                        T.C. Memo. 1996-138



                      UNITED STATES TAX COURT



       STEWART E. FASON AND JANA K. FASON, Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 2731-95.                      Filed March 20, 1996.



     Larry V. Bishins, for petitioner Jana K. Fason.

     Sergio Garcia-Pages, for respondent.



                        MEMORANDUM OPINION

     PARR, Judge:   This case is presently before the Court on

petitioner Jana K. Fason’s motion for summary judgment filed

February 28, 1996, pursuant to Rule 121.1     Respondent has not


1
     All Rule references are to the Tax Court Rules of Practice
and Procedure, and all section references are to the Internal
Revenue Code in effect for the taxable year in issue, unless
otherwise indicated.
                               - 2 -

filed an objection to the motion, and we find that such an

objection is unnecessary.2

     By statutory notice dated December 13, 1994, respondent

determined a deficiency in petitioners’ Federal income tax for

the year ended December 31, 1989, of $294,062 and a penalty under

section 6662(a) in the amount of $58,812.

     Petitioners, Jana K. Fason and Stewart E. Fason (hereinafter

petitioners or petitioner and Mr. Fason, respectively), resided

in Lake Worth, Florida, on February 21, 1995, the date the

petition was filed.   In their petition, petitioners asserted,

among other things, that they properly computed the cost of goods

sold reported on their 1989 Federal income tax return, and that

the bad debt deduction claimed on their 1989 return was

allowable.   On December 11, 1995, petitioner moved for leave to

amend the petition, so she could claim innocent spouse status

pursuant to section 6013(e).   We granted the motion.   On February

28, 1996, petitioner filed a motion for summary judgment.


2
     Under Rule 121, when a motion for summary judgment is made
and supported as provided in the Rule, an adverse party may not
rest upon mere allegations or denials in his pleadings, but his
response by affidavits or as otherwise provided in the Rule must
set forth specific facts showing that there is a genuine issue of
fact for trial, and if he does not so respond, a decision, if
appropriate, may be entered against him. Rule 121(d). However,
the opposing party need not come forth with affidavits or other
documentary evidence unless the moving party makes a prima facie
showing of the absence of a factual issue. Shiosaki v.
Commissioner, 61 T.C. 861 (1974). Here, we are not satisfied
that the moving party has made a prima facie case. (See
discussion infra.)
                                - 3 -

     The sole issue presented for summary adjudication is whether

petitioner is entitled to innocent spouse relief for taxable year

ended December 31, 1989.   We hold that she is not entitled to

summary adjudication on this issue.

     Summary judgment is intended to expedite litigation and

avoid unnecessary and expensive trials.    Florida Peach Corp. v.

Commissioner, 90 T.C. 678, 681 (1988).    Summary judgment may be

granted with respect to all or any part of the legal issues in

controversy "if the pleadings, answers to interrogatories,

depositions, admissions, and any other acceptable materials,

together with the affidavits, if any, show that there is no

genuine issue as to any material fact and that a decision may be

rendered as a matter of law."   Rule 121(b); Sundstrand Corp. v.

Commissioner, 98 T.C. 518, 520 (1992), affd. 17 F.3d 965 (7th

Cir. 1994); Zaentz v. Commissioner, 90 T.C. 753, 754 (1988);

Naftel v. Commissioner, 85 T.C. 527, 529 (1985).    The moving

party bears the burden of proving that there is no genuine issue

of material fact, and factual inferences will be read in a manner

most favorable to the party opposing summary judgment.    Dahlstrom

v. Commissioner, 85 T.C. 812, 821 (1985); Jacklin v.

Commissioner, 79 T.C. 340, 344 (1982).    The existence of any

reasonable doubt as to the facts will result in denial of the

motion for summary judgment.    Hoeme v. Commissioner, 63 T.C. 18,

20 (1974).
                                 - 4 -

Background3

     Petitioners were married during the entire taxable year

1989. They jointly filed a Federal Form 1040, Individual Income

Tax Return, for 1989, claiming a $177,200 bad debt deduction.

They also reported the income and expenses arising from PC

Systems, a retail computer business, on Schedule C of their tax

return.    Petitioners reported ending inventory and cost of goods

sold for PC Systems of $1,321,501 and $4,635,061, respectively.

     In her notice of deficiency, respondent determined that

$168,000 of the $177,200 bad debt deduction claimed by

petitioners was not allowable.    Respondent also determined that

petitioners had understated their Schedule C ending inventory by

$1,067,736 and therefore overstated their cost of goods sold by

the same amount.

Innocent Spouse

     Petitioner claims that she is entitled to innocent spouse

relief for the taxable year 1989.

     As a general rule, spouses who file joint tax returns are

jointly and severally liable for Federal income tax due on their

combined incomes, as well as for interest on, and additions to,

the tax.   Sec. 6013(d)(3); Park v. Commissioner, 25 F.3d 1289,

1292 (5th Cir. 1994), affg. T.C. Memo. 1993-252.   However, an

innocent spouse may obtain relief from such liability if the

3
     The following background findings are made for the sole
purpose of resolving the motion sub judice.
                                - 5 -

requirements of section 6013(e) are satisfied.    Park v.

Commissioner, supra.

      To qualify for innocent spouse status, the spouse seeking

relief must satisfy all of the requirements of section

6013(e)(1).   Section 6013(e)(1) provides, in pertinent part, that

if:

             (A) a joint return has been made under this
      section for a taxable year,

             (B) on such return there is a substantial
      understatement of tax attributable to grossly erroneous
      items of one spouse,

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

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

      then the other spouse shall be relieved of liability for tax
      (including interest, penalties, and other amounts) for such
      taxable year to the extent such liability is attributable to
      such substantial understatement.

Petitioner has the burden of proving each requirement of section

6013(e)(1).   Rule 142(a); Russo v. Commissioner, 98 T.C. 28, 31-

32 (1992).    Failure to prove any one of the requirements will

preclude the spouse from relief.    Park v. Commissioner, supra at

1292; Purcell v. Commissioner, 826 F.2d 470, 473 (6th Cir. 1987),

affg. 86 T.C. 228 (1986); Bokum v. Commissioner, 94 T.C. 126, 138

(1990), affd. 992 F.2d 1132 (11th Cir. 1993).    The question
                                - 6 -

whether a taxpayer has established that he or she is entitled to

relief as an innocent spouse is one of fact.     Park v.

Commissioner, supra at 1291.

     Petitioner has satisfied the first requirement, because she

made a joint return with Mr. Fason for taxable year 1989.

     The second requirement is that there be a substantial

understatement of tax attributable to grossly erroneous items of

one spouse.   Sec. 6013(e)(1)(B).   A substantial understatement is

any understatement which exceeds $500.    Sec. 6013(e)(3).    In

addition, relief is not available for spouses whose preadjustment

year gross income is $20,000 or less, unless the liability

attributable to the substantial understatement is greater than 10

percent of that adjusted gross income.    Sec. 6013(e)(4)(A).      If

the preadjustment year adjusted gross income is more than

$20,000, relief is available only if the liability is greater

than 25 percent of that adjusted gross income.    Sec.

6013(e)(4)(B).   However, if the understatement is attributable to

an omission of an item from gross income, the percentage-of-

adjusted-gross-income rules discussed above do not apply, but the

understatement must still exceed $500.    Sec. 6013(e)(4)(E).

     There are two types of grossly erroneous items: (1) any

claim of a deduction, credit, or basis by a spouse in an amount

for which there is no basis in fact or law, and (2) any item of

gross income attributable to a spouse which is omitted from gross

income.   Sec. 6013(e)(2).   Thus, an understatement of tax
                                - 7 -

attributable to a deduction is a grossly erroneous item only if

the claim of a deduction has no basis in fact or law.    Sec.

6013(e)(2)(B).    The phrase “no basis in fact or law” is not

defined in section 6013(e).    This Court, however, has held:

     A deduction has no basis in law when the expense, even
     if made, does not qualify as a deductible expense under
     well-settled legal principles or when no substantial
     legal argument can be made to support its
     deductibility. Ordinarily, a deduction having no basis
     in fact or in law can be described as frivolous,
     fraudulent, or, to use the word of the [Ways and Means]
     committee report [on the Deficit Reduction Act of
     1984], phony. [Douglas v. Commissioner, 86 T.C. 758,
     762-763 (1986); fn. ref. omitted.]

To prove that a disallowed deduction has no basis in fact or law,

an individual seeking innocent spouse status is not entitled to

rely on the Commissioner’s disallowance of the deduction

contained in the notice of deficiency, without introducing

further evidence to establish that the deduction has no basis in

fact or law.     Douglas v. Commissioner, supra at 763; Rampulla v.

Commissioner, T.C. Memo. 1993-504.

     In this case, for the bad debt deduction to be considered

grossly erroneous, petitioner must prove it had no basis in fact

or law.   Rule 142(a).   Petitioner relies solely on respondent’s

disallowance of the deduction to prove the lack of a basis in

fact or law.   However, respondent’s basis for disallowing the

deduction, set forth in the notice of deficiency, does not make

self-evident that the deduction lacks a basis in fact or law;

rather, the determination merely states that such expense has not
                               - 8 -

been “established” as allowable.   We are unable to conclude on

the record before us that petitioner has carried her burden of

showing that such deduction lacked a basis in fact or law.     In

addition, even if petitioner demonstrated that the deduction

lacked a basis in fact or law, petitioner has not alleged any

facts demonstrating that she meets the percentage-of-adjusted-

gross-income rules set forth in section 6013(e)(4).    See

discussion, supra p. 6.   Therefore, in regard to the bad debt

deduction, we conclude that summary adjudication on petitioner’s

innocent spouse claim is inappropriate.

     As noted above, section 6013(e)(2) treats an omission from

gross income as a grossly erroneous item, regardless of whether

such item had a basis in fact or law.   Since cost of goods sold

is subtracted from gross sales to compute gross income,4 an

overstatement of cost of goods sold is treated as an omission

from gross income, and therefore an overstatement of cost of

goods sold, by itself, is considered grossly erroneous.      In re

Lilly v. Internal Revenue Service, __ F.3d __, __ (4th Cir., Feb.

20, 1996); Lawson v. Commissioner, T.C. Memo. 1994-286; LaBelle

v. Commissioner, T.C. Memo. 1986-602.     Accordingly, in the case

at bar, the overstatement of cost of goods sold is a grossly

erroneous item.   In addition, the understatement arising from

such item creates a substantial understatement, because it is in


4
     Secs. 1.61-3(a) and 1.162-1(a), Income Tax Regs.
                                 - 9 -

excess of $500 and the percentage-of-adjusted-gross-income rules

do not apply.   Sec. 6013(e)(3) and (4)(E).

     Although the overstatement of cost of goods sold creates a

substantial understatement of tax attributable to a grossly

erroneous item, we must examine the remaining elements of section

6013(e), i.e., sec. 6013(e)(1)(C), (D), to determine whether

petitioner can claim innocent spouse status for the liabilities

arising from this item.

     The knowledge test, under section 6013(e)(1)(C), requires a

taxpayer to show that, at the time of signing a joint return, he

or she did not know and had no reason to know of the substantial

understatement of tax on the return.     A spouse has “reason to

know” of an understatement if:

     a reasonably prudent taxpayer under the circumstances
     of the alleged innocent 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. * * * [Park v.
     Commissioner, 25 F.3d at 1293 (citing Sanders v. United
     States, 509 F.2d 162, 166-167 & n.5 (5th Cir. 1975)).]

The primary ingredients of this test are (1) the circumstances

which face the taxpayer; and (2) whether a reasonable person in

the same position would have reason to know that omissions had

been made.   Shea v. Commissioner, 780 F.2d 561, 565-566 (6th Cir.

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

Whether an individual had reason to know of a substantial

understatement is generally regarded as a question of fact.        Id.;

Estate of Gryder v. Commissioner, 705 F.2d 336 (8th Cir. 1983),
                               - 10 -

affg. T.C. Memo. 1981-466; Ratana v. Commissioner, 662 F.2d 220,

224 (4th Cir. 1981), affg. in part and revg. in part T.C. Memo.

1980-353; Sanders v. United States, supra at 166.

     Petitioner has alleged certain facts for the purpose of

demonstrating that she neither knew nor had reason to know of the

substantial understatement arising from the overstatement of cost

of goods sold.   After considering the facts alleged, petitioner’s

state of mind is still not established.    Her state of mind is

clearly an issue of material fact that is not ripe for summary

adjudication.    To resolve this issue, evidence will be required;

i.e., direct testimony and cross-examination.    The facts and

circumstances relating to this issue have not yet been adequately

developed, making this issue inappropriate for summary judgment.

See Dahlstrom v. Commissioner, 85 T.C. 812, 821 (1985); Hoeme v.

Commissioner, 63 T.C. 18, 20 (1974).

     Finally, petitioner has not set forth facts sufficient to

properly address or resolve in her favor the factors we consider

in resolving the issue of whether it would be inequitable to hold

her liable for the deficiency.

     For the reasons stated herein, petitioner’s motion for

summary judgment is denied.

                                      An appropriate order will be

                                 issued.
