                         T.C. Memo. 1996-470



                       UNITED STATES TAX COURT



                 JANICE L. MORRIS, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 4838-95.                   Filed October 21, 1996.



     Phillip H. Hamilton and John J. Vassen, for petitioner.

     Darrell C. Weaver, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION

     CHIECHI, Judge:    Respondent determined the following defi-

ciencies in petitioner's Federal income tax:1

1
   In the notice of deficiency (notice), which was issued to both
petitioner and her former husband, David E. Morris, Jr. (Mr.
Morris or DEM), respondent determined (1) deficiencies in income
tax with respect to both of them and (2) additions to tax for
fraud only with respect to Mr. Morris. Mr. Morris filed his own
petition with the Court in docket No. 4839-95. The Court entered
                                                   (continued...)
                                 - 2 -

                         Year      Deficiency

                         1987         $39,011
                         1988          23,059
                         1989          29,594

     The issues remaining for decision are:

     (1)     Is petitioner entitled to innocent spouse relief under

section 6013(e)(1)2 with respect to the portion of the deficiency

for each of the years 1987, 1988, and 1989 that is attributable

to certain income from funds that Mr. Morris embezzled and that

were not reported in the joint return that they filed for each

such year?     We hold that she is.

     (2)   Is petitioner entitled to innocent spouse relief under

section 6013(e)(1) with respect to the portion of the deficiency

for 1987 that is attributable to deductions for a business bad

debt and the legal expenses incurred in attempting to recover

that debt that were claimed in the joint return for that year?

We hold that she is not.

     (3)   Did petitioner and Mr. Morris underreport by $10,000


1
 (...continued)
a decision in that case, which was based upon an agreement
between Mr. Morris and respondent that Mr. Morris is liable for
deficiencies in income tax and additions to tax for fraud due in
part to the omission of certain income attributable to embezzled
funds from the Federal income tax returns (joint returns) that he
and petitioner filed for the years at issue. Mr. Morris did not
join in the petition filed by petitioner and is not a party in
the present case.
2
   All section references are to the Internal Revenue Code (Code)
in effect for the years at issue. All Rule references are to the
Tax Court Rules of Practice and Procedure.
                                 - 3 -

their gross income for 1989 from Meadows Management, Inc. (Mead-

ows), an S corporation?     We hold that they did.

     (4)   Did Mr. Morris receive during 1989 a constructive

dividend in the amount determined by respondent from Accu-Data,

Inc. (Accu-Data)?     We hold that he did.

     (5)   Has the period of limitations for assessment of tax for

1987 expired as to petitioner?3    We hold that it has not.

                           FINDINGS OF FACT

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

     Petitioner resided in Monticello, Illinois, at the time the

petition was filed.

Mr. Morris' Embezzlement of Funds

     During the early to mid-1970's, Mr. Morris was employed by

the Internal Revenue Service as a revenue agent.      Thereafter,

beginning in 1977 and throughout the years at issue, Mr. Morris

was employed by John Kenny Co., Inc. as an accountant.4       Mr.

Morris terminated his employment with John Kenny Company on

December 15, 1990.

     Mr. Morris began embezzling funds (embezzled funds) from

John Kenny Company several years prior to 1987.      During all


3
   Petitioner advances no argument about the statute of limita-
tions applicable to 1988 and 1989, and we consider petitioner to
have abandoned any argument with respect thereto.
4
   The record refers interchangeably to Mr. Morris' employer as,
inter alia, John Kenny, John Kenny Construction, and John Kenny
Co., Inc. We shall refer to his employer as John Kenny Company.
                               - 4 -

relevant years, Mr. Morris' embezzlement scheme involved his

depositing funds belonging to John Kenny Company into the bank

accounts of the following corporations and other entities that he

controlled:   Accu-Data; Illinois Land Trust No. 031-663-768,

Champaign National Bank, Trustee (Trust 768); Meadows; and Mid

Central Illinois Co. (MCIC).   During the years 1987, 1988, and

1989, Mr. Morris embezzled $70,547, $73,185, and $43,101, respec-

tively, from John Kenny Company that was not reported in the

respective joint returns for those years (unreported embezzlement

income).5

5
   In the notice, respondent determined that Mr. Morris embezzled
$102,972.40, $128,092.34, and $129,046.26 during 1987, 1988, and
1989, respectively, and that, of the total funds that he embez-
zled during each of those years, Mr. Morris reported $32,425 as
gross receipts of Accu-Data during 1987, $54,907.13 as gross
receipts of Accu-Data and Meadows during 1988, and $85,944.95 as
gross receipts of Accu-Data and Meadows during 1989. Respondent
further determined that the differences (1) for 1987 between the
total amount of embezzled funds and the amount of such funds
reported in the corporate returns of Accu-Data covering 1987 and
(2) for each of the years 1988 and 1989 between the total amount
of embezzled funds and the aggregate amount of such funds re-
ported in the corporate returns of Accu-Data and Meadows covering
those years were the amounts of such funds that were omitted from
the joint returns that petitioner and Mr. Morris filed for those
years (viz., $70,547 for 1987, $73,185 for 1988, and $43,101 for
1989). In determining how much of the embezzled funds Mr. Morris
reported for 1987 as gross receipts of Accu-Data, respondent
added one-half of the gross receipts reported in the U.S. corpo-
ration short-form income tax return (Form 1120-A) that Accu-Data
filed for its taxable year ended June 30, 1986, and one-half of
the gross receipts of $35,211 reported in the Form 1120-A that it
filed for its taxable year ended June 30, 1987, and reduced that
sum by certain income of Accu-Data that she determined did not
relate to the embezzled funds. Similarly, in determining how
much of the embezzled funds Mr. Morris reported as gross receipts
of Accu-Data (1) for 1988, respondent added one-half of the gross
                                                   (continued...)
                                - 5 -

     It was not until either late January or early February 1991

that petitioner discovered that Mr. Morris had embezzled funds

from John Kenny Company.   On August 6, 1991, petitioner and Mr.

Morris were divorced, principally because of Mr. Morris' embez-

zlement activities.

     It was not until January 1991 that John Kenny Company

discovered that Mr. Morris had been embezzling funds.   In Febru-

ary 1991, John Kenny Company and/or its owner, John Kenny, sued

petitioner and Mr. Morris to recover the embezzled funds.    That

suit was settled in May 1991.   As part of that settlement, the

beneficial interest in certain land located in Illinois that

Meadows held was transferred to John Kenny Company.

Corporations and Other Entities
that Mr. Morris Controlled

5
 (...continued)
receipts of $31,687 reported in the Form 1120-A that it filed for
its taxable year ended June 30, 1988, and all of the gross
receipts of $20,647 reported in the U.S. income tax return for an
S corporation (Form 1120S) that it filed for its short taxable
year 1988, and reduced that sum by certain income of Accu-Data
for 1988 that she determined did not result from the embezzled
funds; and (2) for 1989, respondent used all of the gross re-
ceipts of $6,000 reported in the Form 1120S that it filed for its
taxable year 1989, as reduced by certain income of Accu-Data for
that year that she determined did not result from the embezzled
funds. In determining how much of the embezzled funds Mr. Morris
reported as gross receipts of Meadows (1) for 1988, respondent
used all of the gross receipts of $22,482 reported in the Form
1120S that it filed for its taxable year 1988, as reduced by
certain income of Meadows for that year that she determined did
not result from the embezzled funds; and (2) for 1989, respondent
used all of the gross receipts of $86,355 reported in the Form
1120S that it filed for its taxable year 1989, as reduced by
certain income of Meadows for that year that she determined did
not result from the embezzled funds.
                               - 6 -

     Accu-Data

     On December 16, 1980, Mr. Morris incorporated Accu-Data for

the purpose of operating an accounting and tax return preparation

business.   He was the sole stockholder of Accu-Data until its

involuntary dissolution on May 1, 1992.   During the years at

issue, (1) Mr. Morris maintained a checking account on behalf of

Accu-Data at the Champaign National Bank (Accu-Data account) on

which he was the sole signatory and into which he deposited

certain of the embezzled funds; and (2) petitioner had no in-

volvement with Accu-Data or that account.

     As president of Accu-Data, Mr. Morris signed the Form 1120-A

that it filed for its taxable year ended June 30, 1988, and the

Forms 1120S that it filed for its taxable years 1988 and 1989.6

     Trust 768

     Trust 768 was created on November 23, 1987.   At that time,

the beneficial interests in Trust 768 were held equally by

(1) John Kenny Company and (2) petitioner and Mr. Morris.    On

February 9, 1988, John Kenny Company assigned its beneficial


6
   Prior to July 1, 1988, Accu-Data was not an S corporation, and
it had a taxable year that ended on June 30. It appears that
Accu-Data became an S corporation on July 1, 1988, and thereafter
adopted the calendar year as its taxable year. The Form 1120S
that Accu-Data filed for its taxable year 1988 covered the last
six months of that year.

   Mr. Morris prepared the Form 1120-A that Accu-Data filed for
its taxable year ended June 30, 1988. It is unclear from the
record who prepared the Forms 1120S that Accu-Data filed for 1988
and 1989.
                              - 7 -

interest in Trust 768 to petitioner.

     During February 1988, Trust 768 purchased for $85,000 61

acres of land situated in Piatt County, Illinois (Illinois land),

on which a gravel and sand pit (gravel pit) was located.   To

facilitate that purchase, Trust 768 borrowed $50,000 from Cham-

paign National Bank, and Mr. Morris wrote a check for $20,000 to

Trust 768 drawn on a joint checking account that petitioner and

Mr. Morris maintained at the First State Bank of Monticello

(joint checking account).7

     On June 15, 1988, petitioner and Mr. Morris assigned their

beneficial interests in Trust 768 to Meadows.   Thereafter, Trust

768 conducted no activities except for maintaining a bank account

at the Champaign National Bank (Trust 768 account) on which Mr.

Morris was the sole signatory and into which he deposited certain

of the embezzled funds.

     Meadows

     Meadows, which was incorporated on May 2, 1988, was involun-

tarily dissolved on October 1, 1991.   During the years at issue,

petitioner was Meadows' sole stockholder, served as its presi-

dent, signed certain corporate documents on its behalf, was a

signatory on a checking account maintained on its behalf at the

National Bank of Monticello in the name of petitioner and Mr.

Morris (Meadows account at the National Bank of Monticello), and

7
   The record does not disclose the source of the remaining
$15,000 that Trust 768 used to purchase the Illinois land.
                                - 8 -

signed at least one check drawn on that account.   However, during

those years, Mr. Morris controlled the affairs of Meadows, and

petitioner was not involved in the day-to-day operations of that

corporation and was not in a position to know how much income

Meadows generated from those operations.

     In addition to the Meadows account at the National Bank of

Monticello, Mr. Morris maintained a checking account in the name

of Meadows at the Champaign National Bank (Meadows account at the

Champaign National Bank) on which he and petitioner were signato-

ries and into which he deposited certain of the embezzled funds.

     During 1988 and 1989, Meadows sold to unrelated persons the

sand and gravel located in the gravel pit and deposited the

proceeds from those sales into the Meadows account at the Na-

tional Bank of Monticello.

     Petitioner visited the Illinois land during 1988 and 1989,

observed children playing around the gravel pit, and became

concerned that those children might sustain injuries for which

Meadows might be held liable.   She therefore suggested that a

liability insurance policy be obtained to cover the Illinois

land.   During 1989, petitioner signed an insurance application

for such a policy in which she indicated that the applicant's

primary occupation was "Accountant".    Petitioner signed a check

for $100 drawn on the Meadows account at the Champaign National

Bank that was used to pay a premium for that policy.

     The Form 1120S that Meadows filed for 1988 was signed by Mr.
                              - 9 -

Morris as its secretary,8 and he prepared the Form 1120S filed by

Meadows for 1989 and signed it as its secretary-vice president.

     MCIC

     During the years at issue, except for maintaining a checking

account at the Champaign National Bank (MCIC account) on which

Mr. Morris was the sole signatory and into which Mr. Morris

deposited certain of the embezzled funds, MCIC conducted no

activities.

The Financial Situation of
Petitioner and Her Family

     Petitioner and Mr. Morris, who were married on December 23,

1967, have a son and a daughter.   During the years at issue,

petitioner was responsible for handling the family finances.    In

that connection, she deposited checks and other funds into the

joint checking account and/or the joint savings account (joint

savings account) that Mr. Morris and she maintained at the First

State Bank of Monticello (joint checking and/or savings accounts)

and used the funds in those accounts to pay the family bills.

     For each of the years 1987, 1988, and 1989, petitioner

prepared (1) an analysis of the amounts deposited into (deposits

analysis) and (2) an analysis of the amounts disbursed from

(disbursements analysis) the joint checking and/or savings

accounts.


8
   It is unclear from the record who prepared the Form 1120S that
Meadows filed for 1988.
                                              - 10 -

         Deposits
         According to the deposits analyses that petitioner prepared

   for the years at issue, petitioner made the following deposits
                      DEM
   into DEM
        the joint   checking
               Payroll    Otheraccount
                                    Cash during   those Water
                                              Savings    years:
                                                              Co.               Less Cash     Net
Year    Checks      Checks       Checks     Deposited   Deposited     Checks     Received   Deposits9

1987   $6,350.00   $23,840.95   $2,730.40   $1,655.00    $ --         $614.74   $4,806.00   $76,458.55
1988   29,850.91    24,361.78       95.50      270.00    6,473.00    1,845.36    3,082.00    59,683.55
1989   15,324.00    23,176.29    1,920.88    2,300.00   23,673.44    3,690.85    3,112.43    67,227.68

         The items under the heading "DEM Checks" were checks drawn

   on the Accu-Data account, the Trust 768 account, the Meadows

   account at the Champaign National Bank, and/or the MCIC account

   that Mr. Morris gave petitioner and that she deposited.                            The

   items under the heading "DEM Payroll Checks" were payroll checks

   that Mr. Morris received from John Kenny Company, endorsed, and

   gave petitioner and that she deposited.                     The items under the

   heading "Other Checks" were checks that petitioner received from

   miscellaneous sources that she deposited.                        The items under the

   heading "Cash Deposited" were cash that petitioner received from



   9
      The amount under the heading "Net Deposits" for each of the
   years at issue that was shown in the deposits analysis for each
   such year is not equal to the amount obtained by reducing the
   total of all the deposits shown in each such deposits analysis by
   the amount shown under the heading "Less Cash Received". The
   amounts under the heading "Net Deposits" are overstated by
   $46,073.46 for 1987 and $254.65 for 1989 and are understated by
   $131 for 1988. The reasons for those discrepancies are not
   disclosed by the record, although part of the discrepancy for
   1987 is attributable to three deposits totaling $46,063 that were
   included under the heading "Net Deposits" for that year but that
   were not included under any other heading. Of that $46,063,
   $39,800 is attributable to a bonus that Mr. Morris received
   during 1987 from John Kenny Company and $4,000 is attributable to
   a check drawn on the Accu-Data account during that year. The
   source of the remaining $2,263 is not disclosed by the record.
                               - 11 -

various sources not identified in the record and that she depos-

ited.   The items under the heading "Savings Deposited" were

withdrawals that petitioner made from the joint savings account

and that she deposited.10   The items under the heading "Water Co.

Checks" were checks that Mr. Morris received as salary from

Douglas Water Co., a company owned by John Kenny, and gave to

petitioner and that she deposited.      The items under the heading

"Less Cash Received" were cash that petitioner retained, and did

not deposit, at the time certain of the deposits listed above

were made.

     Although petitioner's deposits analysis for 1987 showed

deposits totaling $6,350 under the heading "DEM Checks", checks

totaling $11,775 that were all drawn on the Accu-Data account

were paid to the order of petitioner, Mr. Morris, or cash and

represent amounts received by or expended on behalf of petitioner

during 1987.   Of the $5,425 in checks that were deposited but not

shown in the deposits analysis for 1987 under the heading "DEM

10
   Withdrawals from the joint savings account during 1987, 1988,
and 1989 totaled $2,263, $6,473, and $20,237.23, respectively.
Since petitioner did not show in her deposits analysis for 1987
under the heading "Savings Deposited" any deposits into the joint
checking account of funds withdrawn from the joint savings
account during that year, it appears that Mr. Morris, and not
petitioner, made the withdrawals from that account during 1987.
The record does not explain the discrepancy between the total
amount of withdrawals from the joint savings account during 1989
of only $20,237.23 and the withdrawals totaling $23,673.44 that
petitioner showed in her deposits analysis for that year under
the heading "Savings Deposited" as having been made from that
account during 1989 and deposited into the joint checking ac-
count.
                               - 12 -

Checks", (1) $4,000 was included in that deposits analysis under

the heading "Net Deposits", but the source was not disclosed; and

(2) at least $1,100 was included in that deposits analysis under

the heading "Other Checks".

      Although petitioner's deposits analysis for 1987 showed

deposits totaling $614.74 under the heading "Water Co. Checks",

Mr. Morris received a total of $6,500 from Douglas Water Co.

during 1987, and that amount was received by or expended on

behalf of petitioner during that year.

      During 1987, Mr. Morris received a $40,000 bonus (bonus)

from John Kenny Company that was not attributable to embezzled

funds.    Of that amount, $39,800 was deposited into the joint

checking account and was included in the deposits analysis for

1987 under the heading "Net Deposits", although the source of

that deposit was not disclosed in that analysis.

      Although petitioner's deposits analysis for 1988 showed

deposits totaling $29,850.91 under the heading "DEM Checks",

checks totaling $31,144.91 that were drawn on the Accu-Data

account, the Trust 768 account, the Meadows account at the

Champaign National Bank, and the MCIC account were paid to the

order of petitioner, Mr. Morris, or cash and represent amounts

received by or expended on behalf of petitioner during that

year.11

11
     The checks totaling $31,144.91 had the following sources:
                                                     (continued...)
                                    - 13 -

           Although petitioner's deposits analysis for 1989 shows

deposits totaling $15,324 under the heading "DEM Checks", checks

totaling $18,144 that were drawn on the Accu-Data account, the

Meadows account at the Champaign National Bank, and the MCIC

account were paid to the order of petitioner, Mr. Morris, or cash

and represent amounts received by or expended on behalf of

petitioner during that year.12

           Disbursements

           According to the disbursements analyses that petitioner

prepared for the years at issue, petitioner made the following

disbursements from the joint checking account during those years:

     Category of Disbursements13         1987        1988        1989

     Savings                          $950.00    $17,006.00   $28,583.25

     11
          (...continued)
                     Entity Controlled
                       by Mr. Morris               1988

                        Accu-Data               $21,875.00
                        Trust 768                 3,969.91
                        Meadows                     750.00
                        MCIC                      4,550.00
                          Total                  31,144.91
12
          The checks totaling $18,144 had the following sources:

                    Entity Controlled
                      by Mr. Morris                1989

                        Accu-Data                $6,350
                        Meadows                   9,974
                        MCIC                      1,820
                          Total                  18,144
13
   The categories listed are similar to those that appeared in
petitioner's disbursements analyses.
                                  - 14 -

     Cash                         2,408.00    4,673.30    7,645.50
     Insurance                    2,052.73    3,111.35    4,224.81
     Food                           886.79    2,177.33    1,738.06
     Gasoline and repair            382.29    1,606.76    3,411.89
     Medical                      1,008.87      813.76      863.43
     Daughter Cindy                 237.00      450.00      720.00
     Clothing                     2,363.37    2,506.10    1,955.08
     Monthly                     11,558.51    9,479.53   10,665.27
     Miscellaneous               53,961.74   17,080.04    7,636.66
        Total                    75,809.30   58,904.17   67,443.95

The category "Savings" reflected funds that petitioner trans-

ferred to the joint savings account or other savings accounts.

Of the $28,583.25 that was transferred to one or more savings

accounts during 1989, $20,000 was deposited as part of an initial

deposit totaling $35,000 that petitioner and Mr. Morris made in

order to open an account at American Savings.14      The category

"Cash" reflected funds that petitioner received from cashing

checks that were payable to cash.      The category "Insurance"

reflected checks that petitioner wrote to pay premiums for

homeowners', automobile, and medical insurance.      The category

"Gasoline and repair" reflected funds that petitioner spent for

car expenses.     The category "Medical" reflected funds that

petitioner spent for various medical expenses, including medical

insurance premiums.15      The category "Daughter Cindy" reflected

14
   The remaining $15,000 that was used to make that initial
$35,000 deposit into the American Savings account was from the
Meadows account at the National Bank of Monticello. Petitioner
did not receive or have available any of the money deposited into
the American Savings account; Meadows used that money for the
gravel pit.
15
      It is unclear from the record why premiums for medical insur-
                                                      (continued...)
                              - 15 -

funds that petitioner spent on her daughter Cindy.   The category

"Clothing" reflected funds that petitioner spent to purchase

clothing.   The category "Monthly" reflected funds that petitioner

spent to pay items such as utilities, credit card accounts, car

expenses,16 and mortgage payments.   Included in the category

"Monthly" for 1987 were five checks, each in the amount of

$250.32, that were written by petitioner to GMAC during each of

the months January through May 1987 and one check in the amount

of $250.31 that was written by petitioner to GMAC in June 1987.

The category "Miscellaneous" reflected funds that petitioner

spent on various items, including haircuts, birthday presents,

tuition, contributions to organizations such as the Boy Scouts

and a Methodist church, and purchases at stores such as K's

Merchandise Mart and GNC.   The category "Miscellaneous" for 1987

reflected, inter alia, (1) funds totaling $17,560.77 that peti-

tioner used to pay off the mortgage on the house at which peti-

tioner, Mr. Morris, and their children resided and (2) a $20,000

check payable to Trust 768 that was written by Mr. Morris with

respect to that trust's purchase of the Illinois land.   The

source of the funds used to pay off the mortgage and to purchase

the Illinois land was the $40,000 bonus that John Kenny Company

15
 (...continued)
ance were listed in two separate categories in the disbursements
analyses.
16
   It is unclear from the record why car expenses were listed in
two different categories in the disbursements analyses.
                               - 16 -

paid Mr. Morris during 1987.   The category "Miscellaneous" for

1987 also reflected a $6,263.50 disbursement to Bill Abbott on

May 12, 1987.   That disbursement was the downpayment that peti-

tioner made to purchase a 1987 Sunbird, which was the only car

available to her at that time.   Petitioner borrowed the balance

of the purchase price for that car.

     The disbursements that petitioner made during the years at

issue were not lavish in comparison to the disbursements that she

made during years prior to the years at issue.

     Other Deposits, Disbursements, and Transfers

     In addition to the deposits into the joint checking account

that were reflected in petitioner's deposits analyses, certain

deposits were also made to the joint savings account.   The total

amounts deposited into that account during 1987, 1988, and 1989

were $5,015.82, $16,865.45, and $3,432.41, respectively.

     During 1988, Mr. Morris wrote (1) two checks totaling

$17,011 on the Trust 768 account to pay the joint Federal income

tax liabilities that petitioner and he owed for 1986 and 1988 and

(2) three checks totaling $2,853.72 on the Trust 768 account to

pay the joint income tax liabilities that petitioner and he owed

the State of Illinois for 1986 and 1988.17

17
   The joint Federal and State income tax liabilities for 1986
that Mr. Morris paid during 1988 were attributable to the in-
crease in taxes shown in an amended joint return that petitioner
and Mr. Morris filed for 1986, and the joint Federal and State
income tax liabilities for 1988 that Mr. Morris paid during that
                                                   (continued...)
                               - 17 -

     Accu-Data made three payments to GMAC, each in the amount of

$250.32, on July 10, August 6, and September 10, 1987.   It also

paid GMAC $4,464.64 on September 11, 1987, and $10 on September

24, 1987.

     Mr. Morris transferred to petitioner ownership of a life

insurance policy with a cash value of $15,000.18

Petitioner's Education, Work
Experience, and Family Life

     Although petitioner had worked during 1981 and 1982 as an

accounts receivable clerk at a medical supply company, she was

not employed during the years at issue.   Rather, during those

years, petitioner was a homemaker, mother, and part-time college

student.

     During the fall of 1982, petitioner, who had not had any

post-high school education, entered Parkland College.    She took

courses there over the next several years, including two intro-

ductory courses in basic accounting principles, and received a

degree from that institution in the spring of 1987.   In the fall

of 1987, petitioner entered the University of Illinois and took

courses there for two years, including two intermediate account-

ing courses, before she withdrew to devote more time to her

children.   Sometime after the years at issue, petitioner returned

17
 (...continued)
year were attributable to estimated tax payments.
18
   The record does not disclose when that policy was transferred
to petitioner.
                             - 18 -

to the University of Illinois and received a degree in accounting

from that institution.

     During December 1988, petitioner's daughter experienced a

medical problem with which her daughter had a difficult time

coping, and petitioner devoted a significant amount of time

during 1989 in helping her daughter deal with that problem.

Petitioner spent a substantial amount of time during the years at

issue in assisting her son, who suffered from a learning disabil-

ity, to improve his learning skills.

     During the years at issue, Mr. Morris was not at home very

much, and he took affirmative steps to deceive petitioner and

otherwise to prevent her discovery of the embezzled funds.    Mr.

Morris led petitioner to believe that, when he was not at home,

he was working not only for John Kenny Company, but also for

Accu-Data during the evenings and on weekends at an office that

he maintained away from home in an apartment complex.   Although

Mr. Morris discussed his employment with petitioner in terms of

the people with whom he worked, he generally did not inform her

about what he actually did in his employment.   Mr. Morris was not

open with petitioner about his financial affairs, and, when she

questioned him about those matters, he reacted negatively,

causing her to discontinue that line of questioning.
                             - 19 -

Joint Returns

     For each of the years at issue, petitioner and Mr. Morris

filed a joint return that Mr. Morris had prepared.     They claimed

their children as dependents in the 1987 and 1988 joint returns

and claimed their son as a dependent in their 1989 return.

     In the joint returns for the years 1987 through 1989,

petitioner and Mr. Morris reported, inter alia, the following

income (and loss):

                            1987           1988          1989

Wages, salaries, etc.    $41,376.64    $38,101.00     $37,700.00
Taxable interest           2,147.99      2,758.00       5,450.00
Schedule C                  (447.25)       --             --
Schedule D                (3,000.00)    (3,000.00)     (3,000.00)
Schedule E                    --        24,929.00      18,987.00
   Total income           40,077.38     62,788.0019    59,137.00

     The category "Schedule C" reflects the results shown in

Schedule C of the joint return for 1987.   Petitioner and Mr.

Morris included in that schedule the $40,000 bonus that Mr.

Morris received from John Kenny Company during that year.       That

bonus income was completely offset by deductions that they

claimed in that schedule.

     The category "Schedule E" reflects the results shown in the

respective Schedules E of the joint returns for 1988 and 1989.

Petitioner and Mr. Morris included in those schedules the amounts

of ordinary income (or loss) from a trade or business activity


19
   The joint return for 1988 incorrectly showed total income of
$62,083.
                             - 20 -

that was shown in the respective Forms 1120S that Accu-Data and

Meadows, S corporations, filed for those years.20   In Schedule E

of the joint return for each of the years 1988 and 1989, they

reported aggregate income from Accu-Data and Meadows of $24,929

and $18,987, respectively.

     No income attributable to Accu-Data was reflected in the

joint return for 1987, and no income attributable to MCIC or

Trust 768 was reflected in the joint return for any of the years

at issue.

     Mr. Morris received Forms W-2 (Wage and Tax Statement) from

John Kenny Company and Douglas Water Co. for each of the years at

issue that were attached to the joint returns for those years and

that showed the following:




20
   Although petitioner and Mr. Morris included in Schedule E of
their joint return for 1989 only $19,112 of income from Meadows,
the Form 1120S filed by Meadows for that year reflected $29,112
of income.
                             - 21 -

                             1987           1988          1989

John Kenny Co.

  Wages                  $34,876.64   $31,351.34     $31,200.00
  Federal tax withheld     4,935.09     4,236.30       4,200.04
  State tax withheld         811.42       732.90         803.14
  Social Security
    tax withheld           2,493.68       2,354.49     2,343.12

Douglas Water Co.

  Wages                    6,500.00       6,750.00     6,500.00
  Federal tax withheld       542.00         540.00       520.00
  State tax withheld         160.68         166.86       160.68
  Social Security
    tax withheld             464.62        506.98       488.06

     After withholding for various taxes, Mr. Morris received

during 1987, 1988, and 1989, respectively, (1) net wages (a) from

John Kenny Company of $26,636.45, $24,027.65, and $23,853.70 and

(b) from Douglas Water Co. of $5,332.70, $5,536.16, and $5,331.26

and (2) total net wages from both of those companies of

$31,969.15, $29,563.81, and $29,184.96.

     Petitioner relied on Mr. Morris to prepare the joint returns

for the years at issue, had confidence in his ability to prepare

those returns properly, and, as far as petitioner knew, Mr.

Morris never received any complaints about the returns that he

prepared for others.

Criminal Charges of Tax Evasion
Against Mr. Morris

     On December 30, 1992, Mr. Morris pleaded guilty to two

counts of tax evasion under 26 U.S.C. section 7201 (1994) for not

reporting as income in the joint returns for 1987 and 1988
                                - 22 -

certain funds that he had embezzled and that had not been re-

ported as gross receipts of Accu-Data or Meadows.

Bad Debt and Legal Expenses

     Petitioner and Mr. Morris claimed deductions of $37,596 for

a business bad debt and $2,851.25 for legal expenses in Schedule

C of their 1987 joint return.    Those deductions completely offset

the $40,000 bonus that Mr. Morris had received during 1987 and

reported in that schedule.    The activity reported in Schedule C

of the 1987 joint return was identified as "financial services".

     The business bad debt deduction claimed in Schedule C of the

joint return for 1987 was attributable to a loan (Galt loan) made

by Mr. Morris, who was not in the business of making loans during

that year, or by one of the entities that he controlled to either

Tom Galt (Mr. Galt) or Galt Communications, Inc. (Galt Communica-

tions).   Galt Communications, a corporation owned 80 percent by

Mr. Galt and 20 percent by Mr. Morris, was established for the

purpose of selling electronic appliances and cellular telephone

services.   At the time the Galt loan was made, Mr. Morris was not

an employee of Galt Communications, but he hoped to secure future

employment with it.

     The legal expenses claimed as a deduction in Schedule C of

the 1987 joint return were incurred during an unsuccessful

attempt to recover the proceeds of the Galt loan.

     Petitioner inquired about the $37,596 business bad debt

deduction claimed in the 1987 joint return because she thought
                              - 23 -

that that debt had been deducted in the 1986 joint return.    Mr.

Morris confirmed that that debt had been deducted, albeit errone-

ously, in their 1986 joint return and advised her that they would

have to file an amended joint return for 1986 to correct that

error.   Petitioner and Mr. Morris filed an amended joint return

for 1986 that did not claim the business bad debt deduction at

issue.

Meadows--Gross Income

     The Form 1120S that Meadows filed for 1989 showed gross

receipts of $86,355 and ordinary income of $29,112.    In their

joint return for 1989, petitioner and Mr. Morris reported income

from Meadows in the amount of $19,112.

     On April 6, 1989, a deposit of $21,000 attributable to a

check drawn on the MCIC account was made into the Meadows account

at the Champaign National Bank.    A $10,000 check drawn on the

Meadows account at the Champaign National Bank and payable to the

order of Mr. Morris cleared that account on April 17, 1989.      That

$10,000 check and a check payable to Mr. Morris in the amount of

$16,500 that was drawn on the MCIC account were deposited on

April 14, 1989, into an account at Bloomington Federal

(Bloomington Federal account).    On April 26, 1989, a $23,000

deposit was made into the Meadows account at the Champaign

National Bank attributable to a check drawn on the Bloomington

Federal account.
                              - 24 -

Accu-Data--Constructive Distribution

     Accu-Data, a corporation wholly owned by Mr. Morris during

all relevant periods, was a stockholder in Technical Programs,

Inc. (TPI).   During 1981, Accu-Data transferred $12,000 to TPI.

During 1982, Accu-Data transferred an additional $300 to TPI.

Between 1981 and 1983, TPI made payments to and on behalf of

Accu-Data that totaled at least $5,045.   TPI was dissolved on

February 1, 1986, because of its failure to pay franchise tax to

the State of Illinois.

     The Form 1120S that Accu-Data filed for its short taxable

year July 1 through December 31, 1988, reflected as an asset on

its balance sheet at the beginning of the year "Loans to

shareholders" (stockholder loan account) in the amount of $7,217.

No amount was reflected on the balance sheet at the end of that

year concerning those purported loans.    The balance sheet in the

Form 1120S that Accu-Data filed for 1989 showed no assets and

liabilities as of the beginning and end of that year.   The Form

1120-A that Accu-Data filed for its taxable year ended June 30,

1987, contained a balance sheet that showed that the stockholder

loan account increased from $4,394 to $7,217 during that year.

The Form 1120-A that Accu-Data filed for its taxable year ended

June 30, 1988, contained a balance sheet that showed a balance of

$7,217 in the stockholder loan account at the beginning and end

of that year.
                               - 25 -

                              OPINION

     Petitioner bears the burden of proving that respondent's

determinations in the notice are erroneous.   Rule 142(a); Welch

v. Helvering, 290 U.S. 111, 115 (1933).   To satisfy that burden

with respect to the issues remaining in this case, petitioner

relies on her testimony and that of Mr. Morris, as well as on

various documents.   We do not question the general credibility of

petitioner.21   However, as discussed below, we do have reserva-

tions about some of the matters to which Mr. Morris testified.

Innocent Spouse

     Petitioner claims that she qualifies for innocent spouse

relief under section 6013(e) only with respect to the portion of

the deficiency (1) for 1987 that is attributable to the unre-

ported embezzlement income and the erroneous deductions claimed

for a business bad debt and the legal expenses incurred to

recover that debt and (2) for each of the years 1988 and 1989

that is attributable to the unreported embezzlement income.

     Section 6013(e) provides in pertinent part:

     (e) Spouse Relieved of Liability in Certain Cases.--


21
   During her direct testimony, petitioner testified that she
did not write any checks on the Meadows bank accounts. On cross-
examination, respondent introduced a check written by petitioner
on the Meadows account at the Champaign National Bank. We be-
lieve petitioner's testimony that she did not remember writing
that check and do not question the reliability of her testimony
as a result of that, or any other, lapse of memory during her
testimony.
                               - 26 -

           (1) In general.--Under regulations prescribed by
      the Secretary, 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 under-
      statement.

           (2) Grossly Erroneous Items.--For purposes of this
      subsection, the term "grossly erroneous items" means,
      with respect to any spouse--

                (A) any item of gross income attributable to
           such spouse which is omitted from gross income,
           and

                (B) any claim of a deduction, credit, or
           basis by such spouse in an amount for which there
           is no basis in fact or law.

      The spouse claiming innocent spouse relief must prove that

all four requirements prescribed by section 6013(e)(1) are

satisfied in order to be entitled to such relief.22   Resser v.

22
     Neither party advances any argument regarding sec.
                                                     (continued...)
                               - 27 -

Commissioner, 74 F.3d 1528, 1534 (7th Cir. 1996), revg. and

remanding T.C. Memo. 1994-241.   Nonetheless, the innocent spouse

provision was intended to provide relief from "grave injustice"

and is to be applied liberally in favor of the person claiming

its benefits.    Id.

     Respondent concedes (1) that petitioner and Mr. Morris filed

a joint return for each of the years at issue; (2) that there was

a substantial understatement of tax (substantial understatement)

with respect to each of those joint returns; (3) that the unre-

ported embezzlement income for each of the years at issue consti-

tutes a grossly erroneous item that is attributable to Mr.

Morris; and (4) that petitioner did not know about the funds that

Mr. Morris embezzled during those years until late January or

early February 1991 after she signed the joint return for each of

those years.    Respondent argues, however, (1) that neither of the

erroneous deductions in question for 1987 constitutes, as re-

quired by section 6013(e)(1)(B), a grossly erroneous item as

defined in section 6013(e)(2)(B); (2) that petitioner had reason

to know within the meaning of section 6013(e)(1)(C) of the

substantial understatement (a) for 1987 that is attributable to

the unreported embezzlement income and those erroneous deductions


22
 (...continued)
6013(e)(4), and we assume that the parties agree that that
section is satisfied with respect to any liability attributable
to the erroneous deductions in question.
                             - 28 -

and (b) for each of the years 1988 and 1989 that is attributable

to the unreported embezzlement income; and (3) that, under the

facts and circumstances presented here, it is not inequitable

under section 6013(e)(1)(D) to hold petitioner liable for the

portion of the deficiency (a) for 1987 that is attributable to

that embezzlement income and those erroneous deductions and (b)

for each of the years 1988 and 1989 that is attributable to that

embezzlement income.

     Unreported Embezzlement Income

          Section 6013(e)(1)(C)

     In cases involving omissions of income, such as the issue

presented here involving the unreported embezzlement income, the

courts have consistently held that the knowledge contemplated by

section 6013(e)(1)(C) is knowledge of the underlying transaction,

and not of the tax consequences of that transaction.     Quinn v.

Commissioner, 524 F.2d 617, 626 (7th Cir. 1975), affg. 62 T.C.

223 (1974); see Resser v. Commissioner, supra at 1535.    In

evaluating whether petitioner had no reason to know that there

was a substantial understatement within the meaning of section

6013(e)(1)(C), the Court must inquire whether a reasonably

prudent person, under the circumstances of petitioner, could have

been expected to know at the time of signing each of the returns

in question that each such return contained a substantial under-

statement or that further investigation was warranted.    Resser v.
                               - 29 -

Commissioner, supra at 1536; Bokum v. Commissioner, 94 T.C. 126,

148 (1990), affd. 992 F.2d 1132 (11th Cir. 1993).    A spouse may

have a duty to inquire further if he or she knows enough facts so

as to be placed on notice of the possibility of a substantial

understatement.   Guth v. Commissioner, 897 F.2d 441, 444-445 (9th

Cir. 1990), affg. T.C. Memo. 1987-522.

     Factors to be considered in determining whether petitioner

had no reason to know within the meaning of section 6013(e)(1)(C)

     include the spouse's level of education; the spouse's in-
     volvement in the financial and business activities of the
     family; any substantial unexplained increase in the
     family's standard of living; and the culpable spouse's
     evasiveness and deceit about the family's finances. * * *
     [Resser v. Commissioner, supra at 1536.]

     According to the notice, Mr. Morris embezzled $102,972.40,

$128,092.34, and $129,046.26 during the years 1987, 1988, and

1989, respectively, and, of the total embezzled funds, reported

$32,425 as gross receipts of Accu-Data during 1987, $54,907.13 as

the aggregate gross receipts of Accu-Data and Meadows during

1988, and $85,944.95 as the aggregate gross receipts of Accu-Data

and Meadows during 1989.

     During the years at issue, Mr. Morris deposited all of the

embezzled funds into the bank accounts of the following corpora-

tions and other entities that he controlled:    Accu-Data, Trust

768, Meadows, and MCIC.    Checks drawn on those accounts were

received by or were expended on behalf of petitioner during those

years, as follows:
                              - 30 -

     Entities Controlled
        By Mr. Morris         1987         1988         1989

         Accu-Data         $11,775.00   $21,875.00   $6,350.00
         Trust 768             --         3,969.91      --
         Meadows               --           750.00    9,974.00
         MCIC                  --         4,550.00    1,820.00
           Total            11,775.00    31,144.91   18,144.00

In addition, during 1988, checks drawn by Mr. Morris on the Trust

768 account totaling $19,864.72 were used to pay the joint

Federal and State income tax liabilities that Mr. Morris and

petitioner owed for 1986 and 1988.

     The focus of the disagreement of the parties under section

6013(e)(1)(C) is on the funds derived from the bank accounts of

Accu-Data, Trust 768, Meadows, and MCIC that were received by or

expended on behalf of petitioner during the years at issue.      We

have found that those funds totaled $11,775, $51,009.63, and

$18,144 during 1987, 1988, and 1989, respectively.23    Respondent

23
   We were unable to find on the record before us, as respondent
contends, that petitioner also benefited during 1987 from pay-
ments totaling $5,225.60 that Accu-Data made to GMAC on a loan
that financed the family car or that during 1988 and 1989 all of
the funds deposited into the Meadows account at the Champaign
National Bank and the Meadows account at the National Bank of
Monticello were available to petitioner. With respect to the
Accu-Data payments to GMAC during 1987, although petitioner does
not dispute that those payments were made, she contends that they
were not made for the purpose alleged by respondent. We have
found that Accu-Data made three payments to GMAC, each in the
amount of $250.32, on July 10, Aug. 6, and Sept. 10, 1987, and
that it also paid GMAC $4,464.64 and $10 on Sept. 11 and 24,
1987, respectively. We have further found that petitioner wrote
a check to GMAC in each of the months January through May 1987 in
the amount of $250.32 and in June 1987 in the amount of $250.31.
Although it appears that Accu-Data assumed payments on a loan
from GMAC that petitioner had been paying, there is no evidence
                                                   (continued...)
                               - 31 -

contends that those funds were significant enough that, under the

circumstances surrounding petitioner, she should have been put on

notice that an inquiry or investigation into the source of those

funds was warranted.    Because petitioner did not make any such

inquiry, respondent argues that she should be held responsible.

Petitioner disagrees.

23
 (...continued)
in the record that establishes why Accu-Data made those payments
to GMAC during 1987 or that petitioner in any way benefited from
those payments. Petitioner testified that on May 12, 1987, she
purchased a 1987 Sunbird, which was the only car available to her
at that time, by making a downpayment of $6,263.50 and borrowed
the balance of the purchase price for that car. Since petitioner
did not purchase the 1987 Sunbird until May 12, 1987, the monthly
payments that she made to GMAC during the period January through
May 1987 could not have related to that car. It appears that the
probable source of the funds that petitioner used to make the
downpayment on that Sunbird was Accu-Data. However, we have
found that checks totaling at least $11,775 that were drawn on
the Accu-Data account were paid to the order of petitioner, Mr.
Morris, or cash and represented amounts received by or expended
on behalf of petitioner during 1987 and that petitioner included
at least $11,450 of those checks in the deposits analysis that
she prepared for 1987.

   With respect to the availability to petitioner during 1988 and
1989 of the funds in certain bank accounts of Meadows, although
petitioner was a signatory on both of those accounts and signed a
check for $100 drawn on the Meadows account at the Champaign
National Bank to pay the premium on a liability insurance policy
for the Illinois land, we have found that during the years at
issue Mr. Morris controlled the affairs of Meadows and that
petitioner was not involved in its day-to-day operations. We
believe petitioner's testimony that, to her knowledge, she did
not sign any other checks drawn on the Meadows bank accounts. In
this regard, although petitioner and Mr. Morris opened a savings
account at American Savings during 1989 by depositing $20,000
from the joint checking and/or savings accounts and $15,000 from
the Meadows account at the National Bank of Monticello, peti-
tioner testified that the money deposited into that account was
used by Meadows for the gravel pit and that she did not receive
any of that money.
                               - 32 -

     We note initially that, in the Schedules E of the joint

returns that petitioner and Mr. Morris filed for 1988 and 1989,

they reported aggregate income from Accu-Data and Meadows of

$24,929 and $18,987, respectively.      Consequently, the funds

derived from certain bank accounts of Accu-Data, Trust 768,

Meadows, and MCIC that were received by or expended on behalf of

petitioner during the years at issue exceeded the amounts of any

income of such entities that were reported in the joint returns

for 1987 and 1988 (excess funds) by $11,775 and $26,080.63,

respectively, and did not exceed the amount of such income

reported in the joint return for 1989.      On the instant record, we

find that it was not unreasonable for petitioner not to have

inquired into the source of the funds derived from the bank

accounts of Accu-Data, Trust 768, Meadows, and MCIC that were

received by or expended on behalf of petitioner during 1987,

1988, and 1989 to the extent that the joint returns for those

years included income from those entities.

     The question we must now resolve is whether the excess funds

for 1987 and 1988 were significant enough that, under the cir-

cumstances surrounding petitioner, she should have investigated

the source of those funds.24   Based on our examination of the

entire record before us, we find that petitioner had no reason to

believe that (1) the $11,775 of excess funds derived from the

24
   We are limiting our inquiry to 1987 and 1988 because there
were no excess funds for 1989.
                             - 33 -

Accu-Data account during 1987 and (2) the $26,080.63 of excess

funds derived from the bank accounts of Accu-Data, Trust 768,

Meadows, and MCIC during 1988 that were received by or were

expended on behalf of petitioner during those years were funds

that Mr. Morris embezzled from John Kenny Company or that further

investigation was warranted into the source of those funds.

     Although petitioner was responsible during the years at

issue for handling the family finances and although she deposited

checks and other funds, some of which were derived from the bank

accounts of Accu-Data, Trust 768, Meadows, and MCIC, into the

joint checking and/or savings accounts and used the funds in

those accounts to pay the family bills, Mr. Morris took affirma-

tive steps to deceive petitioner and otherwise to prevent her

discovery of the embezzled funds.   And he was successful not only

in deceiving petitioner, but also in deceiving John Kenny Company

from which he had been embezzling funds throughout a period that

commenced several years prior to the years at issue and that

continued throughout those years.   Indeed, it was not until

around late January 1991, well after petitioner signed the joint

return for each of the years at issue, that petitioner and John

Kenny Company even discovered Mr. Morris' prior embezzlement

activities.

     Mr. Morris spent evenings and many weekends away from home

at an office in an apartment complex and led petitioner to

believe that he was working while away from home not only for
                                - 34 -

John Kenny Company, but also for Accu-Data on accounting and tax

preparation matters.     Although Mr. Morris discussed his employ-

ment with petitioner in terms of the people with whom he worked,

he generally did not inform her about what he actually did in his

employment.     Mr. Morris was not open with petitioner about his

financial affairs, and, when she questioned him about those

matters, he reacted negatively, causing her to discontinue that

line of inquiry.

     Under the circumstances presented here, we find that it was

not unreasonable for petitioner, who had no involvement with

Accu-Data, to have believed that during the years at issue Accu-

Data generated significant funds from an accounting and tax

preparation business.25    We further find that, under those

circumstances, it was not unreasonable for petitioner to have

believed that during those years Meadows was capable of generat-

ing significant amounts of gross receipts from the sale of sand

and gravel.26    We have found that Mr. Morris controlled the

affairs of Meadows during the years at issue, that petitioner was

not involved in its day-to-day operations during those years, and

that she was not in a position to know how much income Meadows

25
   In fact, Accu-Data reported gross receipts of (1) $35,210 and
$31,687 in its Forms 1120-A for its taxable years ended June 30,
1987, and June 30, 1988, (2) $20,647 in its Form 1120S for its
short taxable year July 1 through Dec. 31, 1988, and (3) $6,000
in its Form 1120S for its taxable year 1989.
26
   In fact, Meadows reported $22,482 and $86,355 of gross re-
ceipts in the Forms 1120S that it filed for 1988 and 1989.
                                - 35 -

generated from those operations during those years.

     As for the checks drawn during 1988 from the Trust 768

account in the amount of $3,969.91 and from the MCIC account in

the amount of $4,550 that were received by or expended on behalf

of petitioner, under the circumstances presented here, we do not

think that petitioner should have inquired further about the

source of those funds, especially since Mr. Morris controlled the

affairs of those entities.     Indeed, we believe that any attempt

by petitioner to inquire further about the source of any of the

excess funds in question (or about any funds of Accu-Data, Trust

768, Meadows, and MCIC which she received or from which she

benefited during the years at issue) or about the possibility of

a substantial understatement in any of the joint returns in

question would have been resisted by Mr. Morris and would have

been fruitless.

     Respondent contends that petitioner's level of education was

such that she should have investigated further about the excess

funds from the bank accounts of Accu-Data, Trust 768, Meadows,

and MCIC during 1987 and 1988 totaling $11,775 and $26,080.63,

respectively.   We disagree.   Not only did Mr. Morris control the

affairs of those entities, take affirmative steps to deceive and

otherwise prevent petitioner's discovery of the embezzled funds,

and refuse to be open with her about his financial affairs, he

also prepared the joint returns in question, as well as at least

some of the returns covering the years at issue that were filed
                               - 36 -

by the entities that he controlled.     Although petitioner cannot

turn a blind eye to the joint returns in question, Bokum v.

Commissioner, 94 T.C. at 148, she relied on Mr. Morris to prepare

those returns because he was a former revenue agent and an

accountant, she had confidence in his ability to prepare those

returns properly, and, as far as she knew, Mr. Morris never

received any complaints about the returns that he prepared for

others.

     In this connection, we note that the tax consequences of

distributions by, and the operations of, corporations and trusts

are not matters that we would expect petitioner to know because

of her level of education.27   Distributions (1) to stockholders

from corporations28 and (2) to beneficiaries from trusts29 are not

27
   Petitioner earned a degree from Parkland College during 1987,
and her course work there included two basic accounting courses.
She entered the University of Illinois in the fall of 1987 and
took courses there for two years before she withdrew, including
two intermediate accounting courses.
28
   Accu-Data was a C corporation, and not an S corporation,
during the period January 1987 through June 1988. During the
period July 1988 through December 1989, Accu-Data was an S
corporation, as was Meadows throughout 1988 and 1989. Except for
maintaining a checking account at the Champaign National Bank,
MCIC conducted no activities during the years at issue, and it
does not appear that it filed any income tax returns for those
years.
29
   The record does not disclose how Trust 768 should have been
treated for Federal income tax purposes during the years at
issue. However, it does establish that beneficial interests in
that trust were held by petitioner and Mr. Morris starting with
its creation at the end of November 1987 through the middle of
June 1988, when they assigned their interest to Meadows. Except
                                                   (continued...)
                               - 37 -

necessarily taxable.    A loan by a corporation to a stockholder or

by a trust to a beneficiary is generally not taxable unless

forgiven.    Generally, only distributions to stockholders by a C

corporation out of its earnings and profits are taxable.    See

secs. 301, 316(a).    Nor does the stockholder of an S corporation

necessarily have taxable income attributable to distributions

received from and/or the operations of that corporation.    That is

because of the different and, at times, complex rules in sub-

chapter S of the Code.    Generally, an S corporation is not

subject to tax, see sec. 1363(a), but each stockholder of an S

corporation must take into account in such stockholder's income

tax return for the year in which the taxable year of the S

corporation ends, inter alia, such stockholder's pro rata share

of that S corporation's items of income, loss, and deduction, see

sec. 1366(a)(1)(A).    Moreover, a distribution of property by an S

corporation to a stockholder is not necessarily taxable.    See

sec. 1368.   Finally, a distribution to a beneficiary from a trust

subject to subchapter J of the Code is not necessarily taxable to

that beneficiary.    That is because of the different and, at

times, complex rules in subchapter J of the Code.    For example, a


29
 (...continued)
for its purchase of the Illinois land in February 1988 in respect
of which it borrowed $50,000 from the Champaign National Bank,
Trust 768 conducted no activities during the years at issue
except for maintaining an account at that bank. We assume for
discussion purposes that it was subject to subchapter J of the
Code.
                               - 38 -

distribution by a trust to a beneficiary is generally taxable

only to the extent of distributable net income.    See secs. 652,

662.

        Under the circumstances presented here, we do not think

that it was unreasonable that petitioner did not ask Mr. Morris

about the tax consequences of the distributions by and/or the

operations of Accu-Data, Trust 768, Meadows, and MCIC, but

instead relied on him to prepare correctly the joint returns in

question and the returns that he prepared for the entities that

he controlled.

       Additional circumstances that we believe justify peti-

tioner's not inquiring about the possibility of substantial

understatements in the joint returns in question are that, in

addition to her responsibilities for handling the family finances

during the years at issue, petitioner also was preoccupied during

those years as a homemaker, mother, and part-time student.      She

was taking classes at either Parkland College or the University

of Illinois until the spring of 1989.    At that time, she withdrew

from college because it was consuming too much of her time during

a period when she wanted and believed that she had to, and did in

fact, devote more time to her children who were experiencing

serious problems.

       It is also significant to us that there is no suggestion in

the record in this case that petitioner was living lavishly

during the years at issue or that her living conditions signifi-
                             - 39 -

cantly improved during those years.   Petitioner's family expendi-

tures during the years at issue were not lavish compared to her

standard of living during the years prior to those years.30

Although petitioner and Mr. Morris made two large expenditures

during 1987, viz., paying off the $17,560.77 mortgage on their

house and paying $20,000 toward the purchase of the Illinois

land, the source of the funds used to make those expenditures was

the $40,000 bonus that Mr. Morris received during 1987.31

     Based on our examination of the entire record in this case,

we are persuaded, and we find, that a reasonably prudent person,

under the circumstances of petitioner, could not have been

expected to know at the time she signed each of the joint returns

in question that each such return contained a substantial under-

statement attributable to the unreported embezzlement income or

30
   We note that Mr. Morris began embezzling funds from John
Kenny Company several years prior to the years at issue, and
there is no reason to believe that petitioner's standard of
living improved during the years at issue as a result of the
embezzled funds.
31
   Respondent further contends, and petitioner concedes, that
Mr. Morris transferred to petitioner ownership of a life insur-
ance policy that had a cash value of $15,000. Apparently, it is
respondent's view that that transfer should have caused peti-
tioner to investigate further whether the joint returns in
question contained substantial understatements. We disagree. It
is unclear from the record when Mr. Morris transferred ownership
of that policy to petitioner. Nor does the record disclose the
source of the premium payments on that policy. Petitioner
testified that during the years at issue she paid the premiums
for a life insurance policy with funds in the joint checking
and/or savings accounts, but it is not clear from the record
whether those premiums were for the policy, ownership of which
Mr. Morris transferred to her.
                              - 40 -

that further investigation was warranted.     We further find that

at that time petitioner did not know, and had no reason to know,

within the meaning of section 6013(e)(1)(C) that there was a

substantial understatement in each of those joint returns that

was attributable to the unreported embezzlement income.

          Section 6013(e)(1)(D)

     In determining whether it is inequitable under section

6013(e)(1)(D) to hold a taxpayer claiming innocent spouse relief

liable for the deficiency attributable to a substantial under-

statement, we must examine all the relevant facts and circum-

stances, including whether the taxpayer claiming innocent spouse

relief received significant benefits as a result of the items

omitted from gross income, whether that taxpayer participated in

any wrongdoing, and whether that taxpayer has since divorced the

culpable spouse.   Resser v. Commissioner, 74 F.3d at 1543; see

sec. 1.6013-5(b), Income Tax Regs.     In determining whether the

taxpayer received significant benefits from the items omitted

from gross income, normal support, as measured by the taxpayer's

circumstances, is not considered a significant benefit.     Resser

v. Commissioner, supra at 1543.

     There is no evidence in the record to support a finding that

petitioner and her family received other than normal support

during the years at issue.   Petitioner testified, and we found,

that her family expenditures during those years were not lavish

compared to her expenses during years prior to those years.
                                - 41 -

Respondent did not provide any evidence that negates that testi-

mony or that shows that the family expenditures were extraor-

dinary during the years at issue.

        We also find it important that although funds of Accu-Data,

Trust 768, Meadows, and MCIC totaling $11,775, $51,009.63, and

$18,144 were received by or expended on behalf of petitioner

during 1987, 1988, and 1989, respectively,32 respondent deter-

mined in the notice that Mr. Morris' unreported embezzlement

income was $70,547 for 1987, $73,185 for 1988, and $43,101 for

1989.    In addition, the excess funds which petitioner received

from those entities or from which she benefited totaled only

$11,775 for 1987 and $26,080.63 for 1988, and there were no

excess funds for 1989.    On the record before us, we believe that

it would be inequitable to hold petitioner liable for the portion

of the deficiency for each of the years at issue that is attrib-

utable to unreported embezzlement income when that income (1) for

1987 and 1989 substantially exceeds the funds of Accu-Data, Trust

768, Meadows, and MCIC that were expended by or on behalf of

petitioner during each of those years and (2) for 1987 and 1988

substantially exceeds the excess funds that she received or that

were expended on her behalf during each of those years.33

32
   Petitioner did not receive or have expended on her behalf any
unreported embezzled funds for 1989.
33
   We note that petitioner did not receive or have expended on
her behalf during any year at issue embezzled funds that exceeded
                                                   (continued...)
                              - 42 -

     It is also significant that petitioner did not in any way

participate in Mr. Morris' embezzlement schemes.   Mr. Morris went

to great lengths to deceive petitioner into believing that the

funds to which she had access during the years at issue and which

he, unbeknownst to her, had embezzled were from legitimate

sources.

     Another important factor under section 6013(e)(1)(D) is that

in August 1991, about six months after petitioner discovered that

Mr. Morris had been embezzling funds, petitioner and Mr. Morris

were divorced.   The reason for the divorce was primarily attrib-

utable to Mr. Morris' embezzlement activities.

     Based on our review of the entire record before us, we find

that it would be inequitable within the meaning of section

6013(e)(1)(D) to hold petitioner liable for the portion of the

deficiency for each of the years at issue that is attributable to

the unreported embezzlement income.

     For the foregoing reasons, we hold that petitioner qualifies

for innocent spouse relief under section 6013(e) with respect to

33
 (...continued)
the aggregate amount of embezzled funds that respondent deter-
mined had been reported as gross receipts in the Federal income
tax returns filed by Accu-Data and Meadows with respect to each
such year.

   It is also noteworthy that John Kenny Company received the
Illinois land in connection with the settlement of the lawsuit
that it instituted against Mr. Morris and petitioner. Thus,
petitioner did not benefit from the embezzled funds to the extent
of the value of that land. See Schwimmer v. Commissioner, T.C.
Memo. 1996-353.
                                 - 43 -

the portion of deficiency for each of the years at issue that is

attributable to the unreported embezzlement income.

     Claimed Deductions

     In order for a claimed deduction to be a grossly erroneous

item under section 6013(e)(1)(B), there must be a "claim of a

deduction * * * in an amount for which there is no basis in fact

or law."   Sec. 6013(e)(2)(B).    In Douglas v. Commissioner, 86

T.C. 758, 762-763 (1986), we construed the phrase "no basis in

fact or law", as follows:

     As we read the statute as a whole and its legislative
     history, a deduction has no basis in fact when the
     expense for which the deduction is claimed was never,
     in fact, made. A deduction has no basis in law when
     the expense, even if made, does not qualify as a de-
     ductible 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
     committee report, phony. [Fn. ref. omitted.]

The mere fact that a deduction is disallowed does not mean that

the deduction has no basis in fact or in law within the meaning

of section 6013(e)(2)(B).   See id. at 763.

      We are persuaded by the record before us that the deduc-

tions for a bad business debt and the legal expenses incurred in

an attempt to recover that debt, which were claimed in the 1987

joint return and which petitioner concedes are erroneous, are not

frivolous, fraudulent, or phony and that they have some basis in

fact and in law within the meaning of section 6013(e)(2)(B).       The

parties do not dispute that the loan underlying the bad debt
                              - 44 -

deduction (viz., the Galt loan) was in fact made, that that loan

became worthless during 1987, or that legal expenses were in-

curred during that year in the amount claimed in an attempt to

recover the proceeds of that loan.

     With respect to the claimed deduction for a business bad

debt, under section 166(a), a deduction is allowed for a business

bad debt for the year during which it becomes worthless.    If the

debt is a nonbusiness debt, section 166(d)(1) provides that the

loss from the worthlessness of the debt is to be treated as a

short-term capital loss.   Since the parties agree that the Galt

loan was made and that it became worthless during 1987, the only

issue concerning its deductibility is whether it was a business

bad debt for which a deduction is allowed or a nonbusiness bad

debt which is to be treated as a short-term capital loss.    On the

present record, we find that neither the characterization of the

Galt loan as a business debt nor the deduction of that debt when

it became worthless was frivolous, fraudulent, or phony.    See

Bokum v. Commissioner, 94 T.C. at 142.

     Although the parties stipulated that Mr. Morris was not in

the business of lending money during 1987, a person does not have

to be in that business in order for a debt to be considered a

business debt.   A debt is considered a business debt if it was

created or acquired in connection with a trade or business of the

taxpayer or if the loss from its worthlessness is incurred in a

trade or business.   Sec. 166(d)(2).   A debt is considered a
                              - 45 -

business debt if it is proximately related to a taxpayer's trade

or business.   Sec. 1.166-5(b), Income Tax   Regs.; see Putoma

Corp. v. Commissioner, 66 T.C. 652, 673 (1976), affd. 601 F.2d

734 (5th Cir. 1979).   To illustrate, if the dominant motivation

of a person in making a loan to a corporation of which he is both

a stockholder and an employee is to secure such person's employ-

ment, and not to preserve such person's investment, the loan will

be considered a business debt.   See Garner v. Commissioner, 987

F.2d 267, 269 (5th Cir. 1993), affg. T.C. Memo. 1991-569.

       Mr. Morris testified that the purpose of the Galt loan was

to assist Galt Communications in the early stages of its opera-

tions by providing it with money with which to pay its business

expenses.   He further testified, and we have found, that although

he was not an employee of that company at the time he made the

Galt loan, he hoped to secure future employment with it by making

the loan at issue.   Mr. Morris also testified that he believed

that that loan was a business loan.    Although Mr. Morris' testi-

mony is insufficient to establish what his dominant motivation

was in making the Galt loan or whether his involvement with Galt

Communications constituted a trade or business, it does show that

some basis existed for believing that that loan was made primar-

ily for business, and not investment, purposes.   Accordingly, we

find that there was some basis in fact and law to claim a deduc-

tion for the worthless Galt loan.

     With respect to the claimed deduction for legal expenses
                                - 46 -

incurred to recover the Galt loan, the ordinary and necessary

legal expenses incurred in attempting to recover a business debt

may be deductible.   See sec. 162(a).    On the present record, we

find that the claimed deduction for the legal expenses in ques-

tion was not frivolous, fraudulent, or phony.    The record dis-

closes that there was some basis for Mr. Morris' belief that the

Galt loan was a business loan and that the legal expenses in-

curred in attempting to collect that loan were deductible.

Accordingly, we find that there was some basis in fact and law to

claim a deduction for those expenses.

     Based on our review of the record before us, we find that

petitioner has failed to prove that there was no basis in fact or

law within the meaning of section 6013(e)(2)(B) for the claimed

deductions for 1987 for a business bad debt and the legal ex-

penses incurred in attempting to recover that debt.    We further

find that petitioner failed to show that those deductions are

grossly erroneous items under section 6013(e)(1)(B).    Accord-

ingly, we find that petitioner is not entitled to innocent spouse

relief under section 6013(e) with respect to the portion of the

deficiency for 1987 that is attributable to the disallowance of

the deductions in question.34


34
   In light of our holding that the claimed deductions for 1987
are not grossly erroneous items under sec. 6013(e)(1)(B), we
shall not address whether petitioner satisfies sec. 6013(e)(1)(C)
and (D) with respect to the portion of the deficiency for 1987
that is attributable to those deductions.
                               - 47 -

Meadows--Gross Income

     Respondent determined that petitioner and Mr. Morris under-

reported by $10,000 their gross income for 1989 that is attribut-

able to Meadows, an S corporation.      In the Form 1120S that

Meadows filed for that year, it showed $29,112 of ordinary

income.    However, in the 1989 joint return that petitioner and

Mr. Morris filed, they reported income from Meadows of only

$19,112.

     Petitioner contends that the gross receipts, and therefore

the ordinary income, reported in the Form 1120S that Meadows

filed for 1989 were overstated by $10,000 and that the 1989 joint

return in question therefore correctly reflected income from

Meadows of only $19,112.    To support that contention, petitioner

relies on Mr. Morris' testimony and a purported reconciliation of

Meadows' gross income for 1989 that he prepared and that pur-

ported to show the amount and source of the $86,355 of gross

receipts that Meadows reported in its Form 1120S for that year.

Mr. Morris included in that reconciliation purported deposits in

the Meadows account at the Champaign National Bank of $21,000 and

$23,000 on April 6, 1989, and April 26, 1989, respectively.

According to Mr. Morris, the $23,000 deposited on April 26, 1989,

into the Meadows account at the Champaign National Bank included

$10,000 that had previously been included in a deposit of $21,000

that was made into that account on April 6, 1989.
                              - 48 -

     On April 6, 1989, a deposit of $21,000 attributable to a

check drawn on the MCIC account was made into the Meadows account

at the Champaign National Bank.   A $10,000 check drawn on that

Meadows account and payable to Mr. Morris cleared that account on

April 17, 1989.   That $10,000 check and a $16,500 check drawn on

the MCIC account and payable to Mr. Morris were deposited on

April 14, 1989, into the Bloomington Federal account.    On April

26, 1989, a $23,000 check drawn on the Bloomington Federal

account was deposited into the Meadows account at the Champaign

National Bank.

     We are not persuaded by, and are unwilling to rely on, Mr.

Morris' testimony or the purported reconciliation that he pre-

pared to establish that the gross receipts of Meadows shown in

the Form 1120S that it filed for 1989 were overstated by $10,000.

In this connection, it is not clear to us that $10,000 of the

$23,000 deposited into the Meadows account on April 26, 1989, was

the same $10,000 previously deposited into and thereafter dis-

bursed from that account.

     Based on our review of the instant record, we find that

petitioner has failed to prove that the gross receipts, and

therefore the ordinary income, of Meadows for 1989 were over-

stated by $10,000 in the Form 1120S that it filed for that year.

We further find that petitioner and Mr. Morris underreported by

$10,000 their gross income from Meadows for that year.   We

therefore sustain respondent on this issue.
                                - 49 -

Accu-Data--Constructive Distribution

     Respondent contends that during 1989 Mr. Morris received a

constructive dividend from Accu-Data in the amount of $11,504,

which was the amount of the year-end total retained earnings of

Accu-Data that was reflected in the balance sheet in the Form

1120S that it filed for 1988.    Although petitioner does not

dispute that during 1989 Mr. Morris received a constructive

distribution of $11,504 from Accu-Data, she contends that the

amount of that distribution that constitutes a dividend is

limited to $4,287, since that was the amount of Accu-Data's total

retained earnings at the time of that distribution.

     To support that contention, petitioner asserts that during

1981 and 1982 Accu-Data, a stockholder of TPI, lent TPI a total

of $12,300, that those alleged loans became worthless sometime

thereafter but prior to 1989, and that Accu-Data's earnings and

profits as of the beginning of 1989 must be reduced to reflect

that worthless debt.   Respondent counters that the $12,300 that

Accu-Data transferred to TPI was a contribution to its capital.

     The only items of evidence supporting petitioner's conten-

tion that Accu-Data lent TPI $12,300 are Mr. Morris' testimony, a

purported reconciliation that he prepared, and some checks and

bank statements.   We are not persuaded by, and are unwilling to

rely on, that evidence to establish that Accu-Data lent TPI a

total of $12,300, rather than contributing that amount to its

capital.   In this regard, we note that TPI was not a stockholder
                              - 50 -

of Accu-Data.   Consequently, the stockholder loan account asset

reflected on the balance sheets that were contained in the Forms

1120-A and 1120S that Accu-Data filed for relevant years could

not have described a loan from Accu-Data to TPI.35

     Based on our review of the record before us, we find that

petitioner has failed to prove that Mr. Morris did not receive a

constructive dividend from Accu-Data during 1989 in the amount of

$11,504.   We therefore sustain respondent on that issue.

Statute of Limitations

     Petitioner contends that the period of limitations pre-

scribed by section 6501(a), and not the period of limitations

prescribed by section 6501(c), applies to the assessment of a

deficiency against her for 1987 and that that period had expired

prior to the date on which respondent issued the notice for that

year.   Petitioner's contention is apparently based on her reading

of section 6501(c)(1) which applies "In the case of a false or

fraudulent return with the intent to evade tax".     It is peti-

tioner's position that since she did not intend to evade tax when

she signed the 1987 joint return, section 6501(c)(1) does not

apply to her.


35
   We also note that the balance sheet in the Form 1120-A filed
by Accu-Data for the taxable year that ended June 30, 1987,
showed that the stockholder loan account increased from $4,394 to
$7,217 during that year. Assuming arguendo that that asset
related to a loan or loans made by Accu-Data to TPI during 1981
and 1982, it should not have increased during the period July 1,
1986, through June 30, 1987, especially since TPI was dissolved
on Feb. 1. 1986, and Mr. Morris testified that TPI was basically
defunct around 1984 and 1985.
                                - 51 -

     Petitioner's contention is without merit.    Petitioner

concedes that the underpayment in the joint return for 1987 was

attributable to Mr. Morris' fraudulent intent.    Consequently, the

period of limitations is extended indefinitely for that year, and

respondent may assess the tax due for 1987 at any time against

petitioner and/or Mr. Morris.    Vannaman v. Commissioner, 54 T.C.

1011, 1016-1018 (1970); see sec. 6501(c)(1); accord Benjamin v.

Commissioner, 66 T.C. 1084, 1100 (1976), affd. 592 F.2d 1259 (5th

Cir. 1979).

     To reflect the foregoing and the concessions of the parties,


                                     Decision will be entered

                                under Rule 155.
