                        T.C. Memo. 2005-121



                      UNITED STATES TAX COURT



      EUGENE MCCLELLAND AND IONE MCCLELLAND, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 1327-02, 1129-03.     Filed May 24, 2005.



     Paul V. Sween, for petitioner Eugene McClelland.

     William A. Vincent, for petitioner Ione McClelland.

     Blaine Holiday, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:   By separate notices of deficiency, respondent

determined deficiencies in petitioners’ Federal income tax of

$345,037 for the tax year 1997 and $97,037 for the tax year 1998.

Petitioners timely petitioned the Court for redetermination of

respondent’s determinations in both notices, and the cases were
                                - 2 -

consolidated.    In a stipulation of settlement, the parties agreed

to deficiencies of $265,255 for 1997 and zero for 1998.     The sole

remaining issue in this case is whether petitioner Ione

McClelland (Ms. McClelland) is entitled to relief from joint and

several liability pursuant to section 6015(b)1 or, in the

alternative, under section 6015(f).     Respondent concedes this

issue, but petitioner Eugene McClelland (Mr. McClelland) opposes

such relief.    As explained herein, we find Ms. McClelland is

entitled to relief under section 6015(b).

                           FINDINGS OF FACT

     Some of the facts have been stipulated and are so found.

The stipulation of facts and attached exhibits are incorporated

herein by this reference.    During the tax years in issue,

petitioners resided in Red Wing, Minnesota.

Ms. McClelland’s General Background

     Ms. McClelland was born on May 15, 1940, and graduated from

high school in May 1958.    Ms. McClelland married Mr. McClelland

on February 14, 1959.

     In the summer of 1959, Ms. McClelland was trained as a

flight attendant.    However, during 1959 and early 1960, she

worked as a waitress.    From sometime in 1960 until 1967, she


     1
      Unless otherwise indicated, all section references are to
the Internal Revenue Code in effect during the years in issue,
and all Rule references are to the Tax Court Rules of Practice
and Procedure.
                               - 3 -

worked as an electroencephalograph technician at the Rochester

State Hospital in Rochester, Minnesota.   She subsequently

obtained a job with International Business Machines in its

manufacturing department, but the record does not indicate how

long she held the job.   From 1987 until 1994, Ms. McClelland

taught a part-time physical fitness program at St. John’s

Hospital in Red Wing, Minnesota.   However, the majority of Ms.

McClelland’s time was dedicated to managing petitioners’ home,

which included growing and canning produce for the McClelland

family and raising their children.

Red Wing River Towing, Inc.

     Red Wing River Towing, Inc. (Red Wing), was a tugboat towing

service corporation.   Red Wing elected to be taxed as an S

corporation on November 1, 1995.   Red Wing was taxed as an S

corporation for the years in issue, with a fiscal tax year ending

on October 31.   The Schedule K-1, Shareholder’s Share of Income,

Credits, Deductions, etc., attached to Red Wing’s Form 1120S,

U.S. Income Tax Return for an S Corporation, for its fiscal tax

year ended October 31, 1997, identified Mr. McClelland as a 50-

percent shareholder and Ms. McClelland as a 50-percent

shareholder.   Both Mr. McClelland and Ms. McClelland were

officers of Red Wing during the years in issue.   Specifically,

Mr. McClelland was its president, and Ms. McClelland was its

secretary.
                                 - 4 -

     During its fiscal tax year ended October 31, 1997, Red Wing

sold a tugboat for $1.5 million.    This sale was reported on Form

4797, Sale of Business Property, attached to its Form 1120S for

that year.   Red Wing also claimed a $701,410 interest paid

deduction on that return.   The parties agreed that the $701,410

interest paid deduction was improper, and Red Wing did not pay

any of the claimed deduction during its fiscal tax year ended

October 31, 1997.

Notices of Deficiency and Procedural Background

     Respondent issued separate notices of deficiency to

petitioners on August 8, 2001, with regard to their 1997 joint

Federal income tax return, and on October 23, 2002, with regard

to their 1998 joint Federal income tax return.    In their timely

joint petitions, petitioners asserted that Ms. McClelland was

entitled to innocent spouse relief under section 6015(b), or in

the alternative, under section 6015(f).

     On April 21, 2003, Ms. McClelland had Mr. McClelland served

with a Petition for Dissolution of Marriage.   In Minnesota, the

term “dissolution” is synonymous with “divorce”.   Minn. Stat.

Ann. sec. 518.002 (West 2003).    The record does not reflect that

the dissolution of marriage was finalized by the date of trial.

Ms. McClelland retained separate counsel in this case after she

served Mr. McClelland with a Petition for Dissolution of
                                - 5 -

Marriage.    After Ms. McClelland retained separate counsel, she

submitted Form 12510, Questionnaire for Requesting Spouse.

                               OPINION

     Married taxpayers may make a single return of Federal income

taxes (a joint return).    Sec. 6013(a).   Generally, section

6013(d)(3) provides that taxpayers making a joint return are

jointly and severally liable for the amount of tax shown on the

return or found to be owing.    However, under certain

circumstances a spouse who made a joint return may seek relief

under section 6015 from joint and several liability.     Section

6015 applies to any liability for tax arising after July 22,

1998, and to any liability, as is the case here, arising before

July 22, 1998, but remaining unpaid as of that date.     Internal

Revenue Service Restructuring and Reform Act of 1998, Pub. L.

105-206, sec. 3201(g), 112 Stat. 740.      Section 6015 offers three

alternatives to a joint filer seeking relief:     (1) Full or

partial relief under section 6015(b); (2) proportionate relief

under section 6015(c); and (3) equitable relief under section

6015(f).    Here, Ms. McClelland seeks relief from joint and

several liability under section 6015(b), or in the alternative,

section 6015(f) for the 1997 tax deficiency.     Mr. McClelland

opposes Ms. McClelland’s request for innocent spouse relief.

     Before we can address Ms. McClelland’s claim for innocent

spouse relief, we shall discuss:    (1) Whether this Court has
                                - 6 -

jurisdiction to hear Ms. McClelland’s request; and (2) who has

the burden of proof.

A.   Jurisdiction

     The Tax Court is a court of limited jurisdiction, and has

been granted by Congress three jurisdictional bases to review a

claim for relief from joint and several liability.   See Naftel v.

Commissioner, 85 T.C. 527, 529 (1985).   First, we have

jurisdiction where a taxpayer petitioned this Court for

redetermination of a deficiency under section 6213 and claimed

innocent spouse relief under section 6015 as an affirmative

defense.   Id. at 533; see King v. Commissioner, 115 T.C. 118,

121-122 (2000); Corson v. Commissioner, 114 T.C. 354, 363-364

(2000); Butler v. Commissioner, 114 T.C. 276, 287-289 (2000).

Second, under section 6015(e), we have jurisdiction to review a

taxpayer’s petition (a “stand alone” matter) that seeks relief

from joint and several liability where the Secretary denied the

taxpayer’s claim for relief in a notice of final determination,

or where the Secretary failed to rule within 6 months of the

taxpayer’s claim being filed.   Third, a taxpayer may request

relief from joint and several liability on a joint return in her

petition for review of a lien or levy action.   Secs. 6320(c),

6330(c)(2)(A)(i); King v. Commissioner, supra at 122.

     In this case, our jurisdiction to review Ms. McClelland’s

contention that she is an innocent spouse is conferred by
                                - 7 -

petitioners’ timely joint petitions for redetermination of their

deficiencies for 1997 and 1998.    Mr. McClelland’s ability to

challenge Ms. McClelland’s assertion of innocent spouse relief is

likewise provided by this case’s status as a deficiency

proceeding.    See Corson v. Commissioner, supra at 365.

B.   Burden of Proof

      The taxpayer generally bears the burden of proof with

certain exceptions.    Rule 142(a); Alt v. Commissioner, 119 T.C.

306, 311 (2002), affd. 101 Fed. Appx. 34 (6th Cir. 2004); Jonson

v. Commissioner, 118 T.C. 106, 113 (2002), affd. 353 F.3d 1181

(10th Cir. 2003); Baumann v. Commissioner, T.C. Memo. 2005-31.

Rule 142 presumes that the taxpayer and the Commissioner are

adversaries.   See, e.g., Funk v. Commissioner, 123 T.C. 213, 216

(2004); Barnes v. Commissioner, T.C. Memo. 2004-266.     Here, Mr.

McClelland, instead of the Commissioner, is opposing Ms.

McClelland’s claim for innocent spouse relief.2    Additionally,

Ms. McClelland argues that Mr. McClelland’s opposition to her

request for innocent spouse relief is a new matter because he

signed the joint petitions in which it was asserted that she was

an innocent spouse as an affirmative defense and he did not

timely inform Ms. McClelland before trial that he intended to

oppose her request.    See Rule 142(a).   We believe that a taxpayer


      2
      Sec. 7491(a) is not applicable here because it is only
relevant in deciding whether the burden of proof shifts to the
respondent.
                                 - 8 -

seeking innocent spouse relief should generally bear the burden

of proving entitlement thereto.    However, as discussed in greater

detail infra, the burden of proof issue does not influence the

outcome of this case because our decision is based on the

preponderance of the evidence.    See Blodgett v. Commissioner, 394

F.3d 1030, 1035 (8th Cir. 2005), affg. T.C. Memo. 2003-212.

C.   Ms. McClelland’s Claim for Innocent Spouse Relief

      As previously stated, it is agreed that the deficiencies in

this case arose from an incorrect interest paid deduction taken

by Red Wing on its Federal income tax return for its fiscal tax

year ended October 31, 1997.   Under section 1366(a), a

shareholder’s pro rata share of an S corporation’s tax attributes

is included in the shareholder’s tax year in which the taxable

year of the S corporation ends.    In this case, petitioners’ 1997

joint return reflected the improper interest paid deduction

because Red Wing claimed the deduction for its fiscal tax year

ended October 31, 1997.

      Although petitioners petitioned this Court with respect to

respondent’s determinations for their 1997 and 1998 tax years,

the parties have stipulated that petitioners did not have a

deficiency in tax for 1998.

      1.   Section 6015(b)

      A relief-seeking spouse qualifies for innocent spouse relief

under section 6015(b)(1) if:
                                   - 9 -

                    (A) a joint return has been made for a
               taxable year;

                    (B) on such return there is an
               understatement of tax attributable to erroneous
               items of one individual filing the joint return;

                    (C) the other individual filing the joint
               return establishes that in signing the return he
               or she did not know, and had no reason to know,
               that there was such understatement;

                    (D) taking into account all the facts and
               circumstances, it is inequitable to hold the other
               individual liable for the deficiency in tax for
               such taxable year attributable to such
               understatement; and

                    (E) the other individual elects * * * the
               benefits of this subsection not later than the
               date which is 2 years after the date the Secretary
               has begun collection activities with respect to
               the individual making the election * * *.

Because these requirements are stated in the conjunctive, a

requesting spouse must satisfy each requirement to be relieved of

joint and several liability under section 6015(b).       Alt v.

Commissioner, supra at 313.       It is agreed that Ms. McClelland met

three of the five requirements:       section 6015(b)(1)(A), (B), and

(E).       Thus, we shall only address the requirements in section

6015(b)(1)(C) and (D).3




       3
       The Treasury regulations under sec. 6015 do not apply to
the 1997 tax liability in this case because Ms. McClelland’s
claim for innocent spouse relief was filed before the
regulations’ effective date. Sec. 1.6015-9, Income Tax Regs.
                              - 10 -

          a.   Section 6015(b)(1)(C):   Know or Reason To Know

     A spouse seeking relief under section 6015(b) must not have

known or had a reason to know at the time of signing a joint

return that there was an understatement of tax on the return.

Sec. 6015(b)(1).   The general rule in an omission of income case

is the relief-seeking spouse knew or had reason to know of an

understatement of tax if she knew of the transaction that gave

rise to the understatement.   Erdahl v. Commissioner, 930 F.2d

585, 589 (8th Cir. 1991), revg. and remanding T.C. Memo. 1990-

101; Jonson v. Commissioner, supra at 115.    However, in deduction

cases, the Court of Appeals for the Eighth Circuit has adopted a

different standard, following Price v. Commissioner, 887 F.2d 959

(9th Cir. 1989), revg. an Oral Opinion of this Court.     Erdahl v.

Commissioner, supra at 589.

     Under this standard, a spouse has reason to know if “‘a

reasonably prudent taxpayer under the circumstances of the spouse

at the time of signing the return could be expected to know that

the tax liability stated was erroneous or that further

investigation was warranted.’”   Id. at 590 (quoting Stevens v.

Commissioner, 872 F.2d 1499, 1505 (11th Cir. 1989)).     The more

the relief-seeking spouse knows about a transaction, “‘the more

likely it is that she will know or have reason to know that the

deduction arising from that transaction may not be valid.’”      Id.

at 598 n.6 (quoting Price v. Commissioner, supra at 963 n.9).
                                   - 11 -

The duty to inquire may arise when the relief-seeking spouse has

notice that a particular deduction could result in a substantial

understatement.     Id.     The failure to inquire may result in the

constructive knowledge of the understatement.        But, had the

relief-seeking spouse inquired about the underlying transaction

and been assured of its legitimacy, she need not repeat her

inquiry unless the return clearly has red flags.         Id. at 590 n.7.

The factors considered in deciding whether the relief-seeking

spouse had a reason to know or a duty to inquire are:        “‘the

spouse’s level of education, [her] involvement in family

financial affairs, the evasiveness or deceit of the culpable

spouse, and any unusual or lavish expenditures inconsistent with

the family’s ordinary standard of living.’”         Id. at 591 (quoting

Guth v. Commissioner, 897 F.2d 441, 444 (9th Cir. 1990)).

                  i.      Level of Education

     Ms. McClelland graduated from high school in 1958.        In 1959

she was trained as a flight attendant.         She did not receive any

additional formal education.

                  ii.     Involvement in Family Financial Affairs

     Ms. McClelland’s involvement in petitioners’ family’s

financial affairs was limited.       Having heard the testimony, we

believe Mr. McClelland wrote all checks paying their household

bills, and petitioners did not have a joint bank account during

the years in issue.       Before each time Ms. McClelland shopped for
                              - 12 -

groceries, Mr. McClelland would sign a check with his name, and

she would fill out the amount paid.

     With respect to petitioners’ 1997 return and Red Wing’s

Federal income tax return for its fiscal tax year ended October

31, 1997, Mr. McClelland kept and provided all financial records

and other information to Gary Kramer (Mr. Kramer), petitioners’

accountant.   Mr. Kramer completed petitioners’ joint 1997 Federal

income tax returns for the year in issue, as well as Red Wing’s

Federal income tax return for its fiscal tax year ended October

31, 1997.   Ms. McClelland did not review or sign Red Wing’s

Federal income tax return for its fiscal tax year ended October

31, 1997, the only place the incorrect interest deduction

appeared.

     Ms. McClelland’s limited involvement in Red Wing’s financial

affairs included maintaining records that related to the number

of hours its employees worked and signing employee payroll

checks.   Ms. McClelland provided this information to Mr. Kramer,

who used this information to calculate the withholding amounts

Red Wing needed to pay for various purposes.   Mr. Kramer

instructed Ms. McClelland to write checks, each in a specific

amount for Red Wing’s withholding obligations.   Ms. McClelland

wrote checks in the instructed amounts and signed Mr.

McClelland’s name.
                                - 13 -

                iii.    Culpable Spouse’s Evasiveness and Deceit

     Mr. McClelland testified that he was responsible for the

improper interest paid deduction, which ultimately led to the

deficiency in petitioner’s 1997 tax liability.    Even though Mr.

McClelland knew the claimed interest payment was never going to

be made, he entered it into Red Wing’s check registry since Mr.

Kramer used that information to complete Red Wing’s Federal

income tax return.     This is how the incorrect interest payment in

Red Wing’s check registry was reported on Red Wing’s tax return

for its fiscal tax year ended October 31, 1997.    These

circumstances support a conclusion that Mr. McClelland was the

evasive and deceptive taxpayer in this case.

     This conclusion is further bolstered by Ms. McClelland’s

credible testimony that Mr. McClelland did not want her to have

access to financial information.    Mr. McClelland’s control over

Red Wing’s and petitioners’ financial affairs allowed Red Wing,

through Mr. McClelland’s actions, to report the improper interest

paid deduction on its tax return.

     Mr. McClelland argues that, as Red Wing’s secretary, Ms.

McClelland could be expected to be familiar with the various

corporate resolutions and documents submitted into evidence at

trial.   However, Ms. McClelland’s credible testimony that Mr.

McClelland never explained to her the numerous documents he

requested her to sign, nor provided her the opportunity to review
                                   - 14 -

these forms, convinces us that she was unaware of the details of

Red Wing’s corporate business.

                iv.    Unusual or Lavish Expenditures Inconsistent
                       With The Family’s Ordinary Standard of Living

     In this case, a portion of the tax savings caused by the

incorrect interest paid deduction was used to purchase rental

property.   Mr. McClelland gave Ms. McClelland a portion of the

after tax rental income, and she deposited it into her personal

account with Edward Jones.    Ms. McClelland testified that the

rental income she received was to compensate her for past

services she had performed for Red Wing because Mr. McClelland

did not allow her to cash her paychecks from Red Wing, and he had

disposed of the paychecks issued to her.     Mr. McClelland failed

to offer any evidence to the contrary.      Moreover, the majority of

the funds in Ms. McClelland’s personal account were from gifts

and an inheritance she received from her father.

     Ms. McClelland also testified credibly that her family lived

a fairly modest lifestyle, and the record contains no evidence

that petitioners changed their lifestyle as a result of the

incorrect deduction.

                v.    Conclusion

     Taking all the facts and circumstances into consideration,

we hold that Ms. McClelland did not have actual knowledge of the

false interest deduction.
                                - 15 -

     Given this holding, we must decide whether a reasonably

prudent taxpayer, in Ms. McClelland’s position, had a reason to

know that the deduction was false or had a duty to inquire about

this deduction.    Ms. McClelland was a shareholder and officer of

Red Wing, and she knew that Red Wing was selling a tugboat, but

the record does not support a conclusion that she had any reason

to know that Red Wing took an improper interest paid deduction.

Ms. McClelland’s involvement with Red Wing’s financial affairs

was limited, and Mr. McClelland provided all of the financial

information to Mr. Kramer for tax purposes.     Had Ms. McClelland

been provided the opportunity to review Red Wing’s Form 1120S for

its fiscal tax year ended October 31, 1997, she might have

observed the false interest deduction, but she was never provided

such opportunity.    Accordingly, we hold that Ms. McClelland did

not have a reason to know that the interest deduction was false,

nor did she have a duty to inquire into the interest paid

deduction.

          b.      Section 6015(b)(1)(D):   Inequity

     We take into account all the facts and circumstances in

deciding whether it is inequitable to hold the relief-seeking

spouse liable for a deficiency.    Sec. 6015(b)(1)(D).   Because

this requirement is almost identical to the requirement of former

section 6013(e)(1)(D), cases interpreting that section such as

Erdahl v. Commissioner, 930 F.2d 585 (8th Cir. 1989), remain
                                - 16 -

instructive to our analysis.     Butler v. Commissioner, 114 T.C. at

283.    The material factors most often cited and considered are

whether there has been a significant benefit to the spouse

claiming relief, and whether the failure to report the correct

tax liability on the joint return results from concealment,

overreaching, or any other wrongdoing on the part of the other

spouse.    Alt v. Commissioner, 119 T.C. at 314; Jonson v.

Commissioner, 118 T.C. at 119.    Normal support is not considered

a significant benefit.     Jonson v. Commissioner, supra at 119.

       Ms. McClelland benefited from the improper interest

deduction to a certain extent.    She received rental income from

property that was purchased with the proceeds of Red Wing’s

tugboat sale, and the amount of tax actually owed on that sale

was decreased by the improper interest paid deduction.      Any

negative inference we may have drawn from this fact is partially

mitigated by Ms. McClelland’s testimony that the rental income

was to compensate her for past services she provided to Red Wing.

       Mr. McClelland also asserts that his payment of her medical

and credit card bills indicates she significantly benefited from

the incorrect deduction.    The record fails to support a

conclusion that Ms. McClelland’s medical expenses and credit card

bills were anything other than normal support.    The record is

devoid of credible evidence indicating the amount of these

expenditures.
                               - 17 -

     More importantly, we are convinced that Mr. McClelland was

responsible for Red Wing’s claiming an improper interest paid

deduction.   It is well settled that a purpose of section 6015

relief “is to protect one spouse from the overreaching or

dishonesty of the other.”    Purcell v. Commissioner, 826 F.2d 470,

475 (6th Cir. 1987), affg. 86 T.C. 228 (1986).

     We therefore conclude, by a preponderance of the evidence,

that it would be inequitable to hold Ms. McClelland liable for

the 1997 deficiency.

D.   Conclusion

     Ms. McClelland is entitled to innocent spouse relief under

section 6015(b), since the preponderance of the evidence

indicates that she satisfied the requirements therein.

     We need not rule on Ms. McClelland’s alternative claim for

innocent spouse relief under section 6015(f) because of our

holding that she qualifies for relief under section 6015(b).

     To reflect the foregoing and give effect to the parties’

stipulation of settlement,



                                     Appropriate decisions will

                                be entered.
