                         T.C. Memo. 1997-413



                       UNITED STATES TAX COURT



         SHARON LEE BARTLETT, F.K.A. HEITZMAN, Petitioner v.
             COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 33938-84.                 Filed September 17, 1997.



     William R. Harper, for petitioner.

     Russell F. Kurdys, for respondent.



               MEMORANDUM FINDINGS OF FACT AND OPINION

     BEGHE, Judge:    Respondent determined a deficiency of $55,263

in petitioner’s 1979 Federal income tax.    The sole issue is

whether petitioner is entitled to innocent spouse relief under

section 6013(e).1    We hold that she is so entitled.


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


                         FINDINGS OF FACT

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

The stipulation of facts and the attached exhibits are

incorporated herein by this reference.   Petitioner was a resident

of Woodbridge, New Jersey, when she filed her petition.

     The parties stipulated to the inclusion in the record of

this case of the opinions of this Court and of the Court of

Appeals for the Ninth Circuit in Heitzman v. Commissioner, T.C.

Memo. 1987-109, affd. 859 F.2d 783 (9th Cir. 1988), and of the

parties’ briefs in this Court, but not to the truth of any

matters asserted therein.   On September 9, 1986, prior to this

Court’s granting summary judgment in favor of respondent in

Heitzman v. Commissioner, supra, the parties stipulated that if

petitioner’s former husband, Charles J. Heitzman, paid the entire

tax liability at issue in Heitzman v. Commissioner, supra, plus

interest, then petitioner would be discharged from that

liability.   Petitioner also agreed to be bound by the outcome of

that case regarding substantive tax liability but reserved the

right to claim innocent spouse status under section 6013(e).

1.   Background

     When petitioner married for the first time at age 17, she

had completed the 11th grade.   Petitioner had two children from

her first marriage, which ended in divorce.   In June 1973,

petitioner married Mr. Heitzman, a widower with one child.

Petitioner and Mr. Heitzman were residents of Hawaii throughout
                                 - 3 -


their marriage, from 1973 until 1982.    In 1982, Mr. Heitzman

moved to Phoenix, Arizona, to pursue a business development

opportunity with a startup company called Autocast, which had

been formed to manufacture concrete products for the housing

industry.    In 1983, petitioner and Mr. Heitzman were divorced.

They had no children together.

     In 1975, Mr. Heitzman and petitioner bought a house in

Honolulu, which served as their residence.    It was their only

joint investment during their marriage.    Mr. Heitzman made all

his other investment decisions without input from petitioner.

Although petitioner worked part time as a model and received

residuals from the Screen Actors Guild in 1979 for a television

commercial, Mr. Heitzman was the primary breadwinner.    In 1979,

Mr. Heitzman was employed by TSI Corporation as a real estate

developer.    He was also general partner in DMA Heitzman, which

developed condominium projects.

     Petitioner made no independent investments during her

marriage.    In 1975, petitioner completed her high school

education by obtaining her General Education Diploma.    Petitioner

never took any accounting or bookkeeping courses.2

     2
       Petitioner’s only other training was two real estate sales
workshops she took in preparation for an attempt to become a real
estate agent. Petitioner failed the licensing examination the
first time partly because of her inadequate arithmetic skills.
On her second attempt, she passed the exam. Aside from the sale
of a condominium, the listing for which was given to her at Mr.
Heitzman’s behest, petitioner never participated in the sale of
any real estate as a real estate agent. Petitioner did not find
                                                   (continued...)
                               - 4 -


     Petitioner was the homemaker and primary caregiver for her

two sons and Mr. Heitzman’s son.    Mr. Heitzman provided her a

monthly allowance for household expenses that grew over the years

to approximately $1,500 per month.     In 1979, the monthly

allowance was less than $1,500.    Mr. Heitzman also bought

petitioner gifts throughout their marriage in a pattern that did

not change until they separated in 1982.

     On September 5, 1979, Mr. Heitzman contracted with Frank S.

H. Kwon Home Builders to remodel the kitchen and master bedroom

of the family residence.   Work was completed on October 16, 1979.

Costs rose to $41,191 from the original estimate of $29,224.      The

bulk of funds used to pay for remodeling the residence came from

a loan from the Bank of Hawaii.    The record does not reflect the

source of funds used to repay the loan or whether the loan was

ever repaid.   There were loans outstanding to the Bank of Hawaii

when petitioner and Mr. Heitzman were divorced in April 1983.

Mr. Heitzman assumed the obligation to repay these loans as part

of the divorce settlement.   In 1979, petitioner used her

separately earned income to make other improvements to the house,

including installing a parquet floor in the bedroom of

Mr. Heitzman’s son.

     The remodeling had little or no long-term effect on the

value of the house.   In the early 1980's, and continuing through

     2
      (...continued)
the buyer for the condominium. Her role in the sale was
restricted merely to observing the contract negotiations.
                                - 5 -


the time of trial, the Hawaii housing market was driven by two

major factors:   Location and the underlying quality of the

structure.   The prime location of the house and its high quality

workmanship caused its value to rise throughout this period until

Mr. Heitzman and petitioner sold it in 1982.

     Since 1983, petitioner has been employed as a flight

attendant.

2.   Stonehurst Energy Partners

     Ronald Freemond, president and sole shareholder of Wind

River Energy, Inc. (Wind River), a Nevada corporation, formed

Stonehurst Energy Partners (Stonehurst) on December 10, 1979, to

engage in the    development, drilling, and operation of oil wells.

Wind River was the general partner, and Freemond was the initial

limited partner.   Freemond had organized Wind River to be general

partner of Stonehurst.   Although Freemond had “substantial

experience in financial planning and tax advantaged investment”,

he and Wind River had “no experience in drilling for oil and

gas.”

     Between December 10 and December 29, 1979, Mr. Heitzman and

34 other individuals purchased a total of 175 limited partnership

units in Stonehurst at a cost of $6,200 per unit and a total

investment of $1,085,000.   Investors paid $3,100 in cash on the

purchase of each unit and $3,100 with a recourse promissory note

due April 1, 1980.
                                - 6 -


     Wind River was to receive 12 percent of the capital invested

in Stonehurst as an “Initial Management Fee”, and an overriding

production royalty of 6.9 percent of gross revenues from Craig

Natural Resources, Inc. (Craig), the sublessor of the land and

named obligee of the minimum annual royalties, described infra

pp. 6-8.    Craig also was to receive 8 percent of the initial

capital invested in Stonehurst as a “consulting fee”.

     a.    The Stonehurst Private Placement Memorandum

     The Stonehurst Energy Partners Private Placement Memorandum

(the Memorandum) represented that the partnership “intends to

engage in acquiring, drilling and possibly completing twenty-five

(25) or more shallow Developmental Oil Wells in northeastern

Oklahoma.”    The Memorandum characterized these wells as having

more limited prospects of discovering and exploiting “significant

reserves of oil and gas in relation to the capital committed

* * * although bearing less risk” than the drilling of

exploratory wells in a relatively unproven area or formation.

The Memorandum stated that the partnership “does not presently

intend to engage in the drilling of any Exploratory Wells”, while

on another page, it emphasized the “high degree of risk of loss”

involved in “exploration” for oil and gas, and offered no

assurances that investors would recover their capital

contributions.    The Memorandum stated that the offering would be

restricted to individuals who had annual income sufficient to

incur Federal income tax liability at the rate of 50 percent.
                               - 7 -


     b.   Minimum Annual Royalties

     On December 29, 1979, Stonehurst entered into a sublease

agreement with Craig for a 100-percent working interest in oil,

gas, and mineral rights to 340 acres in Nowata County, Oklahoma.

The working interest was restricted to the “Bartlesville Sands

formation, the principal producing zone in the area” and “no

other oil, gas or mineral rights in the subject property”.    R.H.

Energy, Ltd. (“R.H. Energy”), the driller/operator under the

turnkey contract, see infra p. 8, concurrently was to assign its

mineral rights in this land to Craig.

     Stonehurst, as sublessee, agreed to pay Craig, as sublessor,

a production royalty of 67 percent of gross revenue from the sale

of oil and gas.   Stonehurst was obligated to pay a lease bonus of

$10,000, and minimum annual royalties of $2,278,000 for 1979, and

$2,006,000 for each year thereafter through 1994, for a total of

$30,362,000, accruing on December 29 of each year, to be recouped

from the production royalty prior to any expenses’ being paid by

Stonehurst.   In the absence of production, payment of all

royalties was deferred until December 29, 1994.    All minimum

annual royalties accrued but unpaid on that date were then to be

paid in cash by Stonehurst to Craig.    Minimum annual royalties

accruing thereafter were to be paid within 1 year of accrual.

Both the general and limited partners of Stonehurst were relieved

of any liability associated with the accrued but unpaid royalties
                                - 8 -


unless they had assumed personal liability for them.    No interest

was payable on the unpaid accruals.

       Recoupment from the 67-percent production royalties of full

payment of the $30,362,000 of minimum annual royalties projected

to be accrued by Stonehurst through 1994 would have required an

average price per barrel of oil between $58.93 and $86.11 over

the course of the lease at the levels of production assumed by

the economic projections in the Memorandum.    Stonehurst could

avoid liability for all or a proportionate part of the minimum

annual royalties not yet accrued by surrendering its rights under

the sublease to the entire leased property or to any parcel of 6

contiguous acres or more prior to the beginning of the next lease

year.

       c.   Turnkey Contract

       On December 29, 1979, Stonehurst also entered into a

“turnkey and drilling completion contract” with R.H. Energy for

25 wells to be completed by June 30, 1980.    The Memorandum

described R.H. Energy as a joint venture between H.H. Oil & Gas

Co., a Colorado based corporation, and Synergistics Equities,

Ltd.    The Memorandum indicated that there was a relationship

between R.H. Energy and Craig that gave rise to a possible

conflict of interest between R.H. Energy and Wind River

concerning R.H. Energy’s recommendations to Craig about whether

to complete drilling on any wells, inasmuch as incomplete wells

would eventually be forfeited back to R.H. Energy.    This possible
                                     - 9 -


conflict relationship was also the subject of part of the legal

opinion rendered by the law firm of Meserve, Mumper & Hughes,

which was included as an exhibit in the Memorandum.               See infra

p. 14.

     Under the turnkey contract, Stonehurst was obligated to pay

R.H. Energy $12,000 per dry well and $35,000 per well put into

production.     An initial payment of $12,000 per well was due to

R.H. Energy upon notice that drilling would commence within 5

days.     No such notice was given in 1979.         In March 1980, R.H.

Energy gave notice to Stonehurst that drilling of wells on the

property was about to commence.

     d.      Economic Analysis and Predicted Tax Benefits of
             Stonehurst

     The Memorandum presented two economic projections that

purported to show significant tax losses in the early years of

Stonehurst’s operations and distributions of profits in the later

years.     Because no production or revenue was projected for the

initial year, 1979, the tax loss shown for that year was

identical under both projections, amounting to $2,788,000.3              The



     3
         The components of this figure are:
                              Item                     Amount
                Accrued minimum annual royalty       $2,278,000
                Accrued intangible drilling costs       500,000
                Operating costs                          10,000
                  Total                               2,788,000
                                - 10 -


beginning aggregate “at risk exposure” of the limited partners

for 1979 was $2,821,500.     Their 1979 ending aggregate “at risk

exposure” was $33,500, after deduction of the 1979 tax loss shown

for each limited partner.4    The Memorandum estimated aggregate

tax savings to the limited partners of $1,394,000 for 1979 based

upon a marginal tax rate for individuals of 50 percent.     The

Memorandum reported that the “tax loss” to be generated in 1979

was leveraged 5.09 times “with respect to the Initial Cash

Contribution”.

     Each economic projection expressly relied upon the stated

assumption that 89 percent of a total of 55 wells drilled between

1980 and 1983 would produce oil in the quantities assumed in that

projection.   The cover letter to a geological report, discussed

below, and included as an exhibit to the Memorandum, stated that

“Realistically a 90% success ratio should be anticipated.”

Projection A assumed total production of 757,500 barrels of oil

from 1980 to 1994 at declining rates of production of 5, 4, and 3

barrels per day per well in the first 3 years and 3 barrels per

day thereafter.5   Projection B assumed production rates of half

those of projection A.



     4
       Mr. Heitzman’s claimed deduction of $110,170 on the 1979
return was derived from his share of the total losses (7 of 175
units), $2,788,000 less the remaining “at risk exposure”,
$33,500.
     5
       Compare with the Coburn report, infra p. 12, which makes a
somewhat different assumption: an initial production rate of 5
barrels per day, declining to 3 barrels per day within 24 months.
                               - 11 -


     Both projections were also based upon a price per barrel of

oil of $32.50 in 1980 that would increase at a compounded annual

rate of 10 percent per year through 1994.    The Memorandum

projected that the price of oil in 1994 would be $123.44 per

barrel.   Operating costs were also projected to increase at 10

percent per year over the term of the lease.

     e.   Coburn Geological Report

     The Memorandum included a geological report, signed by R. W.

Coburn (hereinafter Coburn report), which identified Mr. Coburn

as a registered Oklahoma petroleum engineer.    The Coburn report

asserted that Stonehurst could expect 90 percent of its wells to

produce oil.    However, the report does not make clear whether

this likelihood pertained to developmental drilling of known

formations or exploratory drilling in new fields.6    The economic

projections described supra explicitly rested upon the 90-percent

success rate.

     The Coburn report asserted that “commercial oil production

can be obtained from the Bartlesville Sand”, which it said was

“the principal producing zone” in Nowata County.     The assertion

about obtaining commercial oil production was uncorroborated by

any supporting geological data, such as log data, seismic data,

or gravity surveys.   The lack of any such data supporting the



     6
       One section of the report refers to “shallow oil
exploration” while another section refers to “proposed
development”. This same inconsistency is also found in the
Memorandum. See supra p. 6.
                              - 12 -


presence of Bartlesville Sand in the immediate area is critical

because the geological structure of Bartlesville reservoirs may

vary greatly in thickness and reservoir quality over short

distances.7   Because developmental drilling occurs only in known

formations, the drilling programs proposed by the Coburn report

and the Memorandum could only have been exploratory, inasmuch as

the nearest actual oil production in the preceding 40 years had

occurred some 8 miles away from the Stonehurst leasehold.

Exploratory drilling, in contrast to developmental drilling, has

an expected likelihood of success of about 10 percent.

     The Coburn report projected reserves of 518,400 barrels

based on 30 notional wells if “water injection is commenced

immediately”.   The report based its projections on a notional

well producing 5 barrels of oil per day, declining thereafter to

3 barrels per day after 24 months.     Without confirmation of known

formations in the immediate vicinity of the leasehold, any

projection of reserves of 518,400 barrels was wildly over-

optimistic.   The yield projection of a notional well over a 15-

year life also unrealistically postulated a constant yield over

the last 13 years of life of the well.    Such a projection curve

is inconsistent with typical oil well production yield curves,




     7
       Bartlesville Sand is fluvial sand deposited in ancient
riverbeds. The best Bartlesville production is found in the
meandering bends of the buried riverbeds in “ox-bow cut-offs”
that have a thick sand bar on the inside edge of the bend
containing large oil deposits.
                              - 13 -


irrespective of whether they are produced by natural reservoir

mechanisms or by waterflooding.

     To obtain a waterflood, injection wells are drilled on an

approximately 1:1 ratio with producing wells.   This would mean up

to 30 (25 if only 25 producing wells were drilled--as the

Memorandum called for) additional wells.   Neither the Coburn

report nor the economic projections in the Stonehurst memorandum

accounted for the costs of drilling any such additional wells.

There was also no proposal for a water flood injection well

pattern.

     The Coburn report also asserted that operating expenses for

a notional well would be $250 per month, which was too low in

1979 to include water flood operating costs required to support

the water injection required to obtain 518,400 barrels of

production over 15 years.   Even the $290 per well per month

projected in the economic projections, which were then inflated

at 10 percent per year over 15 years, was too low for operating a

water flood.

     Even with the problems described supra, the projected

reserve of 518,400 barrels, based upon 30 notional wells, is less

than the 757,500 barrels assumed by the economic projection A

described supra.   The turnkey contract also only called for

drilling 25 wells in 1980, while the two economic projections

both assumed that a total of 55 wells would be drilled, of which

49 would be producers.
                                - 14 -


     The Coburn report itself mentioned “Stonehurst Energy” once,

on the first page, in a typeface different from the remainder of

the report.     In the same paragraph, the last sentence, which

claimed that a projection of the future net revenue of a notional

well drilled in Bartlesville Sand was included in the report, was

also in a typeface different from the rest of the report.     The

report contained no projection of future revenue from a notional

well.     It included only a “pro-forma” projection of production

from a notional well from 1980 to 1994.     The typeface of the

address for Stonehurst on the cover letter signed by Coburn is

also different from the typeface of the rest of the letter.

     f.     The Meserve Firm Federal Tax Opinion Letter

        The Meserve firm wrote a letter to Freemond, which was

reproduced in the Memorandum (“opinion letter”), expressing legal

opinions on various tax issues.     The Meserve firm was counsel to

Craig, Wind River, and all their affiliates.      The Meserve firm

was to receive an overriding royalty of an undisclosed percentage

of production as its fee for legal services.     Additionally,

certain partners and associates of the Meserve firm purchased an

additional overriding royalty of “less than one half of one

percent.”     The opinion letter asserted that, based upon the

Coburn report, Stonehurst had economic substance because the

economic projections showed that the:

        oil and gas reserves expected to be produced are
        adequate to fully pay any Minimum Annual Royalties
        incurred and to return a profit to investors. The
        Partnership therefore anticipates a profit independent
                             - 15 -


     of any favorable tax considerations and it is the
     objective of the General Partner to realize such a
     profit.

The opinion letter claimed that the Coburn report provided a

basis for concluding that Stonehurst had the requisite profit

motive under section 183 to support the deduction of trade or

business expenses.

     The opinion letter concluded that the limited partners would

have sufficient amounts “at risk” under section 465 to be

entitled to the deductions projected for 1979 when Stonehurst

incurred liability upon execution of the turnkey contract with

R.H. Energy and execution of the sublease with Craig.    The

opinion letter analyzed various aspects of the minimum annual

royalties, concluding that they met the requirements of “Rev.

Rul. 77-789”,8 because they were nonrefundable, and were

deductible under sec. 1.612-3(b), Income Tax Regs., as

“substantially uniform payments” because the accruals were

properly considered “payments”.   The opinion letter also

concluded, provided drilling was completed within 12 months of

Stonehurst’s incurring liability under the turnkey contract, that

the entire intangible drilling cost accrued in 1979 would be

deductible by the partnership.    Despite the air of certitude of

the opinion letter, the Memorandum warned that the tax returns of




     8
       This was a typographical error in the opinion letter. The
Internal Revenue Service had issued Rev. Rul. 77-489, 1977-2 C.B.
177.
                               - 16 -


investors may be subject to an increased “likelihood that a

Partner’s return will be subject to audit.”

     g.   Mr. Heitzman’s Purchase of Interest in Stonehurst

     Sometime during 1979, Mr. Heitzman’s personal attorney had

told Gil Sherman, who was selling interests in Stonehurst, about

Mr. Heitzman’s possible interest in a tax shelter.    During

December 1979, Sherman asked Mr. Heitzman if he would be

interested in purchasing an interest in Stonehurst in light of

his large income that year.    Sherman was entitled to receive a

0.5-percent overriding production royalty as compensation for his

efforts in selling the partnership units.

     Mr. Heitzman had heard from other purchasers of interests in

Stonehurst, including his personal attorney and “other

substantial business people”, that Stonehurst “was a good

investment”.   He read the Stonehurst Memorandum, including the

statement in the Coburn report that there was an expected “90%

success ratio to be anticipated”.    Sherman told Mr. Heitzman that

other investors in similar limited partnerships had “done well

and this one should be great”.    Sherman said that they “were

going to make some money”.    Mr. Heitzman concluded that

Stonehurst was a “good investment” with a “big write-off”.

Mr. Heitzman was favorably impressed because “it had been

researched by a large law firm out of Los Angeles”.

     On December 17, 1979, Mr. Heitzman purchased 7 limited

partnership units in Stonehurst, at the stated price of $6,200
                              - 17 -


per unit, for a total price of $43,400.    Mr. Heitzman paid half

in cash on or about that date, with the remainder due on a

recourse promissory note on April 1, 1980, which was acknowledged

by Stonehurst as having been paid on April 18, 1980.    Mr.

Heitzman signed a subscription agreement, by which he

acknowledged that there was substantial risk that he would lose

his entire investment.   He also acknowledged that he had been

advised of the general nature of the probable tax consequences

discussed in the opinion letter, and that he had been further

advised by that same letter to “consult with independent tax

counsel regarding the tax consequences of participating in the

Partnership”--which he did not do.     Mr. Heitzman elected to hold

his interest in Stonehurst as separate property rather than

tenancy in common or joint tenancy with right of survivorship,

both of which were offered as alternatives in the subscription

agreement.

     On or about December 17, 1989, Mr. Heitzman also executed

two assumption agreements.   In the first assumption agreement,

Mr. Heitzman purported to assume personal liability for his

$63,364 pro rata share of $1,600,000 of the minimum annual royalty

that was to accrue on December 29, 1979.    He also purported to

assume personal liability for his pro rata share of a portion of

the minimum annual royalties to accrue in 1980, 1981, 1982, and

1983.   Under the assumption agreement, the limited partners were

to incur total additional liability beyond $1,600,000--up to
                               - 18 -


$3,300,000--only if production for all wells drilled and completed

by November 1, 1980, exceeded 30 barrels per day or 2 barrels per

day per completed well.    Mr. Heitzman would have personally

assumed $130,683 of total liability of $3,300,000 had those

production goals been met.    Nothing in the record indicates that

any oil was ever produced from the leased acreage.

     In the second assumption agreement, Mr. Heitzman purported

to assume personal liability of up to $3,779 per unit (for a

maximum of $26,453) for payment of drilling and completion costs

incurred under the turnkey contract.

3.   Petitioner’s Knowledge of Mr. Heitzman’s Purchase of an
     Interest in Stonehurst

     Mr. Heitzman decided to purchase an interest in Stonehurst

without any input from petitioner about the merits of the

investment.   It is unclear from the record precisely when

Mr. Heitzman apprised petitioner about the Stonehurst purchase.

Petitioner was aware of the purchase prior to filing the 1979

joint income tax return.    Regardless of when Mr. Heitzman told

petitioner about the transaction, he told her only that

Stonehurst “was in oil and gas”, would make some money, and was

a “tax shelter” that would be reflected in the 1979 return.

Mr. Heitzman never explained to petitioner any other aspects of

the Stonehurst investment as he then understood them.    He did not

explain to her any attributes of Stonehurst as a tax shelter,

such as what minimum annual royalties or intangible drilling

costs were, nor give her any further information on Stonehurst as
                              - 19 -


an economic investment.   Petitioner never saw the subscription

agreement or either of the assumption agreements or any other

documents, including the Memorandum, relating to the Stonehurst

investment, either prior to Mr. Heitzman’s purchasing the

interest or at any time thereafter.     Mr. Heitzman kept the

Stonehurst documents at his office and signed the subscription

and assumption agreements there without ever bringing them home.

4.   The 1979 Joint Income Tax Return

     In each of the taxable years from 1973 to 1981, including

1979, petitioner and Mr. Heitzman filed joint Federal income tax

returns that were prepared by a prominent accounting firm,

Alexander Grant, Inc. (Alexander Grant).     Each year, when Mr.

Heitzman asked, petitioner would give him her Forms W-2,

receipts, and other information pertaining to her employment.      He

would then pass that information to their accountant at Alexander

Grant, along with the other information required to complete the

return.   For taxable year 1979, Mr. Heitzman helped petitioner

determine the expenses for her modeling activities by going

through the checkbook and other receipts.

     Petitioner’s 1979 gross income amounted to $3,700, derived

entirely from residuals from a television commercial.     Petitioner

had $3,058 in total deductions, including agency fees and

modeling expenses, that were attributable directly to her

business activities that year.   Her net contribution to taxable

income shown on the return was $642.
                               - 20 -


     In 1979, Mr. Heitzman had $145,311 of business income

related to his role in the development of a large condominium

project by DMA Heitzman.   Additionally, Mr. Heitzman earned

$33,948 in compensation from TSI Corporation.   The 1979 joint

income tax return claimed deductions of $110,170 derived from

Stonehurst.

     On June 14, 1980, petitioner and Mr. Heitzman filed their

joint return after obtaining an appropriate extension.

5.   Events Subsequent to the Filing of the 1979 Return

     On June 22, 1981, Mr. Heitzman and petitioner gave a power

of attorney to two accountants employed by Alexander Grant to

represent them before the Service for tax year 1979.

     In June 1982, petitioner and Mr. Heitzman separated, and he

moved to Phoenix, Arizona.   On April 11, 1983, the Family Court

of the First Circuit of Hawaii granted a final divorce decree to

petitioner and Mr. Heitzman.   The “Agreement Incident to and in

Contemplation of Divorce”, dated March 11, 1983, provided that

Mr. Heitzman would indemnify petitioner for all deficiencies in

State and Federal income tax arising from income tax returns that

they filed jointly during their marriage, specifically mentioning

a $1,281 assessment by the State of Hawaii for 1979.   The

agreement also entitled Mr. Heitzman to any refunds due from

those taxable years.
                               - 21 -


     Mr. Heitzman and petitioner each signed separate Forms 872C,

“Consent to Extend Time to Assess Tax”, extending the period of

limitations for taxable year 1979 until June 30, 1984.

     In May 1983, Mr. Heitzman traveled to Nowata County,

Oklahoma, to investigate the Stonehurst lease.    Mr. Heitzman

found several abandoned wells and associated piping and machinery

at the sites of the leaseholds.    The surrounding area was also

littered with abandoned oil wells.

     Petitioner reported $2,374 in adjusted gross income for

1983.    Petitioner may have had up to $4,461 in additional

adjusted gross income for 1983, although that additional income

may have been reported in other taxable years.9

     In June 1984, Mr. Heitzman filed for bankruptcy after the

failures of his businesses, DMA Heitzman and Autocast.    These

failures were precipitated by the death of Mr. Heitzman’s partner




     9
       For taxable year 1983, petitioner reported $2,374 in
adjusted gross income. Petitioner received an additional $2,250
in support payments during 1983 that were not reported on her
1983 tax return. She also received a check for $1,000, written
on Dec. 27, 1982, for the January 1982 support payment. The
record does not reflect whether that check was reported on
petitioner’s 1982 return.

     Petitioner also received a check for $16,000, dated Dec. 27,
1983, as the final installment payment from the sale of the
house, of which 18.92 percent was taxable income, or $3,027.
Using the Schedule D attached to petitioner’s 1983 tax return, 40
percent of that amount, or $1,211, would have been reported as
gross income on petitioner’s Form 1040 in 1983 if it was to be
included in her 1983 gross income. The record does not reflect
whether that amount was reported on petitioner’s 1984 return.
                              - 22 -


in DMA Heitzman, who had been backing him in both businesses, and

the financial failure of another financial backer of Autocast.

     On June 28, 1984, respondent timely issued a statutory

notice of deficiency to Mr. Heitzman and petitioner, determining

a deficiency of $55,263 for calendar year 1979.   On September 20,

1984, Mr. Heitzman filed a petition with this Court in the names

of himself and petitioner, under docket No. 33436-84.    On

September 26, 1984, petitioner filed a separate petition, docket

No. 33938-84, in response to the same notice.   In her petition,

petitioner disputed the same factual matters as Mr. Heitzman’s

petition and raised additional issues of the period of

limitations and relief as an innocent spouse.   On August 9, 1985,

Mr. Heitzman filed a motion to dismiss petitioner from the case

under docket No. 33436-84.   On September 10, 1985, that motion

was granted.

     On October 10, 1985, the State of Hawaii mailed Mr. Heitzman

a notice of assessment based on an increased Hawaii State income

tax liability of $11,727 that was based upon disallowance of the

deduction with respect to Stonehurst by the Internal Revenue

Service.

     On December 29, 1986, Wind River sent a letter to the

Stonehurst limited partners inviting them to sign an “Agreement,

Release, Consent and Vote to Dissolve” that would terminate

Stonehurst and provide a means to “reduce” the recourse

liabilities that the limited partners had purported to assume in
                              - 23 -


the assumption agreements.   The letter explained that the limited

partners were required to sign this agreement in order to reduce

their liabilities.   In return, the principal payment date would

be extended until December 31, 2001, and the recourse liabilities

reduced by a consolidation of operations with another

partnership, Consolidated Petroleum Equities, Ltd. (CPE).     The

revenues of this new entity were to be applied at a rate of 0.01

percent of “the value of CPE’s share of production from its wells

before deducting royalties or expenses” for every “$1,000 of

outstanding assumed liabilities”.   The letter contained no

financial projections to illuminate how this would be done.     The

proffered documents also purported to release Wind River,

Freemond, and other principals from any liability arising from

Stonehurst.   On the advice of counsel, Mr. Heitzman did not sign

this agreement.

     On March 23, 1987, Freemond sent a note to the limited

partners, exhorting them to execute the documents described

above.   Freemond’s note also said that the enclosed partnership

Form K-1 would be the last one sent because Stonehurst was being

dissolved.

     On February 24, 1987, on cross-motions for partial summary

judgment in the case under docket No. 33436-84, this Court

granted respondent’s motion and denied Mr. Heitzman’s motion.

Heitzman v. Commissioner, T.C. Memo. 1987-109.   We held that, as

a matter of law, Mr. Heitzman was not entitled to deduct his
                               - 24 -


share of the 1979 minimum annual royalty or intangible drilling

costs attributable to Stonehurst.    Id.    On October 18, 1988, the

Court of Appeals for the Ninth Circuit affirmed.      Heitzman v.

Commissioner, 859 F.2d 783 (9th Cir. 1988).

     On May 29, 1990, Mr. Heitzman filed for bankruptcy for a

second time.   As part of the bankruptcy proceedings, Mr. Heitzman

was discharged from any liability resulting from the decision

against him in Heitzman v. Commissioner, T.C. Memo. 1987-109.

                               OPINION

     The Code permits married persons to make “a single return

jointly of income taxes”.   Sec. 6013(a).    Spouses who file a

joint return are jointly and severally liable for any tax due on

their aggregate income, including interest.     Sec. 6013(d)(3).

The sole issue for decision is whether petitioner is entitled to

innocent spouse relief from joint liability on her and Mr.

Heitzman’s 1979 income tax return.

     To qualify for statutory relief from joint and several

liability under section 6013(e),10 a putative innocent spouse

must establish:   (1) A joint return was made under section 6013;



     10
       We apply the statute as amended by Congress in 1984 even
though the year before us is 1979. The Deficit Reduction Act of
1984, Pub. L. 98-369, sec. 424(a), 98 Stat. 494, 801-802, amended
sec. 6013(e) retroactively to all open tax years to which the
1954 Code applies.

     Petitioner argued in   the alternative that she met the
requirements of sec. 6004   of the Technical and Miscellaneous
Revenue Act of 1988, Pub.   L. 100-647, 102 Stat. 3342, 3685-3686.
We need not consider this   alternative argument.
                                - 25 -


sec. 6013(e)(1)(A); (2) there was a substantial understatement of

tax attributable to grossly erroneous items of one spouse; sec.

6013(e)(1)(B); (3) at the time of signing the return, the other

spouse did not know and had no reason to know that there was such

an understatement; sec. 6013(e)(1)(C); (4) taking into account

all the facts and circumstances, it would be inequitable to hold

the other spouse liable for the deficiency in tax for such

taxable year attributable to the understatement.       Sec.

6013(e)(1)(D).

     For purposes of section 6013(e), an understatement of tax is

substantial if it exceeds $500.     Sec. 6013(e)(3).    With respect

to grossly erroneous deductions, the understatement must exceed a

specified percentage of the putative innocent spouse’s gross

income for the “preadjustment year”, which is the taxable year

immediately preceding the year in which the statutory notice of

deficiency was issued.     Sec. 6013(e)(4).

     The taxpayer has the burden of proving each element by a

preponderance of the evidence.     Rule 142(a); Stevens v.

Commissioner, 872 F.2d 1499, 1504 (11th Cir. 1989), affg. T.C.

Memo. 1988-63; Purcell v. Commissioner, 826 F.2d 470, 473 (6th

Cir. 1987), affg. 86 T.C. 228 (1986); Sonnenborn v. Commissioner,

57 T.C. 373, 382 (1971).    Failure to carry that burden on any one

of the elements will prevent a taxpayer from qualifying for

innocent spouse relief.     Purificato v. Commissioner, 9 F.3d 290,

293 (3d Cir. 1993), affg. T.C. Memo. 1992-580; Stevens v.
                                   - 26 -


Commissioner, supra at 1504; Purcell v. Commissioner, supra at

473.

       The parties agree that a joint return was filed.       The record

also compels the conclusion that the understatement of $55,263

attributable to the items in question was substantial, sec.

6013(e)(3), and we so find.

       Respondent has contested each of the remaining issues,

including whether the deficiency exceeds the specified percentage

of petitioner’s adjusted gross income for 1983, her preadjustment

year.       Sec. 6013(e)(4)(C).   Section 6013(e)(4)(A) requires that

the substantial understatement exceed 10 percent of the claimant

spouse’s adjusted gross income (AGI) for the preadjustment year

if the AGI is $20,000 or less.       We find that petitioner’s

adjusted gross income for 1983 could not have exceeded $6,835

even if additional items of income described in the record, which

may well have been reported in other taxable years, are added to

petitioner’s reported 1983 adjusted gross income.       The

understatement of $55,263 exceeds 10 percent of petitioner’s 1983

adjusted gross income.

       We consider each of the remaining contested elements.

1.     “Grossly Erroneous Items of One Spouse”

       a.     Attributable to Other Spouse

       Respondent does not argue that the disallowed Stonehurst

deductions claimed on the 1979 return were not attributable to

Mr. Heitzman.       The record shows that petitioner had no ownership
                                - 27 -


interest in Stonehurst.    Mr. Heitzman deliberately held his

interest in Stonehurst as separate property when he had the

opportunity to elect to hold his interest as a joint survivorship

tenency or tenancy in common.     If petitioner and Mr. Heitzman had

filed separate returns, Mr. Heitzman would have claimed the

deduction on his return, and petitioner would not have been

liable for the resulting understatement.     Therefore the

disallowed deductions were items attributable to Mr. Heitzman.

     b.    Grossly Erroneous Deduction

     The Code defines a “grossly erroneous” deduction as one

having no basis in fact or law.     Sec. 6013(e)(2).   Neither the

Code nor the applicable regulations define “basis in fact or

law”.     However, Congress did not intend that the innocent spouse

defense would allow the putative innocent spouse to escape

liability for apparently legitimate claims that are later

disallowed.     Friedman v. Commissioner, 53 F.3d 523, 529 (2d. Cir.

1995), affg. in part, revg. and remanding in part T.C. Memo.

1993-549.     Addressing this issue, we have stated that

     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 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 may be described as frivolous,
     fraudulent, or * * * phony. [Belk v. Commissioner, 93
     T.C. 434, 442 (1989); Douglas v. Commissioner, 86 T.C.
     758, 762-763 (1986).]
                              - 28 -


     We inquire first whether the minimum annual royalty and the

intangible drilling expense deductions are grossly erroneous as

having no basis in fact or law because they arose from a sham

transaction entered into solely for the purpose of obtaining

favorable tax consequences.   Sham transactions are not given

effect for Federal income tax purposes, Frank Lyon Co. v. United

States, 435 U.S. 561, 573 (1978); Ferrell v. Commissioner, 90

T.C. 1154, 1199 (1988), and   the claimed deductions arising

therefrom are “phony” or “frivolous”, without basis in fact or

law, and therefore grossly erroneous under section 6013(e)(2),

even if an expense or loss is actually incurred.   See, e.g.,

Bouskos v. Commissioner, T.C. Memo. 1987-574 (deductions arising

from coal-mining lease that was “a mere tax shelter designed to

enrich the general partners and provide sizable tax deductions to

the limited partners” were phony and had no basis in law or fact)

(quoting Tallal v. Commissioner, T.C. Memo. 1984-486, affd. 778

F.2d 275 (5th Cir. 1985)); cf. Somervill v. Commissioner, T.C.

Memo. 1996-165 (claimed deductions in tax shelter that was a sham

were not grossly erroneous because they were “not without some

support in the case law”) (quoting Finkelman v. Commissioner,

T.C. Memo. 1989-72, affd. without published opinion 937 F.2d 612

(9th Cir. 1991)).

     The putative innocent spouse must carry the burden of

producing evidence of the sham nature of the underlying

transaction and the lack of profit motive on the part of the
                                - 29 -


entity and its principals.    Here, petitioner must establish that,

at the partnership level, Stonehurst was a sham transaction

without profit motive.     Hulter v. Commissioner, 91 T.C. 371, 393

(1988); Fox v. Commissioner, 80 T.C. 972, 1006-1008 (1983), affd.

without published opinion 742 F.2d 1441 (2d Cir. 1984), affd. sub

nom. Barnard v. Commissioner, 731 F.2d 230 (4th Cir. 1984), affd.

without published opinions sub nom. Hook v. Commissioner, Kratsa

v. Commissioner, Leffel v. Commissioner, Rosenblatt v.

Commissioner, Zemel v. Commissioner, 734 F.2d 5-7, 9 (3d Cir.

1984); see also Bealor v. Commissioner, T.C. Memo. 1996-435.

This was an issue that was not litigated in Heitzman v.

Commissioner, T.C. Memo. 1987-109, and the record in the case at

hand lacks any direct reference to the economic motives of the

general partner.   Wind River had been organized to act as general

partner in Stonehurst, and Freemond had no previous experience in

oil and gas exploration.    For purposes of our inquiry, Freemond

and Wind River are shadowy figures, present only in the

Memorandum and later letters chronicling Stonehurst’s dwindling

prospects of finding oil or natural gas and its ultimate demise.

     The evidence in the record that Stonehurst was a sham

transaction is circumstantial, and comes from the following

sources:   (1) The Stonehurst documentation, (2) the testimony and

report of petitioner’s expert, Charles M. Bowers, and (3) the

testimony of Mr. Heitzman.    Our analysis of Stonehurst is also

informed by our report in Osterhout v. Commissioner, T.C. Memo.
                              - 30 -


1993-251, affd. on this issue and revd. in part without published

opinion sub nom. Balboa Energy Fund 1981 v. Commissioner, 85 F.3d

634 (9th Cir. 1996), which held similarly structured oil and gas

partnerships--which used up-front accruals of minimum advance

royalties to generate claims for large tax deductions that were

never paid for--to be sham transactions.    In Osterhout, we found

that “the objective of the * * * [partnerships at issue in that

case] was to help investors avoid taxes and to enrich the coffers

of the promoters”, including Meserve, a partner in the law firm

rendering the tax opinion for Stonehurst.   There are striking

parallels between Osterhout and the case at hand.

     In Osterhout, as in the case at hand, the promotional

material emphasized the tax benefits available to investors who

would benefit regardless of whether oil and gas were actually

discovered.   An investor in Stonehurst could seemingly “win” by

receiving tax deductions far in excess of the amount paid for the

partnership interest even if no oil or gas was produced.   See

Ferrell v. Commissioner, 90 T.C. at 1183; Osterhout v.

Commissioner, supra (citing Barnard v. Commissioner, 731 F.2d 230

(4th Cir. 1984), affg. Fox v. Commissioner, 80 T.C. 972 (1983)).

     In cases such as Osterhout, where “the promised tax benefits

are suspiciously excessive and the transaction is carried out

with complete indifference to profit, it is clear the parties

intended to structure the transaction for the tax benefits.”

Osterhout v. Commissioner, supra (citing Flowers v. Commissioner,
                               - 31 -


80 T.C. 914, 941 (1983)).    The record in the case at hand is

replete with similar indicia of indifference to profits on the

part of Stonehurst and its principals.

     Petitioner’s expert, Charles M. Bowers (Bowers), a petroleum

engineer registered in Oklahoma, concluded that the Coburn report

was egregiously flawed in several ways.    In Bowers’ view, the

most egregious flaw in the Coburn report was the assertion that

“commercial oil production can be obtained from the Bartlesville

Sand”.    Because of the unique characteristics of Bartlesville

Sand,11 there would have had to have been previous oil production

in commercial quantities on the lease in order for the Coburn

report to make such an assertion without its being a gross

misrepresentation.    The Coburn report referred to no evidence to

support its contentions about the likelihood of discovering oil

in commercial quantities.    Furthermore, Mr. Heitzman testified at

trial that the maps he was shown indicated that the closest

proven Bartlesville Sand was 8 miles from the leasehold.12

     Another egregious flaw in the Coburn report was its claim of

a 90-percent success rate for exploratory drilling.    Likelihoods

of success on the order of 90 percent are associated with

developmental drilling, which the Memorandum itself defined as


     11
          See supra n.7.
     12
       Now repealed sec. 56(h)(6)(B), providing energy based
preference adjustments to the alternative minimum tax, defined
the minimum distance of an exploratory well from other wells as
1.25 miles or 800 feet in depth (the exploratory well being
deeper).
                               - 32 -


drilling wells in “the presently proven productive area of an oil

or gas reservoir.”   Despite the representation in the Memorandum

that Stonehurst was planning to engage in a developmental

drilling program, there were, as discussed supra, no “proven

productive areas” on the Stonehurst leasehold.   Bowers testified

that a 10-percent likelihood of success in exploratory drilling

would be relatively generous under the best of conditions.

     Consistent with Bowers’ opinion that the Coburn report was

“disturbingly generic”, was the different typeface used in the

report whenever it referred to Stonehurst.   We believe, based

upon Bowers’ evaluation and the record as a whole, that the

Coburn report could not have been relied upon to support the

assumptions in the economic projections.   The Coburn report is a

strong indication of the lack of profit motive of the Stonehurst

partnership and its principals.   See Hulter v. Commissioner, 91

T.C. at 393; Fox v. Commissioner, 80 T.C. at 1006-1008.

     In Osterhout v. Commissioner, supra, we found that the

“promotional valuations pertaining to the prospective oil and gas

production of * * * [the partnerships in issue] were inflated.”

Those inflated valuations were supported by inaccurate geology

reports and world oil price projections that were significantly

inflated in comparison to actual downward market movements

occurring as the leases were entered into in 1981, 1982, and

1983.   Id.   The economic projections in the Stonehurst Memorandum

were similarly unrealistic.   See Krause v. Commissioner, 99 T.C.
                               - 33 -


132, 169-170 (1992), affd. sub nom. Hildebrand v. Commissioner,

28 F.3d 1024 (10th Cir. 1994); see also Tallal v. Commissioner,

T.C. Memo. 1984-486, affd. 778 F.2d 275 (5th Cir. 1985).

     The Memorandum used three critically flawed assumptions to

support the economic projections of Stonehurst’s asserted

profitability after having paid a 67-percent production royalty.

The first was the assertion in the Coburn report of a 90-percent

chance of finding oil with the projected drilling program, which

as we have found, was completely unwarranted and invalidates the

economic projections.    The Memorandum projected as many as 23

wells producing 5 barrels a day in 1981 out of a total of 25

wells drilled.    A 10-percent likelihood of finding oil at all

renders virtually nil the possibility that Stonehurst could pay

the minimum annual royalty.    This flawed assumption also

highlights internal inconsistencies in the Memorandum, which, on

one page, disavowed any intention to conduct exploratory

drilling, while on another page, warned of the risks involved in

“exploration” for oil.

     The second flawed assumption was the projected size of the

reserves.   The Coburn report estimated that only 518,400 barrels

of oil would be produced over a 15-year period, while the

economic projections in the Memorandum projected, without any

additional support, that 757,700 barrels would be produced over a

similar period.    Neither the Coburn report nor the Memorandum

cited any justification for either estimate.    These projected
                               - 34 -


reserves were particularly unreasonable since the sublease

restricted Stonehurst’s mineral rights to oil produced from

Bartlesville Sand.

     Furthermore, the Coburn report assumed that waterflooding

would be necessary to obtain 518,400 barrels of oil over 15

years.   Bowers testified that waterflooding would require

substantial additional capital to support additional drilling and

would result in increased operating costs.    See also Yates

Petroleum Corp. v. Commissioner, T.C. Memo. 1992-146 (discussing

economic feasibility of secondary and tertiary oil recovery

programs); In re Dept. of Energy Stripper Well Exemption

Litigation, 520 F. Supp. 1232, 1244-1247 (D. Kan. 1981), revd.

and remanded on other grounds 690 F.2d 1375 (Temp. Emer. Ct. App.

1982) (expert testimony describes waterflood process and expense

involved).    Neither the Coburn report nor the economic

projections in the Memorandum took such costs into account.

     The Memorandum’s third critically flawed assumption was that

1980 oil prices of $32.50 per barrel would increase at 10-percent

per year, compounded annually, peaking at $123.44 per barrel in

1994.    Even though Stonehurst was marketed in December 1979, at a

time when world oil markets had been destabilized by war in the

Middle East, the Iranian revolution, and the resulting embargo,

Krause v. Commissioner, 99 T.C. at 134, the Memorandum contained

no support for the 10-percent price escalation.    Indeed, the

price of domestic oil never exceeded $40 in the 1980-81
                               - 35 -


timeframe.    In Krause v. Commissioner, supra, we noted that the

peak domestic price in March 1981 was $34.70 per barrel.13   In

Ferrell v. Commissioner, 90 T.C. at 1195 n.27, we took judicial

notice that the price of oil in the United States as a whole

peaked at $31.77 per barrel in 1981 and declined thereafter to

$24.08 per barrel in 1985.   Bowers testified at trial that by the

early 1990's, the market price of oil worldwide was less than $20

per barrel.   Although, as our analysis in cases like Krause v.

Commissioner, supra, and Ferrell v. Commissioner, supra, shows,

we are aware that such price declines were not forecast in

December 1979, the Stonehurst Memorandum provided no support for

its wildly over-inflated oil price projections.

     The structure of the minimum annual royalty that Stonehurst

was to pay Craig was very similar to that described in Osterhout

v. Commissioner, supra, where we found such structures “foreign

to the oil and gas industry” because of the “speculative nature

of an oil well” in comparison to coal mining leases where such

royalties are used “due to the definitive quantity of coal that

can be mined”.14   In this case, Bowers characterized Stonehurst


     13
       The spot price of Saudi light crude oil peaked at $46 per
barrel in August 1980. Krause v. Commissioner, 99 T.C. 132, 134
(1992), affd. sub nom. Hildebrand v. Commissioner, 28 F.3d 1024
(10th Cir. 1994).
     14
       In Osterhout v. Commissioner, T.C. Memo. 1993-251, affd.
on this issue and revd. in part without published opinion sub
nom. Balboa Energy Fund 1981 v. Commissioner, 85 F.3d 634 (9th
Cir. 1996), we cited the expert testimony of Mr. John Teeple,
respondent’s expert witness, an attorney who had been involved in
                                                   (continued...)
                               - 36 -


as “a very unusual deal.    I’ve never quite seen one put together

like this before.”    Bowers’ conclusion is supported by the

extremely remote possibility that any oil production that could

pay the minimum annual royalty would result from the exploratory

drilling on the leasehold.

     The fees paid to the promoters and the overriding production

royalty due to Craig, the sublessor, which were 67 percent of the

gross revenues before any expenses, are also unreasonable,

especially in light of Stonehurst’s highly restricted mineral

rights under the lease.    According to the Memorandum, Craig was

also to receive 8 percent of the initial capital contribution as

a “consulting fee”.    The Memorandum and the Meserve firm legal

opinion both disclosed interrelationships between the various

entities involved in Stonehurst, most notably that R.H. Energy

had assigned its rights in the sublease to Craig, and that the

Meserve firm was legal counsel to both Stonehurst and Craig.

While the record does not fully develop the scope of these

interrelationships, this unanswered question is yet another

indication of the indifference of Stonehurst and its principals

to the likelihood of any profit that would inure to the

investors.15


     14
      (...continued)
oil and gas matters since 1960.
     15
       We note in passing that the presence of the Meserve
firm’s legal opinion does not alter our finding that Stonehurst
was a sham transaction that rendered the claimed deductions
                                                   (continued...)
                              - 37 -


     In Osterhout v. Commissioner, supra, we found that the

recourse notes issued by the limited partners to the sublessor of

the land leased to the partnerships in issue were “merely * * * a

facade to support the current deductibility of the amounts

accrued as MAR [minimum annual royalties]”.   The recourse notes

given to Craig and R.H. Energy and the assumption agreements

signed by the 35 individuals who bought partnership units in

Stonehurst served exactly the same purpose.

     In Osterhout v. Commissioner, supra, the possibility of

payment of the notes was so remote as to be illusory.   The

likelihood of payment of the notes to Craig and R.H. Energy was

just as illusory.   On December 29, 1986, Wind River sent a letter

to the Stonehurst limited partners inviting them to sign an

agreement that would relieve the principals in Stonehurst of all

liabilities and “reduce” the liabilities of the limited partners

by providing a means to pay them down and by further delaying the

due date of the principal until December 31, 2001.   Such an

offer, completely unsupported by reference to any discernible

economic reality, suggests that Craig did not entertain any

realistic possibility of being paid in the absence of actual oil



     15
      (...continued)
grossly erroneous. Like the Martin law firm opinion letter in
Osterhout v. Commissioner, supra, with respect to additions to
tax for negligence and whether it was reasonable in the
circumstances of that case for the taxpayers to rely on it, the
Meserve firm’s opinion letter is germane in this case only as a
factor in determining whether petitioner had reason to know of
the grossly erroneous deductions.
                              - 38 -


or gas production--the remote likelihood of which in 1979 was

subsequently confirmed by the lack of any production from the

leasehold.

     The form of the recourse notes indicates the remoteness of

any possibility of payment.   In Osterhout v. Commissioner, supra,

the principal was not due and payable for 12 years, and the notes

themselves were interest free, a form “foreign to the business

world.”   The principal on the Stonehurst note given to Craig was

not due for 15 years and was likewise interest free.

     Stonehurst was formed solely to enrich the promoters and

provide claims to tax deductions for the limited partners.   The

activities of Stonehurst served no viable economic or commercial

profit objective.   While we realize that oil and gas exploration

is highly speculative and can yield large profits, that Congress

enacted certain tax measures to encourage oil and gas

exploration, and that the Stonehurst promotional materials

contained representations of profitability, the structure of

those materials, with their flawed assumptions, internal

inconsistencies, and the unbusinesslike structure of the so-

called minimum advance royalty, all demonstrate that any

possibility of profits was so remote as to be negligible.

Compare United States v. Dean, 224 F.2d 26, 29 (1st Cir. 1955)

(for purposes of sec. 20.2055-2(b)(1), Estate Tax Regs., “so

remote as to be negligible” defined as the “chance which persons

generally would disregard as so highly improbable that it might
                               - 39 -


be ignored with reasonable safety in undertaking a serious

business transaction”); see also Estate of Clopton v.

Commissioner, 93 T.C. 275, 285-286 (1989); Briggs v.

Commissioner, 72 T.C. 646, 656-657 (1979), affd. without

published opinion 665 F.2d 1051 (9th Cir. 1981).

      We find that Stonehurst, like the partnerships at issue in

Osterhout v. Commissioner, T.C. Memo. 1993-251, was a sham

transaction entered into for tax benefits without any objective

possibility of producing an economic profit independent of the

contemplated tax benefits that should not be given effect for

Federal income tax purposes.   Frank Lyon Co. v. United States,

435 U.S. at 573; Ferrell v. Commissioner, 90 T.C. at 1199.   We

find that the minimum annual royalty and the intangible drilling

costs accrued by Stonehurst in 1979 and claimed by Mr. Heitzman

on the 1979 joint return to be completely without basis in fact

or law, sec. 6013(e)(2)(B), Belk v. Commissioner, 93 T.C. at 442;

Bouskos v. Commissioner, T.C. Memo. 1987-574 citing Douglas v.

Commissioner, 86 T.C. at 762-763, and therefore grossly erroneous

for purposes of section 6013(e)(1)(B).16




     16
       Because we held in Heitzman v. Commissioner, T.C. Memo.
1987-109, affd. 859 F.2d 783 (9th Cir. 1988), that neither the
minimum annual royalty nor the intangible drilling costs could
have been claimed as deductions in 1979, as a matter of law, we
also find them to be grossly erroneous as being without basis in
law. Reser v. Commissioner, 112 F.3d 1258, 1265 (5th Cir. 1997),
affg. in part and revg. in part T.C. Memo. 1995-572.
                                - 40 -


2.   Knowledge or Reason to Know

     Petitioner must establish “that * * * she did not know, and

had no reason to know, that there was * * * [a] substantial

understatement” on the 1979 joint return.     Sec. 6013(e)(1)(C).

Respondent does not contend that petitioner had actual knowledge

of the understatements on the 1979 return nor would the record

support a contention to that effect.     Petitioner did not have

actual knowledge of the understatement at the time the 1979

return was signed.

     We now turn to whether petitioner had reason to know of the

substantial understatement of income tax on the 1979 joint

return.     Respondent contends that petitioner did have reason to

know.     We disagree.17

     17
       Respondent relies heavily on a letter dated Nov. 25,
1985, that Mr. Heitzman wrote to the Atlanta Appeals Office in
response to a request for information from him concerning
petitioner. In that letter, Mr. Heitzman stated that he and
petitioner “reviewed very carefully any investment either one of
us made during our marriage”. At trial in the case at hand,
Mr. Heitzman recanted what he wrote in the letter.

     Mr. Heitzman wrote that letter less than 2 years after he
and petitioner were divorced. In 1985, Mr. Heitzman was still
very bitter over the failure of his marriage with petitioner.
Compounding Mr. Heitzman’s bitterness was the bankruptcy of both
of his businesses because of the death of his partner, who was
also one of his major financial backers, and the financial
failure of his other major financial backer. To make matters
worse, Mr. Heitzman was also in the early stages of litigation
concerning the deficiency arising from the Stonehurst deductions
that eventually culminated in the decision in Heitzman v.
Commissioner, supra. He also had not yet been discharged from
bankruptcy and may well have hoped for contribution from
petitioner irrespective of the “hold harmless” clause in the
divorce settlement agreement.
                                                   (continued...)
                              - 41 -


     In Bokum v. Commissioner, 94 T.C. 126 (1990), affd. on

another ground 999 F.2d 1132 (11th Cir. 1993), we held that “the

taxpayer claiming innocent spouse status must establish that he

or she is unaware of the circumstances that give rise to error on

the tax return and not merely to be unaware of the tax

consequences”.   Id. at 145-146 (citing Purcell v. Commissioner,

86 T.C. 228, 238 (1986), affd. 826 F.2d 470 (6th Cir. 1987)).   In

Bokum v. Commissioner, supra at 146, we held that a putative

innocent spouse’s knowledge of the relevant underlying

transaction incident to the grossly erroneous deduction and the

appearance of a large, unexplained deduction on the face of the

income tax return, id. at 148, are both independently sufficient

to cause the putative innocent spouse either to have a reason to

know of the substantial understatement of tax incident to a

grossly erroneous deduction or to impose upon her a duty to

inquire.




     17
      (...continued)
     At trial, Mr. Heitzman explained his state of mind:

     you put all that together, and it was pretty * * *
     devastating. And so, you know, I felt my world has
     fallen apart. I was bitter because of the marriage
     that didn’t work. I’m sorry. * * * I take full
     responsibility * * * [for] the letter I wrote * * *
     [which] doesn’t reflect the facts * * * when I now can
     look at it later.

     Based upon Mr. Heitzman’s testimony at trial and the
evidence in the record directly contradicting allegations in the
letter, we give the letter no credence.
                              - 42 -


     With respect to petitioner’s knowledge of the underlying

transaction, which in this case was Mr. Heitzman’s purchase of

the Stonehurst interest in December 1979, petitioner knew of the

bare existence of the transaction, but little more.   Both

Mr. Heitzman’s testimony and that of petitioner herself show that

he informed her of his purchase either shortly before it was made

or at some point thereafter, prior to the filing of the 1979

return.

     In considering whether this bare knowledge of the

transaction is sufficient to hold petitioner to have had reason

to know of the understatement, we must consider several factors

used by this Court and others:   (1) The putative innocent

spouse’s level of education; (2) her involvement in the family’s

financial affairs; (3) the putative guilty spouse’s evasiveness

or deceit concerning the family’s finances, and; (4) the presence

of lavish or unusual expenditures or any large unexplained

increase in the family’s standard of living.   Flynn v.

Commissioner, 93 T.C. 355, 365-366 (1989); see also Silverman v.

Commissioner, T.C. Memo. 1996-69, revd. on other grounds 116 F.3d

172 (6th Cir. 1997).

     Petitioner was a woman of limited education and no financial

sophistication who trusted Mr. Heitzman and deferred to him on

all business matters.   Mr. Heitzman told petitioner that the

Stonehurst partnership was a tax shelter “in oil and gas” that

would make some money, facts that, to petitioner, were consistent
                                - 43 -


with a legitimate investment in light of contemporaneous

instability in oil prices and supplies.   Given petitioner’s lack

of financial sophistication, the minimal explanation that she

received from Mr. Heitzman was sufficient to apprise her of the

existence of the transaction and to allay any questions she might

have had under the circumstances, while leaving her effectively

without any substantive knowledge of the transaction.

     Petitioner’s awareness that Stonehurst was a “tax shelter”

is not particularly probative, in the context of her limited

financial sophistication, of whether she substantively knew of

the underlying transaction.   As we have observed in similar

cases, in the late 1970's and early 1980's, a person such as

petitioner who did not understand tax matters could quite

reasonably interpret the term “tax shelter” as legitimately

sheltering income from tax, see, e.g., Foley v. Commissioner,

T.C. Memo. 1995-16, especially in light of Mr. Heitzman’s comment

that Stonehurst would “make a lot of money”.   It was common

knowledge in the 1980's and earlier that “wily investors could

find legal ways and means of attaining spectacular tax benefits

through cunning investment strategies.”    Friedman v.

Commissioner, 53 F.3d at 531.    The fact that Stonehurst “was in

oil and gas” in 1979, a time when oil prices were rising, only

lent further credence to its potential value as a legitimate and

possibly quite lucrative investment.
                              - 44 -


     That petitioner was satisfied by Mr. Heitzman’s superficial

explanation of the Stonehurst transaction precisely captures how

uninvolved she was in the family’s financial affairs.   The only

joint investment that Mr. Heitzman and petitioner made together

was their home.   Mr. Heitzman routinely made investment decisions

during their marriage with no participation by petitioner.   In

petitioner’s mind, the Stonehurst purchase was like every other

business transaction that Mr. Heitzman had made during their

marriage:   It was his property and his affair, and petitioner was

not privy to any meaningful information about it.    Petitioner did

not review any documentation such as the Stonehurst Memorandum or

the purchase contract or assumption agreements.    She knew nothing

of the substance of the transaction, nor did Mr. Heitzman discuss

with her any of its salient substantive aspects.

     While Mr. Heitzman was neither evasive nor deceptive with

petitioner about his investment and other financial decisions, by

the same token, he brooked no intrusion by petitioner into what

he considered his affairs.   Mr. Heitzman regarded the Stonehurst

purchase and his other, legitimate investments to be his, funded

with his money.   Petitioner had no role in deciding whether to

purchase the Stonehurst interest.   She also remained uninvolved

in subsequently claiming the deductions incident to that

transaction on their 1979 joint income tax return.   In any case,

given the context of her and Mr. Heitzman’s marital relationship,

petitioner would never have expected to have had such a role.
                               - 45 -


Just as surely as if Mr. Heitzman had deliberately hidden the

transaction from petitioner, or had deliberately deceived her

about its existence or its tax consequences, the dynamics of

their marital relationship effectively walled petitioner off from

any substantive knowledge of the transaction.

     The record also does not reflect any change in the family’s

standard of living during the 1979-80 timeframe.   Indeed, the

only change in standard of living was a precipitous decline in

petitioner’s standard of living in the aftermath of their 1983

divorce.

     With respect to the appearance on the 1979 return of the

deductions related to Stonehurst, we find that, at the time the

return was signed, their appearance on the return would not have

caused petitioner to have reason to know of the understatement.

To all appearances, they were perfectly valid.   Any questions

that their size might have engendered had already been allayed

because Mr. Heitzman had already apprised petitioner of the

purchase in a way that fully legitimized it in her eyes.

Furthermore, the return had been prepared and signed by a

prominent accounting firm as income tax return preparer and was

without any apparent defect.   Compare Bokum v. Commissioner, 94

T.C. at 147-148 (taxpayer incurred a duty to inquire by signing a

return prepared, but not signed, by an income tax return

preparer, which contained a huge, unexplained deduction and an

obvious arithmetic error).
                                - 46 -


       Alexander Grant, a prominent national accounting firm, had

prepared the 1979 return without raising any question about the

Stonehurst deductions.    Alexander Grant had prepared each of the

joint returns from 1973 to 1981 for Mr. Heitzman and petitioner.

Under the circumstances, petitioner was entitled to rely upon the

imprimatur of legitimacy that Alexander Grant lent to the joint

return.     To petitioner, cognizant of Mr. Heitzman’s explanation

and the manner in which the return was prepared, nothing was

amiss.18

       Even if we were to find that the return should have alerted

a reasonable taxpayer to question the deduction as not being

legitimate--and we do not so find--to impose a duty to inquire on

petitioner under these circumstances would be to impose a duty to

perform a futile act.     Reser v. Commissioner, 112 F.3d 1258, 1269

(5th Cir. 1997), affg. in part and revg. in part T.C. Memo. 1995-

572.    She already knew that a qualified income tax return

preparer had prepared the return without question, and the duty

to inquire “does not extend so far as to impose on a spouse the



       18
       The lack of mention in the record that Alexander Grant
questioned the deductions claimed pursuant to Stonehurst when it
prepared petitioner’s and Mr. Heitzman’s 1979 joint return does
not change the analysis of whether those deductions were grossly
erroneous. We cannot determine from the record whether Alexander
Grant’s actions were reasonable or not in signing the return
based on the information available to them, nor need we answer
that question. It suffices for our purposes that the return was
signed by a respected income tax return preparer, and petitioner
acted reasonably in relying on that signature with respect to
whether petitioner should have questioned the validity of the
deductions claimed on the returns.
                               - 47 -


duty to seek advice from her own independent legal and financial

advisers”.    Friedman v. Commissioner, 53 F.3d at 531.    Even if

petitioner had asked any questions, her lack of financial

sophistication, her nonexistent role in Mr. Heitzman’s business

and investment activities, and Mr. Heitzman’s attitude toward

petitioner’s participation in those affairs, would have allowed

her to uncover no more than she already knew.   Had Mr. Heitzman

shown petitioner the pertinent documents, their aura of

verisimilitude would have provided her with little to question.

The fundamental mendacity of the documents could have been

uncovered only by a much more sophisticated and skeptical

investor--which, in 1980, petitioner was not.   Even the warning

to seek the opinion of independent tax counsel would not have

caused petitioner to question the deductions claimed on the

return because the return bore the imprimatur of an independent

and respected income tax return preparer.

     For purposes of sec. 6013(e)(1)(C), we find that, under the

circumstances of this case, petitioner neither knew nor had

reason to know of the understatement on the 1979 joint income tax

return.   She had no effective knowledge of the relevant

underlying transaction nor did she have a duty to inquire into

the validity of the deductions arising from the transaction that

were claimed on the 1979 joint income tax return.    Bokum v.

Commissioner, 94 T.C. at 145-148; Flynn v. Commissioner, 93 T.C.

at 365-366.
                              - 48 -


3.   Equities

     Petitioner must show, based on all the facts and

circumstances, that it would be inequitable to hold her liable

for the deficiency attributable to the substantial

understatement.   Sec. 6013(e)(1)(D); sec. 1.6013-5(b), Income Tax

Regs.   Relevant factors include:   (1) Whether the taxpayer

seeking relief significantly benefited, directly or indirectly;

(2) whether the spouse seeking relief has been deserted,

divorced, or separated from the other spouse, and; (3) the

probable hardships that would befall the spouse seeking relief if

she were not relieved of joint liability.

     The record reveals that petitioner did not significantly

benefit from the grossly erroneous deduction attributable to Mr.

Heitzman’s interest in Stonehurst.     Mr. Heitzman spent $43,400

purchasing his interest.   His total claimed State and Federal

income tax savings were $66,990.    Mr. Heitzman netted no more

than $23,590 from the Stonehurst deductions.     The record does not

show the disposition of these funds.     However, money being

fungible, petitioner must show that she did not even indirectly

benefit.

     Normal support does not constitute a “significant benefit”,

Flynn v. Commissioner, supra at 367, and is measured by the

circumstances in each case, id.     Petitioner’s and Mr. Heitzman’s

standard of living, while comfortable throughout this period, did

not appreciably change in 1979 or thereafter until they separated
                              - 49 -


in 1982, when petitioner’s disposable income dropped

precipitously.

     The remodeling of the family residence was completed and

paid for prior to Mr. Heitzman’s ever having contemplated the

purchase of his interest in Stonehurst and was not funded in any

way by the tax savings.   Indeed, petitioner had used her own

limited resources in 1979 to make additional improvements to the

residence.   Even if the cost of remodeling could have been traced

indirectly to the tax savings, the remodeling contributed little

to any increase in the value of the residence between 1979 and

1982, when it was sold pursuant to their divorce settlement.

Such increases were entirely attributable to market forces and

the desirable location and quality of the house.

     Another factor to be taken into account is the 1983 divorce

between petitioner and Mr. Heitzman.   Flynn v. Commissioner, 93

T.C. at 367; sec. 1.6013-5(b), Income Tax Regs.    There is nothing

in the record to indicate that petitioner received any more in

the divorce settlement, which primarily consisted of her share of

the proceeds from the sale of the residence and about $14,000 in

alimony, than she otherwise would have.   In view of   the standard

of living that petitioner and Mr. Heitzman enjoyed while married,

such a settlement is well within the bounds of normal support.

See, e.g., Foley v. Commissioner, T.C. Memo. 1995-16.    The

divorce also takes on added importance in light of the provision

in the settlement agreement whereby Mr. Heitzman agreed to
                              - 50 -


indemnify petitioner for all deficiencies arising from their

joint returns and of Mr. Heitzman’s subsequent bankruptcies in

1984 and 1990, which have apparently relieved him of his

obligations under the divorce settlement agreement.

     Despite Mr. Heitzman’s agreement in the divorce settlement

that he was and would be responsible for any income tax

deficiencies, his 1990 bankruptcy discharged him from any

liability on the deficiency upheld against him in Heitzman v.

Commissioner, T.C. Memo. 1987-109, thus imposing on petitioner

the burden of paying the deficiency of $55,263 and more than 17

years of accrued interest of at least four times that amount if

she does not qualify for innocent spouse relief.

     Finally, respondent argues, citing McCoy v. Commissioner, 57

T.C. 732, 734-735 (1972), that both Mr. Heitzman and petitioner

were equally ignorant of the income tax consequences of the

Stonehurst deduction and should therefore be held jointly liable.

Respondent’s reliance on McCoy v. Commissioner, supra, is

misplaced.   The case at hand is one that the innocent spouse

provisions were intended to reach--Mr. Heitzman and petitioner

were not equally ignorant of the income tax consequences of the

Stonehurst deduction.   Cf. Pewitt v. Commissioner, T.C. Memo.

1997-288 (wife and husband were equally knowledgeable--and

equally ignorant of Federal income tax consequences--wife

attended sales meeting where both she and husband were informed

of tax benefits and risks).   Mr. Heitzman was consciously trying
                              - 51 -


to shelter income from taxation in 1979.   While Mr. Heitzman was

not guilty of any wrongdoing in striving to minimize his tax

burden, he failed to ensure that he was not taking a frivolous

position in claiming the deductions.   By his own admission, he

did no research and did not seek an opinion from independent tax

counsel either prior to his purchase of the interest or prior to

claiming the deductions on the 1979 return.19

     Furthermore, the Stonehurst interest was entirely Mr.

Heitzman’s.   He had all of the relevant information solely in his

possession--including the warning to seek the opinion of an

independent tax counsel--and he should have known that the

deductions were, to say the least, questionable.   Petitioner was

privy to none of that information, and, as we have already found,

she had no reason to know of the understatement because Mr.

Heitzman had given her sufficient information to dispel any

disquiet she might have had under the circumstances.   Friedman v.

Commissioner, 53 F.3d at 531; Foley v. Commissioner, supra.

Thus, we find that it would be inequitable, under the facts and

circumstances of this case, to hold petitioner liable for the




     19
       There is nothing in the record to indicate whether the
Alexander Grant income tax return preparers were apprised of
sufficient facts concerning Stonehurst to cause them to question
the deduction more closely. That issue is not relevant to this
case. What the record does reflect is that, as far as petitioner
was concerned, Alexander Grant had given the return its
imprimatur by preparing and signing it without comment. Cf.
Bokum v. Commissioner, 94 T.C. 126, 147-148, 156 (1990), affd. on
another ground 992 F.2d 1132 (11th Cir. 1993).
                              - 52 -


deficiency attributable to the understatement on the 1979 tax

return.

     Petitioner has established every element of entitlement to

innocent spouse relief.   By reason of the foregoing,


                                       Decision will be entered

                                  for petitioner.
