J

     Respondent contends that the seven Reaves Livestock checks

payable to S&J in 1986 are constructive dividends to Mr. and Mrs.
                               - 35 -

Reaves because Mr. Reaves endorsed three of them, and the other

four are endorsed "S&J Farms" but no one signed them.   We

disagree.    We have found that Mr. Reaves used the proceeds from

these checks to buy the livestock as noted on each check.

     7.     Conclusion

     We conclude that Mr. and Mrs. Reaves received constructive

dividends of $93,410 in 1984, $130,551 in 1985, $270,2007 in

1986, and $222,982 in 1987.

C.   Mr. and Mrs. Reaves' Liability for Additions to Tax for
     Fraud

     1.     Background

     Respondent determined that Mr. and Mrs. Reaves are liable

for the addition to tax for fraud under section 6653(b) for 1984,

1985, 1986, 1987, and 1988.   For 1984 and 1985, if any part of a

tax underpayment is due to fraud, the addition to tax for fraud

under section 6653(b)(1) is 50 percent of the total underpayment

of tax, and the addition to tax under section 6653(b)(2) is 50

percent of the interest payable under section 6601, but only with

respect to that part of the underpayment that is due to fraud.



     7
       We have found that Mr. and Mrs. Reaves received
constructive dividends of $306,345 in 1986. Respondent
determined that Mr. and Mrs. Reaves received constructive
dividends of $270,200. We hold that Mr. and Mrs. Reaves received
constructive dividends in the amount that respondent determined
for 1986.
                               - 36 -

For 1986 and 1987, the addition to tax for fraud under section

6653(b)(1)(A) is 75 percent of the part of a tax underpayment

that is due to fraud, and the addition to tax under section

6653(b)(1)(B) is 50 percent of the interest payable under section

6601 with respect to that part of the underpayment that is due to

fraud.

     Respondent has the burden of proving by clear and convincing

evidence that Mr. and Mrs. Reaves fraudulently underpaid tax.

Sec. 7454(a); Rule 142(b); Stoltzfus v. United States, 398 F.2d

1002, 1004 (3d Cir. 1968).    Fraud cannot be imputed from one

spouse to another.   Secs. 6653(b)(4) (for 1984 and 1985) and

6653(b)(3) (for 1986 and 1987).    Thus, respondent must prove that

each spouse committed fraud.    Hicks Co. v. Commissioner, 56 T.C.

982, 1030 (1971), affd. 470 F.2d 87 (1st Cir. 1972); Stone v.

Commissioner, 56 T.C. 213, 227-228 (1971).

     2.   Underpayment

     Mr. and Mrs. Reaves concede that they underpaid tax in 1984,

1985, 1986, and 1987.

     3.   Fraudulent Intent

     Respondent must prove by clear and convincing evidence that

Mr. and Mrs. Reaves had fraudulent intent.    Parks v.

Commissioner, 94 T.C. 654, 664 (1990).    For purposes of section

6653(b), fraud is actual, intentional wrongdoing, Mitchell v.
                              - 37 -

Commissioner, 118 F.2d 308, 310 (5th Cir. 1941), revg. 40 B.T.A.

424 (1939), or intentionally committing an act for the specific

purpose of evading a tax believed to be owing, Webb v.

Commissioner, 394 F.2d 366, 377 (5th Cir. 1968), affg. T.C. Memo.

1966-81.

     The Commissioner may prove fraud by circumstantial evidence

because direct evidence of the taxpayer's intent is rarely

available.   Stephenson v. Commissioner, 79 T.C. 995, 1005-1006

(1982), affd. 748 F.2d 331 (6th Cir. 1984).    The courts have

developed a number of objective indicators or "badges" of fraud.

Recklitis v. Commissioner, 91 T.C. 874, 910 (1988).    Several

badges of fraud are present in this case:    (a) Substantially

understating income for several years, (b) having inadequate

books and records, (c) dealing in cash to conceal income, (d)

using fictitious names, (e) concealing income from their return

preparer, (f) diverting corporate income for personal use, and

(g) being convicted under section 7206(1).    Bradford v.

Commissioner, 796 F.2d 303, 307-308 (9th Cir. 1986), affg. T.C.

Memo. 1984-601; Ruark v. Commissioner, 449 F.2d 311, 312-313 (9th

Cir. 1971), affg. T.C. Memo. 1969-48; Wright v. Commissioner, 84

T.C. 636, 643-644 (1985).
                               - 38 -

            a.   Substantially Understating Income

     A pattern of consistently and substantially underreporting

income over several years is evidence of fraud.      Holland v.

United States, 348 U.S. 121, 137-139 (1954); Estate of Mazzoni v.

Commissioner, 451 F.2d 197, 202 (3d Cir. 1971), affg. T.C. Memo.

1970-37.    Mr. and Mrs. Reaves did not report or account for

nearly $500,000 over 4 years from the 282 checks.     Mr. and Mrs.

Reaves received but did not report constructive dividends from

the First Citizens accounts and the John Chavis checks totaling

$13,814 in 1984, $19,551 in 1985, $89,150 in 1986, and $68,556 in

1987.   This badge of fraud applies to Mr. and Mrs. Reaves for

1984, 1985, 1986, and 1987, because they both knew of their

personal expenses paid from the First Citizens accounts and the

John Chavis checks in each of those years.    It also applies to

Mr. Reaves because he knew of the 282 checks.

            b.   Failing to Maintain Adequate Records

     A taxpayer's failure to maintain accurate records is a badge

of fraud.    Bradford v. Commissioner, supra at 307; Lollis v.

Commissioner, 595 F.2d, 1189, 1192 (9th Cir. 1979), affg. T.C.

Memo. 1976-15; Merritt v. Commissioner, 301 F.2d 484, 487 (5th

Cir. 1962), affg. T.C. Memo. 1959-172.    Mr. and Mrs. Reaves

produced no records showing that they received or how they used

the proceeds from the 282 checks, John Chavis checks, or the
                                - 39 -

First Citizens checks that were income to them.       This badge of

fraud applies to Mr. and Mrs. Reaves for 1984, 1985, 1986, and

1987, because they both did not maintain accurate records in each

of those years.

           c.     Dealing in Cash to Conceal Income

     A taxpayer's use of cash to conceal income is evidence of

fraud.    Bradford v. Commissioner, supra.   Mr. Reaves used the 282

checks to obtain cash which was concealed income.       Mrs. Reaves

used the John Chavis checks to obtain cash which was concealed

income.    This badge of fraud applies to Mr. and Mrs. Reaves for

1984, 1985, 1986, and 1987, because they used cash to conceal

income in each of those years.

            d.    Using a Fictitious Name

     Using a fictitious name may be evidence of fraud.       Lipsitz

v. Commissioner, 21 T.C. 917, 937 (1954), affd. 220 F.2d 871 (4th

Cir. 1955).

     The 282 checks were written to fictitious payees.       Mr.

Reaves endorsed one of the checks in 1986.    His endorsement of

that check is a badge of fraud for him for 1986.

     Mrs. Reaves signed some of the 282 checks for Reaves

Livestock in 1984, 1985, 1986, and 1987, and endorsed some of

them in 1985 and 1986.    She also cashed checks written to
                                - 40 -

fictitious persons (Ray Hunt and John Chavis) in 1984, 1985,

1986, and 1987.

     Mr. Reaves opened the S&J account with a Social Security

number that was neither his nor Mrs. Reaves'.    Mr. Reaves

speculated that it might have been Prevatte's, but he also said

that he did not know.    This is a badge of fraud for Mr. Reaves.

     This badge of fraud applies to Mr. and Mrs. Reaves for 1984,

1985, 1986, and 1987, because they both used fictitious names in

each of those years.

          e.      Concealing Income from Return Preparers

     Concealing income from a taxpayer's return preparer can be

evidence of fraud.     Korecky v. Commissioner, 781 F.2d 1566, 1569

(11th Cir. 1986), affg. T.C. Memo. 1985-63; Farber v.

Commissioner, 43 T.C. 407, 420 (1965), modified 44 T.C. 408

(1965).   Davis did not know about the First Citizens accounts or

John Chavis checks or know that the 282 checks were written to

fictitious payees when he filed Mr. and Mrs. Reaves' returns for

the years in issue.     Mr. Reaves did not tell Davis about any of

these items.   Mrs. Reaves gave Mr. and Mrs. Reaves' personal

return information to Davis, but she did not tell Davis about the

First Citizens accounts or the John Chavis checks.

     Petitioners contend that Davis had access to all of their

records and should have taken them into account.    We disagree.
                                - 41 -

Mr. and Mrs. Reaves should have told Davis about the First

Citizen accounts and the 282 checks, or instructed Lawson and

Wright to do so.    Instead, Mr. Reaves concealed these items from

Davis.    He left no record showing how the proceeds from the 282

checks were used.    He opened the First Citizens accounts without

including them as a part of Reaves Livestock's records.

     Petitioners contend that Wright and Lawson should have told

Davis about the John Chavis checks.      We disagree.   Wright and

Lawson were not responsible for telling Davis how much income Mr.

and Mrs. Reaves had.

     This badge of fraud applies to Mr. and Mrs. Reaves for 1984,

1985, 1986, and 1987, because they concealed income from Davis in

each of those years.

            f.   Diversion of Corporate Income for Personal Use

     A taxpayer's diversion of corporate funds to his own use is

evidence of fraud.     Solomon v. Commissioner, 732 F.2d 1459, 1460-

1461 (6th Cir. 1984), affg. T.C. Memo. 1982-603; United States v.

Brill, 270 F.2d 525, 527 (3d Cir. 1959).      Mr. Reaves diverted

Reaves Livestock income to himself and Mrs. Reaves through the

First Citizens accounts and through the 282 checks.       Mrs. Reaves

knew that she was receiving corporate income through the John

Chavis checks.     Mr. and Mrs. Reaves did not report their diverted

income.    This badge of fraud applies to Mr. and Mrs. Reaves for
                                 - 42 -

1984, 1985, 1986, and 1987, because they both knowingly received

diverted income for their personal use in each of those years.

            g.     Conviction Under Section 7206(1)

     A conviction for willfully and knowingly subscribing to a

false income tax return under section 7206(1) is evidence that

the taxpayer fraudulently intended to evade taxes.       Wright v.

Commissioner, 84 T.C. at 643-644.      Mrs. Reaves pleaded guilty to

violating section 7206(1) for 1986.       Mr. Reaves pleaded guilty to

violating section 7206(1) for 1987.       This badge of fraud applies

to Mrs. Reaves for 1986 and Mr. Reaves for 1987.

     4.     Reliance on Wright, Lawson, and Davis

     Mr. and Mrs. Reaves contend that they are not liable for the

addition to tax for fraud because they relied on Wright, Lawson,

and Davis to correctly prepare their income tax returns.      We

disagree.

     A taxpayer is not liable for the addition to tax for fraud

under section 6653(b) if the taxpayer relied in good faith on a

qualified accountant and disclosed all material facts necessary

to prepare a correct tax return.      Alexander Shokai, Inc. v.

Commissioner, 34 F.3d 1480, 1486 (9th Cir. 1994), affg. T.C.

Memo. 1992-41; United States v. Whyte, 699 F.2d 375, 379-380 (7th

Cir. 1983); United States v. Garavaglia, 566 F.2d 1056, 1060 (6th

Cir. 1977).      Wright and Lawson were not involved in preparing Mr.
                               - 43 -

and Mrs. Reaves' personal returns or in providing the Reaves'

personal financial information to Davis.   Mr. and Mrs. Reaves did

not rely on them for their personal taxes.   Neither Mr. nor Mrs.

Reaves told Davis about the 282 checks, First Citizens accounts,

or the John Chavis checks.   Since they did not disclose all

material facts to Davis, they may not now escape liability for

fraud by claiming they relied on him.

     5.    Items Attributable to Fraud

     Respondent has shown by clear and convincing evidence:    (a)

Mr. Reaves intended to evade tax with respect to the 282 checks

(respondent concedes that Mrs. Reaves did not know about the 282

checks); (b) Mr. and Mrs. Reaves intended to evade tax with

respect to the withdrawals from the First Citizens accounts that

they used for personal purposes; and (c) Mrs. Reaves intended to

evade tax with respect to the John Chavis checks for each year in

issue.    Thus, Mr. Reaves is liable for the additions to tax under

section 6653(b)(1) with respect to the entire underpayment for

1984 and 1985.   He is liable for the additions to tax under

section 6653(b)(2) for 1984 and 1985 and under section

6653(b)(1)(A) and (B) for 1986 and 1987 with respect to the

underpayments relating to the 282 checks and withdrawals from the

First Citizens accounts that Mr. and Mrs. Reaves used for

personal purposes.
                              - 44 -

     Mrs. Reaves is liable for the additions to tax under section

6653(b)(1) with respect to the entire underpayment for 1984 and

1985, except for each underpayment for which she is an innocent

spouse.   She is liable for additions to tax under section

6653(b)(2) for 1984 and 1985 and under sections 6653(b)(1)(A) and

(B) for 1986 and 1987 with respect to the underpayments relating

to the withdrawals from the First Citizens accounts that Mr. and

Mrs. Reaves used for personal purposes and the John Chavis

checks.

     Petitioners contend that neither Mr. nor Mrs. Reaves is

liable for the additions to tax for fraud on the underpayment of

tax related to the 282 checks, the withdrawals from the First

Citizens accounts, and the John Chavis checks because the

underpayments are the fault of Wright and Lawson.    We disagree.

Mr. Reaves controlled Reaves Livestock.   His testimony that he

did not know about the 282 checks is not credible.   Mr. and Mrs.

Reaves controlled the First Citizens accounts.   Even if Wright or

Lawson invented the John Chavis check scheme, Mrs. Reaves was a

knowing participant.   We conclude that Mr. and Mrs. Reaves are

liable for the underpayments due to fraud as described above.

     The time to assess tax owed by Mr. and Mrs. Reaves has not

expired for 1984 because Mrs. Reaves is liable for the addition

to tax for fraud for 1984.   Sec. 6501(c)(1).
                               - 45 -

D.   Reaves Livestock Liability for Additions to Tax for Fraud

     1.   Underpayment of Corporate Income Tax

     Petitioners concede that Reaves Livestock underpaid its

income tax and that Mr. Reaves caused Reaves Livestock's receipts

that were not reported as income on the original corporate

returns to be diverted to the First Citizens accounts in 1984,

1985, 1986, and 1987.

     2.   Corporate Fraudulent Intent

     We may impute the fraud of a shareholder or an officer of a

corporation to the corporation if the shareholder or officer

controls the corporation, the corporation was the agent's alter

ego, or the corporate agent's fraudulent acts benefited the

corporation.   Loftin & Woodward Inc. v. United States, 577 F.2d

1206, 1244 (5th Cir. 1978); Ruidoso Racing Association, Inc. v.

Commissioner, 476 F.2d 502, 506 (10th Cir. 1973), affg. in part

and remanding in part T.C. Memo. 1971-194.    These circumstances

are present here.   Mr. Reaves was president and sole shareholder

of Reaves Livestock.    He and Mrs. Reaves, vice president of

Reaves Livestock, controlled Reaves Livestock.    Reaves Livestock

underreported its income by deducting as an expense the 282

checks to fictitious payees.    Reaves Livestock also underreported

its income by diverting income to the First Citizens accounts and

by overstating deductions with payments to the First Citizens
                               - 46 -

accounts.   Mr. and Mrs. Reaves controlled the First Citizens

accounts.   Reaves Livestock also underreported its income by

deducting the John Chavis checks which petitioners concede are

constructive dividends and not deductible expenses.    Reaves

Livestock participated in the fraud involving the 282 checks, the

First Citizens accounts, and the John Chavis checks.    Reaves

Livestock fraudulently underpaid tax with respect to the 282

checks, the deposits to the First Citizens accounts, and the John

Chavis checks for each year in issue.

     We conclude that respondent has shown by clear and

convincing evidence that Reaves Livestock fraudulently intended

to underpay tax for 1984, 1985, 1986, and 1987.

     3.     Items Attributable to Corporate Fraud

     We must identify the items with respect to which Reaves

Livestock fraudulently intended to underpay tax because the

additions to tax under section 6653(b)(2) for 1984 and 1985, and

under section 6653(b)(1)(A) and (B) for 1986 and 1987 apply to

the portion of the underpayment attributable to fraud.    As

discussed above in par. D-2, Reaves Livestock fraudulently

intended to underpay tax with respect to deductions it overstated

by deducting the 282 checks, checks for deposit to the First

Citizens accounts, and the John Chavis checks, and with respect
                              - 47 -

to income it diverted from Reaves Livestock to the First Citizens

accounts.

     The time to assess tax owed by Reaves Livestock did not

expire for any of the years in issue because Reaves Livestock is

liable for fraud in 1984, 1985, 1986, and 1987.   Sec. 6501(c)(1).

E.   Addition to Tax for Substantial Understatement

     Respondent contends that Mr. and Mrs. Reaves and Reaves

Livestock are liable for the addition to tax for substantial

understatement of tax for 1984, 1985, 1986, and 1987.

     Section 6661(a) imposes an addition to tax of 25 percent of

the amount of any underpayment attributable to a substantial

understatement of tax.   Pallottini v. Commissioner, 90 T.C. 498

(1988).   An understatement is the amount by which the correct tax

exceeds the tax reported on the return.   Sec. 6661(b)(2)(A).   An

understatement is substantial if it exceeds the greater of 10

percent of the correct tax or $5,000 ($10,000 in the case of a

corporation).   Sec. 6661(b)(1).   Petitioners bear the burden of

proving that the addition to tax under section 6661 does not

apply.8   Rule 142(a); Tweeddale v. Commissioner, 92 T.C. 501, 506

(1989).



     8
       Petitioners do not contend that they have substantial
authority or that they adequately disclosed the understatement
under sec. 6661(b)(2)(B)(i) and (ii).
                               - 48 -

     Petitioners contend that respondent should waive this

addition to tax because they relied on professional advice and

acted in good faith.   Sec. 6661(c); see Mailman v. Commissioner,

91 T.C. 1079, 1082-1084 (1988).   We disagree for reasons stated

at par. C-4, above.    The mistakes on their return were not Davis'

fault.   Petitioners did not convince us that they acted in good

faith in failing to report income from the 282 checks,

withdrawals from the First Citizens accounts for personal

purposes, and the John Chavis checks.

     Reaves Livestock did not give Davis all of the information

about the 282 checks, the First Citizens accounts, and the John

Chavis checks.   Thus, the mistakes on the Reaves Livestock

returns were not his fault.

     We conclude that Mr. and Mrs. Reaves and Reaves Livestock

are liable for the addition to tax for substantial understatement

of tax for 1984, 1985, 1986, and 1987, if calculations under Rule

155 show that the understatements are substantial for purposes of

section 6661(a).
                              - 49 -

F.   Whether Mrs. Reaves Qualifies as an Innocent Spouse

     1.   Background

     Mrs. Reaves contends that she qualifies as an innocent

spouse under section 6013(e) for the constructive dividends

discussed above except for the John Chavis checks and the $10,197

of unreported income that she conceded that she had in 1986.    She

contends that she qualifies as an innocent spouse as to all other

amounts at issue, including income that Mr. and Mrs. Reaves

conceded they received from the First Citizens accounts.

     To qualify as an innocent spouse under section 6013(e), Mrs.

Reaves must prove:   (a) She filed a joint return for the years in

issue; (b) there is a substantial understatement of income tax

attributable to grossly erroneous items of the other spouse on

the return; (c) she did not know or have reason to know of the

substantial understatement when she signed the return; and (d) it

would be inequitable to hold her liable for the deficiency

attributable to the substantial understatement.   Sec. 6013(e)(1).

Failure to meet any of these requirements precludes a taxpayer

from qualifying as an innocent spouse.   Sec. 6013(e)(1); Purcell

v. Commissioner, 826 F.2d 470, 473 (6th Cir. 1987), affg. 86 T.C.

228 (1986); Shea v. Commissioner, 780 F.2d 561, 565 (6th Cir.

1986), affg. in part and revg. in part T.C. Memo. 1984-310.
                              - 50 -

     Respondent concedes that Mrs. Reaves filed a joint return

with Mr. Reaves for each year in issue and that all items are

grossly erroneous because they are omitted income, but disputes

that they are attributable to Mr. Reaves.9

     We conclude that Mrs. Reaves knew or had reason to know of

the understatements (other than those relating to the 282 checks)

when she signed the returns and that it is not inequitable to

hold her liable for tax.

     2.    Knowledge of the Understatements on the Returns

     To be entitled to relief as an innocent spouse, Mrs. Reaves

must show that she did not know and had no reason to know that

there were understatements on the returns for the years in issue.

Sec. 6013(e)(1)(C).

     Mrs. Reaves maintained her family's financial records.     She

gave Davis the items that he used to prepare their income tax

returns.   She was vice president of Reaves Livestock and was

authorized to sign its checks.   She knew that checks were written

on the First Citizens accounts for items that petitioners

conceded are personal.   She also knew that checks were written

for personal items, such as for her beach house furniture, on the

Reaves Livestock account.   She routinely signed and cashed checks


     9
       Respondent concedes that Mrs. Reaves is an innocent spouse
with respect to the 282 checks.
                               - 51 -

drawn on the Reaves Livestock account at Southern National and

the First Citizens accounts.   She should have known about the

understatements resulting from the personal expenses paid from

the First Citizens accounts that petitioners conceded.

     3.   Not Inequitable To Hold Mrs. Reaves Liable

     To be entitled to relief as an innocent spouse, Mrs. Reaves

must show that it would be inequitable to hold her liable for

the deficiencies in tax for the years in issue.   Sec.

6013(e)(1)(D).

     In deciding whether it is inequitable to hold a spouse

liable for a deficiency, we consider whether the purported

innocent spouse significantly benefited beyond normal support,

either directly or indirectly, from the unreported income.

Hayman v. Commissioner, 992 F.2d 1256, 1262 (2d Cir. 1993), affg.

T.C. Memo. 1992-228; Belk v. Commissioner, 93 T.C. 434, 440

(1989); Purcell v. Commissioner, 86 T.C. at 242; H. Rept. 98-432

(Part 2) 1501, 1502 (1984); sec. 1.6013-5(b), Income Tax Regs.

Normal support is determined by the circumstances of the

taxpayers.   Sanders v. United States, 509 F.2d 162 (5th Cir.

1975); Estate of Krock v. Commissioner, 93 T.C. 672, 678 (1989);

Flynn v. Commissioner, 93 T.C. 355, 367 (1989).

     Mrs. Reaves contends that she did not benefit from the

substantial understatement of income by her husband or receive
                             - 52 -

substantial amounts from him in the years in issue.   Mrs. Reaves

points out that they had a conservative lifestyle.

     Mrs. Reaves benefited from the understatements on

petitioners' 1984, 1985, 1986, 1987, and 1988 returns because the

constructive dividends were payments of her family's personal

expenses from the First Citizens accounts.

     We conclude that Mrs. Reaves is not an innocent spouse under

section 6013(e) except with respect to the tax on the income from

the 282 checks.

     To reflect concessions and the foregoing,


                                             Decisions will be

                                        entered under Rule 155.
