                        T.C. Memo. 2008-63



                      UNITED STATES TAX COURT



     JOSEPH D. DUNNE AND ELIZABETH M. DUNNE, Petitioners v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 24666-05.              Filed March 12, 2008.



     Steven D. Simpson, for petitioners.

     J. Craig Young, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GOEKE, Judge:   Respondent determined deficiencies in

petitioners’ 1997 and 1999 Federal income taxes of $822,298 and

$2,566, respectively, and additions to tax under section
                                - 2 -

6651(a)(1)1 of $205,028.25 and $592.50, respectively, for 1997

and 1999.    After concessions,2 the issues for decision are:

     (1)    Whether respondent bears the burden of proof under

section 7491(a).    We hold that respondent does not;

     (2)    whether petitioner Joseph Dunne was a shareholder of

FRC International, Inc. (FRC), in 1997 and whether petitioners

must pay income tax on FRC’s income under section 1366.    We hold

that Mr. Dunne ceased to be a shareholder of FRC on May 8, 1997,

and therefore under section 1377(a)(1) petitioners are liable for

paying income tax only on Mr. Dunne’s pro rata share of FRC’s

income on the basis of the number of days in 1997 that he owned

the stock;

     (3)    whether Mrs. Dunne is eligible for relief from joint

liability under section 6015 for 1997.    We hold that she is not;

     (4)    whether petitioners may claim as trade or business

expenses $20,000 of legal expenses that they incurred in 1999.

We hold that they may not, but they may claim the $20,000 as

miscellaneous itemized expenses;




     1
       All section references are to the Internal Revenue Code
(the Code) in effect for the years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.
     2
       Petitioners concede that the statute of limitations does
not bar the assessment or collection of any amount due for 1997
or 1999. Petitioners also concede that petitioner Elizabeth
Dunne does not qualify for innocent spouse relief under sec. 6015
for 1999.
                                 - 3 -

       (5)   whether petitioners failed to report a $15,000 capital

gain on their 1999 Federal income tax return.     We hold that they

did not, because we find that respondent’s determination as to

this item was arbitrary; and

       (6)   whether petitioners are liable for additions to tax

under section 6651(a)(1) for 1997 and 1999.     We hold that they

are.

                           FINDINGS OF FACT

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

The stipulated facts and the accompanying exhibits are

incorporated herein by this reference.

       Petitioners resided in Sanford, North Carolina, at the time

they filed their petition.

FRC International, Inc.

       Mr. Dunne incorporated FRC in Delaware in 1982.   FRC’s

principal place of business was Holland, Ohio.     FRC was in the

business of selling fire protection material, particularly a

chemical called halon, through contracts with the Federal

Government.     FRC was an S corporation for all relevant periods.

       Mr. Dunne was FRC’s sole shareholder from the time of its

incorporation until 1993.     Mr. Dunne was also a director and an

employee of FRC.     In 1993, Richard Marcus became a 50-percent

shareholder of FRC while Mr. Dunne continued to own the remaining

50 percent.     Mr. Marcus also became the president of FRC and
                                - 4 -

remained in that position at all relevant times.    Mr. Dunne and

Mr. Marcus were also coguarantors of a $4 million line of credit

from FRC’s bank that was set up in connection with a particular

contract that FRC had to provide halon to the Government (the

halon contract).

     FRC did not hold any formal shareholder or board of

directors meetings during any relevant period.    Before 1997 Mr.

Dunne was living in North Carolina, and he flew to FRC’s office

in Holland, Ohio, every 1 or 2 months.   Mr. Dunne exercised only

limited managerial control over FRC at that time.

Problems Between Mr. Dunne and Mr. Marcus

     Mr. Dunne and Mr. Marcus began to have disagreements about

the operation of FRC in 1995.   They discussed possible buyout

arrangements--some where Mr. Marcus would buy Mr. Dunne’s shares

and some where the reverse was true.

     On August 1, 1996, Mr. Dunne and Mr. Marcus met at the

Inverness Country Club.   At this meeting, Mr. Dunne agreed

informally to sell Mr. Marcus or FRC his FRC stock on an

unspecified later date, but they anticipated the sale would occur

by December 31, 1996 (the Inverness agreement).    The price was to

be based upon an independent valuation of FRC.    Mr. Dunne agreed

that Mr. Marcus could conduct the business of FRC as he wished.

Mr. Dunne and Mr. Marcus did not make a binding agreement or sign

a contract at this time, and no sale occurred in 1996.
                               - 5 -

     On January 16, 1997, through their respective attorneys, Mr.

Marcus made an offer to Mr. Dunne, which was based on the

Inverness agreement and subsequently would end the relationship

between Mr. Dunne and FRC.   Mr. Dunne did not accept this offer.

     By letter dated January 24, 1997, as president of FRC, Mr.

Marcus terminated Mr. Dunne’s employment as of January 25, 1997.

Mr. Marcus wrote that he understood that Mr. Dunne would continue

to be an FRC shareholder and a member of the board of directors.

Mr. Dunne was not involved in the management or operation of FRC

after this date.

     On February 3, 1997, Mr. Marcus e-mailed FRC’s employees

directing them not to discuss FRC’s business with or provide

information to Mr. Dunne but to refer such calls to him.

     On February 26, 1997, Mr. Dunne filed a Verified Petition

for Appointment of a Custodian against FRC in the Chancery Court

of New Castle County, Delaware, pursuant to section 226 of

Delaware’s general corporate law.   That section allows

shareholders of a corporation to have a custodian appointed for

that corporation in certain circumstances.   In his petition, Mr.

Dunne stated that he was a 50-percent owner, the chairman of the

board, and the secretary of FRC.    Mr. Dunne also stated that he

and Mr. Marcus did not reach an agreement at the Inverness

Country Club meeting.
                                  - 6 -

       On March 18, 1997, Mr. Marcus mailed a letter to a potential

business partner.      Mr. Marcus wrote:   “As of January 25, 1997 Joe

Dunne was terminated as an employee of FRC, therefore he does not

speak for or represent the company in anyway.       In addition, it is

our position that Joe has in effect sold his shares of stock to

me.”

The Settlement Agreement

       On May 8, 1997, Mr. Dunne and Mr. Marcus executed a

settlement agreement.      This agreement provided that in exchange

for his 50-percent interest in FRC, Mr. Dunne would receive

$175,000 plus 50 percent of FRC’s total net profit from the halon

contract.     The parties agreed that the payment of $175,000

represented FRC’s net book value.       The settlement agreement

provided that the $175,000 was payable as of the date of

settlement (the settlement date), but also that it was payable in

seven equal monthly payments beginning on June 1, 1997.

       Regarding Mr. Dunne’s FRC stock, the settlement agreement

provided:

       TO BE DELIVERED IN ESCROW FULLY ENDORSED PENDING FINAL
       DISTRIBUTION OF ALL MONIES DUE UNDER HALON CONTRACT &
       TWO ESCROW ACCTS, OR PAYMENT OF NET B.V. OF FRCI,
       WHICHEVER IS LATER. NO SHAREHOLDER OR DIRECTOR RIGHTS
       IN JDD AFTER DATE OF SETTLEMENT. ESCROW ACCT PROCEEDS
       TO BE DISTRIBUTED NET OF ALL COSTS & EXPENSES 1/2 TO
       JDD & 1/2 TO RMM.

          *        *        *       *        *       *      *
                               - 7 -

     SETTLEMENT DATE IS DATE OF SIGNING MEMORIALIZING
     DOCUMENT, ANTICIPATED TO BE COMPLETE NOT LATER THAN
     5/16/97.

     However, contrary to the agreement, Mr. Dunne did not escrow

his FRC stock certificates at that time.   The settlement

agreement also provided that all disputes were to be resolved by

arbitration.

     Soon after they executed the settlement agreement, Mr. Dunne

and Mr. Marcus began disputing its provisions.    On October 7,

1997, Mr. Dunne, Mr. Marcus, and FRC executed an agreement to

arbitrate these disputes.

Mr. Dunne’s Relationship With FRC

     FRC paid Mr. Dunne and Mr. Marcus equal dividends each month

from January through April of 1997, totaling between $20,000 and

$26,000 for each.   FRC paid these dividends so that Mr. Dunne and

Mr. Marcus could satisfy their income tax liabilities.

     In September of 1997, Mr. Dunne sent several letters and

reports regarding FRC to FRC’s bank, listing his titles as

“Director, Officer, Co-Owner of FRC, Int’l.”     An officer of the

bank replied with correspondence acknowledging Mr. Dunne’s

titles.

     On October 6, 1997, the bank’s attorney sent Mr. Dunne a

letter stating that the bank was aware of Mr. Dunne’s agreement

to sell his interest in FRC and of the dispute between Mr. Dunne

and Mr. Marcus.   Because the bank did not know what authority Mr.
                               - 8 -

Dunne had concerning FRC’s affairs and did not wish to be a party

to the dispute, it informed Mr. Dunne through counsel that it

would provide Mr. Dunne with further financial information only

upon the request of FRC through its president.

     Mr. Dunne responded in a letter dated October 8, 1997, in

which he asked the bank’s attorney for documentation showing that

he was not a director, officer, and coowner of FRC and therefore

not entitled to receive copies of FRC’s financial information

from the bank.   Mr. Dunne also sent a letter to the bank

reasserting his position as a director, officer, and coowner of

FRC and asking for the documentation that the bank relied upon to

determine that he no longer held those positions.   The attorney

for the bank responded by a fax dated October 15, 1997, that it

received no document indicating that Mr. Dunne was no longer a

director, officer, or coowner of FRC but that out of caution it

would like FRC’s president to be aware of Mr. Dunne’s requests

for FRC’s financial information.   Mr. Dunne sent several more

letters to both the bank’s attorney and the bank asserting his

position as a director, officer, and coowner of FRC.

     On April 15, 1998, Mr. Dunne wrote to an FRC employee

requesting copies of FRC’s Form 1120S, U.S. Income Tax Return for

an S Corporation, and Mr. Dunne’s Schedule K-1, Shareholder’s

Share of Income, Credits, Deductions, etc., for 1997.   Mr. Dunne

stated that he understood that FRC’s taxable income for 1997
                               - 9 -

would be about $4.3 million.   Mr. Dunne also requested that FRC

continue its practice of depositing Mr. Dunne’s estimated tax

liability directly with respondent.    He did not believe that this

would be a problem because FRC had over $3 million in cash.    Mr.

Dunne signed this letter as “Co-Owner and Chairman of the Board”

of FRC.

     On September 21, 1998, FRC filed a Form 1120S for 1997 and

attached Schedules K-1 for Mr. Dunne and Mr. Marcus.   The

Schedules K-1 reported Mr. Dunne’s and Mr. Marcus’s shareholder

percentages for 1997 to be 50 percent each and reported their pro

rata shares of FRC’s income and loss as $2,116,600 of ordinary

income, $27,504 of interest income, and $1,953 of capital loss.

FRC sent Mr. Dunne a Schedule K-1 for 1997 identical to the

Schedule K-1 it submitted to respondent.

The Arbitration Award

     In October of 1997, Mr. Marcus offered to pay Mr. Dunne $2.2

million in full satisfaction of all payments required by the

settlement agreement.   Mr. Dunne responded with a $2.6 million

counteroffer, which he withdrew.   Mr. Dunne decided to let the

arbitrator decide on the award because he thought he was entitled

to receive about $4.9 million under the settlement agreement.

     The arbitrator entered an arbitration award (the arbitration

award) on June 8, 1998.   The arbitrator determined that Mr.

Dunne’s share of the halon contract was $511,267.54, which was
                                - 10 -

payable on the settlement date.     Mr. Dunne was also entitled to

$175,000 for the sale of his FRC stock on the settlement date.

The arbitrator confirmed that the paragraph governing the

transfer of FRC stock required Mr. Dunne to escrow the stock

certificates on the settlement date, and that the certificates

would be held in escrow until Mr. Dunne had received the money

owed to him.     The arbitrator noted that there was no settlement

date at that point because no memorializing document had been

signed.     He directed that the settlement date would be June 22,

1998.

     None of the parties involved complied with the arbitration

award.     On June 9, 1998, FRC and Mr. Marcus filed a complaint in

the Court of Common Pleas of Lucas County, Ohio, to confirm the

arbitration award.    The complaint was removed to the U.S.

District Court for the Northern District of Ohio.     On August 10,

1998, Mr. Dunne filed an answer and counterclaim in which he

stated that he was a 50-percent shareholder of FRC.     On May 6,

1999, the District Court confirmed the arbitration award.     All

parties involved appealed.

Petitioners’ Returns

        On September 1, 1999, petitioners jointly filed a Form 1040,

U.S. Individual Income Tax Return, for 1997.     After an extension,

petitioners’ 1997 Form 1040 was due on August 15, 1998.

Petitioners attached a Form 8082, Notice of Inconsistent
                             - 11 -

Treatment or Administrative Adjustment Request, to their 1997

return stating that they were not reporting the income or losses

listed on the Schedule K-1 from FRC.   They explained that Mr.

Dunne filed a shareholder complaint regarding several issues:

(1) That Mr. Dunne was a 50-percent shareholder of FRC but was

frozen out of dividend distributions in 1997; (2) that FRC did

not provide Mr. Dunne with certain information; (3) that Mr.

Dunne was disengaged from FRC’s books, records, and resolutions;

and (4) that FRC may have made an unequal distribution of income

earned in 1997 that could require a revocation of its S

corporation status.

     On September 17, 1999, FRC filed a Form 1120S for 1998 and

attached Schedules K-1 for Mr. Dunne and Mr. Marcus.   The

Schedules K-1 reported that Mr. Dunne owned 23.69863 percent of

the stock and Mr. Marcus owned the rest.   In computing the

ownership percentages shown on the 1998 Schedules K-1, FRC’s

accountants assumed that Mr. Dunne and Mr. Marcus each owned 50

percent of FRC’s stock until June 22, 1998, and that Mr. Marcus

became the sole shareholder after that date.    FRC reported a net

loss in 1998.

     FRC sent Mr. Dunne a Schedule K-1 for 1998 identical to the

Schedule K-1 that it submitted to respondent.   In response to

receiving his Schedule K-1 for 1998, on September 22, 1999, Mr.

Dunne faxed a letter to FRC’s accountants stating that the
                                - 12 -

Schedule K-1 was incorrect because Mr. Dunne still owned 50

percent of FRC.

     On August 14, 2001, petitioners jointly filed a Form 1040

for 1999.   This return was due on April 15, 2000.

The Transfer of Legal Title

        On October 30, 2000, Mr. Dunne, Mr. Marcus, and FRC entered

into an agreement and release of claims to settle all disputes

between them.     Pursuant to the agreement, Mr. Dunne endorsed and

delivered his FRC stock certificates to Mr. Marcus, and Mr.

Marcus and FRC paid Mr. Dunne the balance of the funds due to him

under the arbitration award.

Respondent’s Examination

     In mid-2001 the Internal Revenue Service (IRS) began

examining petitioners’ 1997, 1998, and 1999 Federal income tax

returns.    Petitioners provided the examining agent with a large

number of documents.    Petitioners also gave the examining agent a

summary of their position, which concluded that Mr. Dunne

transferred beneficial ownership of his FRC shares on May 8,

1997.    In her April 15, 2002, examination report the examining

agent concluded that petitioners had deficiencies of $822,298 and

$2,566 for 1997 and 1999, respectively.    The examining agent also

concluded on the basis of the arbitration award that the

settlement date for the stock sale was June 22, 1998; thus

petitioners were required to include all of the amounts reported
                               - 13 -

on Mr. Dunne’s Schedule K-1 on their 1997 tax return.

Furthermore, petitioners were liable for additions to tax under

section 6651(a)(1) and (2) for 1997 and 1999.

     On August 18, 2005, Mrs. Dunne sent to respondent a Form

8857, Request for Innocent Spouse Relief, for the year 1997.

Mrs. Dunne stated that she signed the 1997 return but did not

review it because there had never been a problem previously.

Mrs. Dunne knew that her husband was selling his interest in a

corporation and was concerned about what the effect of the

litigation regarding the sale would be.    When she told her

husband about her concerns, Mr. Dunne responded that he was

handling the sale according to his attorney’s written advice,

which was that Mr. Dunne had sold his interest in the corporation

and petitioners did not need to report the income listed on the

Schedule K-1.    Because it was a complicated transaction, Mrs.

Dunne relied on Mr. Dunne and his attorney, and Mrs. Dunne was

not involved in the corporation at all.

     Mrs. Dunne listed her average monthly household income as

$5,157 and expenses as $4,971.87.    Petitioners were married and

living together at all relevant times, and Mrs. Dunne did not

suffer any spousal abuse or poor mental or physical health at any

relevant time.    Mrs. Dunne has no knowledge of tax law except

that income tax returns are due on April 15.
                                - 14 -

     On October 7, 2005, respondent mailed petitioners a

statutory notice of deficiency for 1997 and 1999.    Respondent

determined that Mr. Dunne remained a 50-percent shareholder of

FRC throughout 1997 and that petitioners should have reported Mr.

Dunne’s pro rata share of FRC’s items of income and loss as shown

on the Schedule K-1 for 1997.

     Regarding 1999, respondent determined that $20,000 of legal

expenses that petitioners claimed as a deduction on their

Schedule C, Profit or Loss From Business, should be disallowed.

However, this amount should be included as a miscellaneous

itemized deduction on petitioners’ Schedule A, Itemized

Deductions.   These legal expenses related to Mr. Dunne’s disputes

over the settlement agreement.    Respondent further determined

that petitioners realized, but failed to report on their 1999

return, a $15,000 capital gain.    However, there is no evidence in

the record as to the source of this alleged capital gain.

     Respondent stated that Mrs. Dunne was not entitled to relief

from joint liability under section 6015 for either 1997 or 1999.3

     Finally, respondent determined that petitioners were liable

for additions to tax for failure to file timely income tax

returns for both 1997 and 1999.




     3
       Respondent found that there were no grounds to grant Mrs.
Dunne relief for tax year 1999 because she did not submit a Form
8857 for that year, and Mrs. Dunne has conceded this issue.
                               - 15 -

      Petitioners timely petitioned this Court to redetermine all

of respondent’s adjustments.

                               OPINION

I.   Burden of Proof

      Petitioners contend that under section 7491(a), respondent

bears the burden of proof relating to all items in the notice of

deficiency.   Petitioners also contend that respondent’s

determinations relating to 1999 are arbitrary and capricious, but

we will address that issue separately with respect to those

items.

      As a general rule, taxpayers bear the burden of proving that

the Commissioner’s determinations are incorrect.   Rule 142(a).

However, section 7491(a) may in specific circumstances place the

burden on the Commissioner with regard to any factual issue

relating to a taxpayer’s liability for tax if the taxpayers

produce credible evidence with respect to that issue and meet the

requirements found in section 7491(a)(2).   The requirements

applicable here are that the taxpayers have (1) complied with all

substantiation requirements of the Code, (2) maintained all

required records, and (3) cooperated with reasonable requests by

the Secretary for witnesses, information, documents, meetings,

and interviews.   The taxpayers bear the burden of proving that

they have met the requirements of section 7491(a)(2).      Miner v.
                              - 16 -

Commissioner, T.C. Memo. 2003-39; Nichols v. Commissioner, T.C.

Memo. 2003-24, affd. 79 Fed. Appx. 282 (9th Cir. 2003).

      Petitioners raised the issue of whether section 7491(a)

applies for the first time in their posttrial brief.   Respondent

argues that he would be prejudiced if we were to allow

petitioners to raise the section 7491(a)(2) requirements issue

for the first time on brief because had they raised the issue

earlier, respondent could have presented evidence showing that

petitioners have not satisfied the requirements.   We agree with

respondent.   See Smith v. Commissioner, T.C. Memo. 2007-368;

Deihl v. Commissioner, T.C. Memo. 2005-287.   Furthermore, other

than the testimony of the examining agent that petitioners

provided her with a lot of information, the record contains no

specific evidence that petitioners have complied with all of the

substantiation and record maintenance requirements or cooperated

with respondent’s information requests.   Therefore, the record is

insufficient for us to find that petitioners have satisfied the

requirements of section 7491(a)(2), and we conclude a shift of

the burden of proof is not appropriate in this case.

II.   Whether Petitioners Must Pay Income Tax on FRC’s Income for
      1997

      Petitioners argue that they are not required to pay income

tax on any of FRC’s income or loss for 1997 because collateral

estoppel prevents respondent from taxing petitioners in an amount

in excess of what they received from the arbitration award and
                                - 17 -

because Mr. Dunne was not a beneficial owner of FRC for any part

of 1997.

     The doctrine of collateral estoppel provides that once an

issue of fact or law is “actually and necessarily determined by a

court of competent jurisdiction, that determination is conclusive

in subsequent suits based on a different cause of action

involving a party to the prior litigation.”    Montana v. United

States, 440 U.S. 147, 153 (1979); Parklane Hosiery Co. v. Shore,

439 U.S. 322, 326 n.5 (1979).    For collateral estoppel to apply,

the following five conditions must be satisfied:

     (1)   The issue in the second suit must be identical in all

respects to the one decided in the first suit;

     (2)   there must be a final judgment rendered by a court of

competent jurisdiction;

     (3)   collateral estoppel may be invoked against parties and

their privies to the prior judgment;

     (4)   the parties must actually have litigated the issue and

the resolution of the issue must have been essential to the prior

decision; and

     (5)   the controlling facts and applicable legal rules must

remain unchanged from those in the prior litigation.

Brotman v. Commissioner, 105 T.C. 141, 148 (1995); Peck v.

Commissioner, 90 T.C. 162, 166-167 (1988), affd. 904 F.2d 525

(9th Cir. 1990).
                                - 18 -

       Collateral estoppel does not apply against respondent in

this case.    Collateral estoppel may be invoked against parties

and their privies to the prior judgment, but respondent was not a

party to the arbitration or a privy of Mr. Dunne, Mr. Marcus, or

FRC.    While petitioners correctly point out that the Supreme

Court held in Parklane Hosiery Co. v. Shore, supra at 332-333,

that collateral estoppel can apply where a party to the second

proceeding was not a party to the first proceeding, they

misunderstand the scope of that rule.     The U.S. Supreme Court

approved the use of collateral estoppel, whether mutual or

nonmutual, in cases where the party against whom collateral

estoppel is asserted has litigated and lost in the prior

proceeding.    Id. at 329.   Therefore, even assuming respondent

could have asserted that collateral estoppel applied against

petitioners in this case if all of the other conditions had been

satisfied, the reverse is not true.

       Furthermore, neither the tax consequences of the settlement

agreement nor Mr. Dunne’s shareholder status were issues in the

arbitration.    The arbitration merely dealt with the terms of the

settlement agreement, and the settlement agreement contained no

terms relating to the settlement agreement’s tax consequences

except that it provided that Mr. Dunne would have no shareholder

rights after the settlement date.    Because petitioners are

arguing that Mr. Dunne ceased to be a shareholder of FRC for
                               - 19 -

Federal income tax purposes before the settlement date of June

22, 1998, we assume that petitioners’ argument is only that the

amount of the arbitration award would somehow be relevant to Mr.

Dunne’s shareholder status or the amount of FRC’s income that is

taxable to petitioners.    However, this is incorrect because the

amount that Mr. Dunne was entitled to receive from the

arbitration award is irrelevant for determining his shareholder

status or tax liability.    See Chen v. Commissioner, T.C. Memo.

2006-160; Knott v. Commissioner, T.C. Memo. 1991-352.    The amount

that Mr. Dunne received from the arbitration award may be

relevant for the purpose of determining Mr. Dunne’s basis in his

FRC stock, but that matter is not at issue in this case.

     Petitioners also argue that they are not liable for tax on

FRC’s income in 1997 because Mr. Dunne was not the beneficial

owner of his FRC shares in 1997, and for that reason alone his

1997 Schedule K-1 is incorrect.    Petitioners do not dispute that

FRC had a valid S corporation election in effect in 1997, that

the amount of FRC’s income and loss reported on its Form 1120S is

correct, or that the total amount of income and loss reported on

the Schedules K-1 is consistent with FRC’s Form 1120S.

     Section 1366(a)(1) provides that in determining the income

tax liability of an S corporation shareholder, the shareholder

shall take into account his pro rata share of the S corporation’s

items of income, loss, deduction, and credit (tax items) for the
                               - 20 -

S corporation’s taxable year ending with or in the shareholder’s

taxable year.   The S corporation’s income is taxable to the

shareholder regardless of whether any income is distributed.

Chen v. Commissioner, supra; Knott v. Commissioner, supra.

     Section 1377(a)(1) allocates each item of an S corporation’s

income or loss pro rata on a per share per day of ownership

basis.   If a shareholder sells his stock during the S

corporation’s taxable year, he must take into account his pro

rata share of the total amount of the S corporation’s tax items

according to the number of days in that year that he held his

stock, regardless of whether the tax items arose before or after

the sale.   Sec. 1377(a)(1).   The shareholders may elect to

compute the selling shareholder’s pro rata share of the tax items

as if the S corporation’s taxable year ends on the date the

shareholder’s ownership interest terminates, but the FRC

shareholders did not make such an election.    Sec. 1377(a)(2).

     It is well settled that beneficial ownership, not legal

title, determines stock ownership for Federal income tax

purposes.   Ragghianti v. Commissioner, 71 T.C. 346, 349 (1978),

affd. 652 F.2d 65 (9th Cir. 1981); Pacific Coast Music Jobbers,

Inc. v. Commissioner, 55 T.C. 866, 874 (1971), affd. without

published opinion 457 F.2d 1165 (5th Cir. 1972).    Therefore, we

must determine whether Mr. Dunne was the beneficial owner of any

of FRC’s stock during 1997.
                               - 21 -

     To determine when beneficial ownership has passed from one

person to another, a court generally must determine at what point

the transferee acquires more attributes of ownership than the

transferor.    Ragghianti v. Commissioner, supra at 349; Pacific

Coast Music Jobbers, Inc. v. Commissioner, supra at 874; Cordes

v. Commissioner, T.C. Memo. 1994-377.    Where there is a written

agreement that is intended to result in the sale of stock but

provides for the transfer of legal title at a later date, we will

consider whether that agreement suffices to transfer

“substantially all” of the accouterments of ownership at the time

of its execution.    Ragghianti v. Commissioner, supra at 349;

Pacific Coast Music Jobbers, Inc. v. Commissioner, supra at 874.

However, if a taxpayer has entered into an unambiguous written

agreement providing that a sale of stock is to occur at a

specific date, the taxpayer must provide “strong proof” that

beneficial ownership of the stock occurred at a time other than

the date set in the agreement.    Danenberg v. Commissioner, 73

T.C. 370, 391-392 (1979); Lucas v. Commissioner, 58 T.C. 1022,

1032 (1972).

     Petitioners argue that Mr. Dunne was not a shareholder of

FRC at any time during 1997 because the Inverness agreement,

which petitioners claim was merely memorialized by the settlement

agreement, transferred beneficial ownership of Mr. Dunne’s shares

to Mr. Marcus no later than December 31, 1996.   We disagree.
                               - 22 -

     When beneficial ownership of stock is transferred, with or

without legal title, the transfer generally occurs pursuant to an

agreement between the transferor and the transferee.      Reitz v.

Commissioner, 61 T.C. 443, 447 (1974), affd. 507 F.2d 1279 (5th

Cir. 1975).   Petitioners argue that “Mr. Dunne was stripped of

his beneficial ownership rights” in FRC after the Inverness

agreement, but they have not cited any cases, nor are we aware of

any, where one shareholder was able to take beneficial ownership

of stock away from another shareholder absent an agreement

between the two shareholders or a provision in the corporation’s

governing articles to that effect.      On the contrary, we have held

that when one shareholder merely interferes with another

shareholder’s participation in the corporation as a result of a

poor relationship between the shareholders, such interference

does not amount to a deprivation of the economic benefit of the

shares.   Hightower v. Commissioner, T.C. Memo. 2005-274, affd.

without published opinion 2008-1 USTC par. 50,185 (9th Cir.

2008).

     We do not believe that the Inverness agreement gave Mr.

Marcus any rights to Mr. Dunne’s stock either by December 31,

1996, or on some other date.   Clearly, Mr. Dunne and Mr. Marcus

intended a sale to occur at some point, but they did not set any

concrete terms or make any binding agreement.     It is apparent

from the testimony that the Inverness agreement was merely an
                                - 23 -

agreement to make a more formal agreement at a later date.      It

appears that Mr. Marcus attempted to memorialize this by

extending a settlement offer in his January 16, 1997, letter to

Mr. Dunne, but Mr. Dunne did not accept that offer.

     The other facts and circumstances also indicate that the

Inverness agreement did not transfer any accouterments of owning

Mr. Dunne’s shares to Mr. Marcus.    While Mr. Dunne told Mr.

Marcus that he could conduct business as he wished at the

Inverness meeting, Mr. Marcus appears to have already had that

power as president of FRC.   Furthermore, Mr. Dunne was not

exercising significant managerial control before 1997.    In

addition, after the Inverness agreement, Mr. Dunne continued to

receive dividends from FRC and he continued to enjoy the benefits

and burdens of being a shareholder because he had not fixed a

selling price for his shares.    Mr. Dunne also exercised his right

as a shareholder to petition for appointment of a custodian for

FRC in a State court.   Finally, Mr. Dunne repeatedly asserted to

FRC and third parties that he continued to be a shareholder of

FRC after 1996.   Therefore, we find that Mr. Dunne retained

beneficial ownership of FRC for at least part of 1997.

     We next consider whether the May 8, 1997, settlement

agreement transferred beneficial ownership of Mr. Dunne’s stock
                               - 24 -

to Mr. Marcus.4   The parties do not dispute that the settlement

agreement, unlike the Inverness agreement, was a valid and

legally enforceable contract under which Mr. Dunne agreed to sell

his FRC stock.    However, because the settlement agreement did not

terminate Mr. Dunne’s interest in FRC until the settlement date,

which in 1997 was still some unspecified date in the future, we

must consider whether Mr. Marcus nonetheless possessed

substantially all of the accouterments of ownership by May 8,

1997.

     The key provisions of the settlement agreement are that in

exchange for his stock Mr. Dunne would receive the book value of

FRC, set at $175,000, and half of the profit from the halon

contract.    Mr. Dunne’s FRC stock would be held in escrow until he

received his share of the halon contract and the book value of

his stock.   The settlement agreement also provided that Mr. Dunne

would have no shareholder or director rights after the settlement

date, which was to be the date of signing a memorializing

document anticipated to be no later than May 16, 1997.

     Respondent argues that because the settlement agreement

expressly provided that Mr. Dunne would hold no shareholder


     4
       While respondent argues that petitioners have abandoned
this alternative argument because they did not argue it in their
posttrial brief, we believe that it is in the best interest of
justice to consider this alternative argument. During the trial,
we raised the issue of whether it was appropriate to consider the
settlement date as the date of sale, and respondent addressed
this issue on brief.
                              - 25 -

rights after the settlement date, Mr. Dunne would retain

beneficial ownership of his shares until the settlement date, and

therefore petitioners must come forward with “strong proof” to

contradict this language.   While we agree that respondent’s

interpretation of this language is plausible, we find that this

language is ambiguous and therefore petitioners need not refute

it with “strong proof”.   See Danenberg v. Commissioner, 73 T.C.

at 391-392; Lucas v. Commissioner, 58 T.C. at 1032.   It is

undisputed that Mr. Dunne retained the right to keep legal title

to the stock after he signed the settlement agreement.   Mr.

Marcus testified at trial that he and Mr. Dunne intended that Mr.

Dunne would retain beneficial ownership of his shares until the

settlement date, but we did not find his testimony to be any more

credible than Mr. Dunne’s testimony that this was not his

intention, particularly because of the animosity between the two

witnesses.   Because the settlement agreement does not specify

whether the “shareholder rights” include more than the retention

of legal title to the stock, we will not require a higher

standard of proof because of this statement.

      To determine whether an agreement that does not itself

transfer legal title nonetheless transfers substantially all of

the accouterments of ownership, we look at all of the facts and

circumstances surrounding the transfer, relying on objective

evidence of the parties’ intentions provided by their overt acts.
                                - 26 -

Ragghianti v. Commissioner, 71 T.C. at 349-350; Pacific Coast

Music Jobbers, Inc. v. Commissioner, 55 T.C. at 874.     Some of the

factors that we have considered in determining whether a person

holds the accouterments of stock ownership for Federal income tax

purposes are:

     (1)   Whether the person has legal title or a contractual

right to obtain legal title in the future, Ragghianti v.

Commissioner, supra at 349;

     (2)   whether the person has the right to receive

consideration from the transferee of the stock, Hook v.

Commissioner, 58 T.C. 267, 275 (1972); Willie v. Commissioner,

T.C. Memo. 1991-182;

     (3)   whether the person enjoys the economic benefits and

burdens of being a shareholder, Pacific Coast Music Jobbers, Inc.

v. Commissioner, supra at 875-876; Yelencsics v. Commissioner, 74

T.C. 1513, 1527 (1980);

     (4)   whether the person has the power to control the

company, Yelencsics v. Commissioner, supra at 1527; Cepeda v.

Commissioner, T.C. Memo. 1994-62, affd. without published opinion

56 F.3d 1384 (5th Cir. 1995);

     (5)   whether the person has the right to attend shareholder

meetings, Yelencsics v. Commissioner, supra at 1528; Ragghianti

v. Commissioner, supra at 350-351;
                               - 27 -

     (6)    whether the person has the ability to vote the shares,

Yelencsics v. Commissioner, supra at 1528; Pacific Coast Music

Jobbers, Inc. v. Commissioner, supra at 874;

     (7)    whether the stock certificates are in the person’s

possession or are being held in escrow for the benefit of that

person, Pacific Coast Music Jobbers, Inc. v. Commissioner, supra

at 874;

     (8)    whether the corporation lists the person as a

shareholder on its tax returns, Feraco v. Commissioner, T.C.

Memo. 2000-312; Pahl v. Commissioner, T.C. Memo. 1996-176, affd.

150 F.3d 1124 (9th Cir. 1998);

     (9)    whether the person lists himself as a shareholder on

his individual tax return, Willie v. Commissioner, supra; Wilson

v. Commissioner, T.C. Memo. 1975-92, affd. 560 F.2d 687 (5th Cir.

1977);

     (10)    whether the person has been compensated for the amount

of income taxes due by reason of the person’s shareholder status,

Hightower v. Commissioner, T.C. Memo. 2005-274;

     (11)    whether the person has access to the corporate books,

Haskel v. Commissioner, T.C. Memo. 1980-243; and

     (12)    whether the person shows by his overt acts that he

believes he is the owner of the stock, Pahl v. Commissioner,

supra; Willie v. Commissioner, supra.
                              - 28 -

     None of these factors alone is determinative, and their

weight in each case depends on the surrounding facts and

circumstances.   One difficulty in this case is that it is not

clear what rights an FRC shareholder was supposed to possess

because FRC did not observe any corporate formalities.

Furthermore, Mr. Marcus was a shareholder both before and after

Mr. Dunne transferred beneficial ownership of his stock.

Therefore, we will consider these factors in light of the rights

Mr. Dunne had as a shareholder of FRC before the settlement

agreement that he no longer had afterward, and where relevant,

what rights Mr. Marcus did or did not gain as a result of the

settlement agreement.

     The fact that the settlement agreement gave Mr. Marcus the

right to obtain legal title to the stock upon the satisfaction of

certain conditions, which were likely to be satisfied at some

point, weighs in favor of petitioners.   See Pacific Coast Music

Jobbers, Inc. v. Commissioner, supra at 874.   While there was

certainly much dispute over some of the terms of the settlement

agreement, particularly the amount due to Mr. Dunne under the

halon contract, it is undisputed that the settlement agreement

contained Mr. Dunne’s binding agreement to sell his stock for an

amount that could be objectively determined and that Mr. Marcus

had the intention and ability to comply with the terms of the

sale once the disputes were settled.   It appears that the signing
                              - 29 -

of a memorializing document was intended to be a mere formality.

The settlement date was anticipated to be no more than 8 days

after the signing of the agreement and there were no contract

terms left to be decided on the settlement date, which suggests

that the memorializing document would not contain any terms

additional to or different from those contained in the settlement

agreement.   Furthermore, the arbitrator found the settlement

agreement sufficiently definite to order the parties to comply

with its terms in the arbitration award without requiring the

parties to draw up a new memorializing document.   Therefore,

while under the terms of the settlement agreement Mr. Dunne had

the right to retain legal title of his stock until the settlement

date, the fact that the settlement agreement gave Mr. Marcus the

right to legal title upon the satisfaction of certain conditions

is a stronger indicium of beneficial ownership.    See id. at 874.

     Similarly, the fact that the settlement agreement gave Mr.

Dunne a contractual right to obtain $175,000 and his share of the

halon contract from Mr. Marcus as consideration for his shares

weighs in favor of petitioners.   We have recognized that a

transfer of beneficial ownership can occur before the entire sale

price has been paid.   See Pacific Coast Music Jobbers, Inc. v.

Commissioner, 55 T.C. 866 (1971).

     The next factor we consider is whether Mr. Dunne continued

to enjoy the economic benefits and burdens of being a shareholder
                              - 30 -

after the settlement agreement.   Benefits and burdens of stock

ownership generally include sharing in the successes and failures

of the corporation and receiving dividends.     Id. at 875-876;

Yelencsics v. Commissioner, 74 T.C. at 1528.

     Before the settlement agreement, Mr. Dunne shared in the

successes and failures of FRC because those successes and

failures affected the value of his stock.     After the settlement

agreement, Mr. Dunne ceased to share in most of the business

successes and failures of FRC because he agreed to sell his stock

for the book value of FRC and his share of the halon contract.

Mr. Dunne and Mr. Marcus agreed to set the book value of FRC at

$175,000, and there is no indication that either Mr. Dunne or Mr.

Marcus could renegotiate that amount if the value of FRC were to

change substantially between May 8, 1997, and the settlement

date.   Therefore, with the exception of FRC’s performance on the

halon contract, FRC’s successes and failures had no economic

effect on Mr. Dunne after May 8, 1997.

     Mr. Dunne received monthly dividends from FRC from January

through April of 1997, but he received no dividends after the

settlement agreement.   Had Mr. Dunne retained beneficial

ownership of FRC, we would expect these dividends to have

continued through the end of 1997.     However, Mr. Marcus also

ceased receiving dividends after April 1997.     Had the settlement

agreement transferred beneficial ownership of Mr. Dunne’s shares
                                - 31 -

to Mr. Marcus, we would expect FRC to have paid Mr. Marcus double

the amount of monthly dividends that it had previously been

paying.   Therefore, the nonpayment of dividends after April 1997

merely indicates that FRC was not sure what Mr. Dunne’s status

was after the settlement agreement.

     The fact that Mr. Dunne was not compensated for any taxes

relating to FRC’s income after the settlement agreement favors

petitioners.   FRC generally had a practice of compensating its

shareholders for the income taxes they owed by virtue of their

stock ownership.   Had FRC considered Mr. Dunne to be a

shareholder, it would have paid the amount of the taxes either to

or on behalf of Mr. Dunne.

     Throughout Mr. Dunne’s correspondence with FRC’s bank and

the bank’s attorney in September and October 1997, Mr. Dunne

repeatedly asserted that he was a director, officer, and coowner

of FRC.   Mr. Dunne’s request for proof that he did not have those

titles after the bank denied him access to certain records

suggests that he asserted those titles with the belief that they

entitled them to this access.    Mr. Dunne also used those titles

when he wrote to an FRC employee to request copies of FRC’s Form

1120S and his Schedule K-1 for 1997.

     Petitioners argue that Mr. Dunne asserted these titles

because he retained legal ownership of FRC and he believed he had

rights as a creditor of FRC.    Petitioners also rely on Mr.
                                - 32 -

Marcus’s statement in his March 18, 1997, letter that it was his

position that Mr. Dunne had in effect already sold his shares.

While Mr. Dunne’s actions indicate he believed he retained an

interest in his FRC stock after signing the settlement agreement,

we find that his belief was not based on a clear understanding of

the law or the nature of his interest and is not controlling.

       While petitioners argue that Mr. Dunne’s lack of managerial

control over FRC after the settlement agreement favors them, we

disagree.    It is not clear whether Mr. Dunne exercised any

managerial control at all before 1997 or, if he did, whether he

exercised control as a shareholder as opposed to an employee.

See Pacific Coast Music Jobbers, Inc. v. Commissioner, supra at

877.    Furthermore, any decrease in Mr. Dunne’s control over FRC

is consistent with Mr. Marcus’s termination of Mr. Dunne’s

employment on January 25, 1997.    The fact that Mr. Marcus was in

complete control of FRC in 1997 is consistent with his status as

FRC’s president.    Therefore, in the absence of evidence that

shareholders of FRC had a right to manage, this factor is

neutral.

       The facts that Mr. Dunne did not participate in shareholder

meetings or vote his shares are neutral because FRC never

maintained these corporate formalities.

       The fact that Mr. Dunne retained possession of the FRC stock

certificates is also neutral.    While a transfer of the stock
                                - 33 -

certificates would have helped petitioners’ case, retaining

possession of stock merely as security to ensure payment for the

stock does not indicate retained beneficial ownership in this

case.     Hook v. Commissioner, 58 T.C. at 275; Pacific Coast Music

Jobbers, Inc. v. Commissioner, supra at 875.

        The facts that FRC listed Mr. Dunne as a shareholder on its

return and petitioners did not list Mr. Dunne as a shareholder on

their return are neutral when examined together because there is

no reason to believe that either return is probative.

        Because Mr. Dunne had access to some of FRC’s records after

the settlement agreement but then was denied access to others,

these facts together are neutral.     The most likely explanation is

the one given by FRC’s bank--that the bank was unsure whether Mr.

Dunne continued to be a shareholder after the settlement

agreement and it did not want to take unnecessary risks.

        It is clear from the record that no one involved was sure

whether Mr. Dunne was a shareholder of FRC after May 8, 1997,

including Mr. Dunne himself.     While we find that Mr. Dunne

believed that he was a still a shareholder in 1997 when he

thought that was his most advantageous position, his belief was

not based on a clear understanding of the law and is not

controlling.     The halon contract was Mr. Dunne’s only interest in

FRC after the settlement agreement.      In light of our analysis of

the above factors, we find that Mr. Dunne’s retention of an
                                  - 34 -

interest in a single contract, over which he was exercising no

managerial control after May 8, 1997, did not prevent him from

transferring substantially all of the accouterments of ownership

of FRC to Mr. Marcus in the settlement agreement.

       Considering all of these factors, we hold, on the basis of

our finding that Mr. Dunne ceased to be a shareholder of FRC on

May 8, 1997, that petitioners must pay tax on their pro rata

share of FRC’s tax items.

III.    Whether Mrs. Dunne Qualifies for Relief From Joint
        Liability Under Section 6015 for 1997

       Section 6013(d)(3) provides that taxpayers filing a joint

return are jointly and severally liable for the taxes due.

Section 6015 provides that notwithstanding section 6013(d)(3),

under certain facts and circumstances a taxpayer may be relieved

of joint and several liability.       Except as otherwise provided in

section 6015, the requesting spouse bears the burden of proof.

Rule 142(a); Alt v. Commissioner, 119 T.C. 306, 311 (2002), affd.

101 Fed. Appx. 34 (6th Cir. 2004).

       Mrs. Dunne argues that she is entitled to relief under

section 6015(b) or (f).       Relief under section 6015(b)(1) is

available if:

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

            (B) on such return there is an understatement of
       tax attributable to erroneous items of 1 individual
       filing the joint return;
                              - 35 -

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

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

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

Respondent concedes that Mrs. Dunne meets all of these conditions

except for those found in section 6015(b)(1)(C) and (D).

     Under section 6015(b)(1)(C), Mrs. Dunne is eligible for

relief under this section only if she did not know or have reason

to know at the time she signed the joint return that there was an

understatement of tax on the return.

     Petitioners’ omission of income in 1997 arose because Mr.

Dunne was a shareholder of FRC until May 8, 1997, but petitioners

treated Mr. Dunne as ceasing to be a shareholder no later than

December 31, 1996.   Mrs. Dunne’s Form 8857 makes it clear that

she was aware that there were some issues regarding Mr. Dunne’s

connection with FRC, but she did not know any of the

circumstances of the sale because she relied upon Mr. Dunne to

handle the tax return, and Mr. Dunne relied upon the advice of an

attorney that petitioners were not required to report the income

on the Schedule K-1.
                                - 36 -

     Generally, blind reliance upon the other spouse to handle

tax issues is not sufficient to allow the requesting spouse to

avoid liability under section 6015.      See Butler v. Commissioner,

114 T.C. 276, 283-284 (2000).    However, Mrs. Dunne asked Mr.

Dunne whether the sale of his FRC stock would create any problems

relating to their taxes, and Mr. Dunne assured her that he was

handling the sale properly according to advice from his attorney.

This is a unique case with complicated facts and legal issues,

and we find that Mrs. Dunne satisfied her duty of inquiry.      See

Juell v. Commissioner, T.C. Memo. 2007-219.     Therefore, we find

that Mrs. Dunne did not have actual or constructive knowledge

that there was an omission on petitioners’ 1997 tax return and

thus satisfies the section 6015(b)(1)(C) requirement.

     However, Mrs. Dunne fails to satisfy the fourth condition.

Under section 6015(b)(1)(D), relief is available under that

section only if, taking into account all the facts and

circumstances, it would be inequitable to hold the requesting

spouse liable for the deficiency.    The two most often cited

factors to be considered are:    (1) Whether there has been a

significant benefit to the spouse claiming relief, and (2)

whether the failure to report the correct tax liability on the

joint return results from concealment, overreaching, or any other

wrongdoing on the part of the other spouse.      Alt v. Commissioner,

supra at 314.
                              - 37 -

     Mrs. Dunne had full access to petitioners’ joint checking

and savings accounts, and she offered no evidence that Mr. Dunne

deposited the dividends he received from FRC into a separate

account that she could not access.     Since it appears Mrs. Dunne

financially benefited as much as did Mr. Dunne from ownership of

FRC and from avoiding taxation on his share of income, the

significant benefit factor does not favor Mrs. Dunne’s position.

See Richardson v. Commissioner, T.C. Memo. 2006-69, affd. 509

F.3d 736 (6th Cir. 2007).   Furthermore, Mrs. Dunne has offered no

evidence that Mr. Dunne concealed anything from her or committed

any wrongdoing.

     We may also consider factors used in determining “inequity”

in the context of section 6015(f).     Juell v. Commissioner, T.C.

Memo. 2007-219.   However, because we find without relying on the

other factors that Mrs. Dunne has not shown that she is eligible

for relief under section 6015(b), and because we find that taken

together those factors weigh against relief for Mrs. Dunne, as

discussed below, we need not consider them here also.

     Section 6015(f) provides that the Secretary may relieve an

individual of joint and several liability if relief is not

available to the individual under section 6015(b) or (c) and it

is inequitable to hold the individual liable for any deficiency

taking into account all the facts and circumstances under

procedures prescribed by the Secretary.    These procedures are
                              - 38 -

found in Rev. Proc. 2003-61, 2003-2 C.B. 296.   We review

respondent’s denial of relief under section 6015(f) for abuse of

discretion.   See Alt v. Commissioner, 119 T.C. at 315-316.

     Rev. Proc. 2003-61, sec. 4.01, 2003-2 C.B. at 297, provides

seven threshold conditions to determine relief.   Respondent

concedes that Mrs. Dunne satisfies these conditions.    Mrs. Dunne

mistakenly argues that she is entitled to relief by satisfying

these threshold conditions alone.   On the contrary, after a

taxpayer satisfies the threshold requirements, Rev. Proc. 2003-

61, sec. 4.03, 2003-2 C.B. at 298, provides the Commissioner a

nonexclusive list of factors that the Commissioner uses in

determining whether the individual is entitled to relief on the

basis of all the facts and circumstances in the case.   The

relevant factors to be considered here are marital status,

economic hardship, knowledge or reason to know, significant

benefit, and compliance with the income tax laws.

     The fact that petitioners have been married and living

together at all relevant times is neutral.

     The economic hardship factor also weighs against Mrs. Dunne.

Mrs. Dunne’s only argument regarding this factor is that the

amount of tax due is large.   However, Mrs. Dunne has not provided

any evidence that (1) she will suffer economic hardship if we do

not grant her relief, (2) she does not have sufficient assets to
                               - 39 -

pay this liability, or (3) the burden of paying this liability

will fall on her instead of Mr. Dunne.

     The knowledge factor weighs in favor of Mrs. Dunne.    As we

stated in our discussion of section 6015(b)(1)(C), given the

circumstances of this case, Mrs. Dunne had no reason to know that

Mr. Dunne held beneficial ownership of FRC through May 8, 1997,

and she satisfied her duty of inquiry.

     As discussed above, Mrs. Dunne presumably received some

benefit from Mr. Dunne’s status as a shareholder during 1997

because she shared bank accounts with Mr. Dunne, most likely had

access to the dividends he received from FRC, and benefited as he

did from avoiding tax on his share of its income.   This factor

weighs against Mrs. Dunne.   See Richardson v. Commissioner,

supra.

     The compliance with the income tax law factor weighs

slightly against Mrs. Dunne.   Mrs. Dunne testified that the one

thing she knows about the tax law is that income tax returns are

due on April 15, yet as discussed below she failed to file her

1999 tax return on time without any reasonable cause.

     Mrs. Dunne has not argued that there are any other factors

that we should consider.   We find on the basis of all the facts

and circumstances Mrs. Dunne has failed to carry her burden and

thus is not entitled to equitable relief under section 6015(f),
                                - 40 -

and we find respondent did not abuse his discretion in denying

Mrs. Dunne such relief.

IV.   Whether Petitioners May Claim $20,000 of Legal Expenses That
      They Incurred in 1999 as Trade or Business Expenses

      In the notice of deficiency respondent disallowed a

deduction for $20,000 that petitioners listed on their Schedule C

as a business expense but added the $20,000 deduction to their

Schedule A as a miscellaneous itemized expense.    If the $20,000

is deductible on petitioners’ Schedule C, then it is not subject

to the 2-percent floor generally applicable to miscellaneous

itemized deductions under section 67.

      Deductions are a matter of legislative grace, and taxpayers

bear the burden of proving entitlement to the deductions claimed.

Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440

(1934).   In addition, taxpayers must maintain sufficient records

to substantiate any deductions claimed.    Sec. 6001.

      Petitioners argue that the notice of deficiency is arbitrary

as to the tax items for 1999.    As discussed below, in certain

cases we have found that the Commissioner’s presumption of

correctness does not attach when a determination is found to be a

“naked” assessment and therefore arbitrary and excessive.

However, this doctrine applies only to unreported income, and the

usual presumption of correctness attaches when taxpayers assert

that the notice of deficiency is incorrect as to disallowed
                              - 41 -

deductions.   Hutchinson v. Commissioner, T.C. Memo. 1980-551.

Furthermore, if taxpayers do not substantiate their claimed

deductions, the Commissioner is not arbitrary or unreasonable in

denying them.   Roberts v. Commissioner, 62 T.C. 834, 837 (1974);

Taylor v. Commissioner, T.C. Memo. 2006-67.

      Petitioners offered no evidence regarding any expenditures

they made that would be eligible for a trade or business expense

deduction on their Schedule C.   Petitioners argue on brief that

these expenses were incurred for the collection of income, but

they offered no evidence to substantiate that the income was from

a trade or business they conducted.    Therefore, petitioners’

legal expenses are properly deductible only on their Schedule A.

V.   Whether Petitioners Had $15,000 of Unreported Income in 1999

      In the notice of deficiency, respondent determined that

petitioners failed to report a $15,000 capital gain.    In general,

the Commissioner’s determinations are presumed correct, and the

taxpayers bear the burden of proving that they are wrong.    Rule

142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).    The Court

generally will not look behind a notice of deficiency to examine

the evidence used or the propriety of the Commissioner’s motives

or procedures in making his determination.    Greenberg’s Express,

Inc. v. Commissioner, 62 T.C. 324, 327 (1974).    To overcome this

presumption of correctness, taxpayers may produce evidence that

the statutory notice is arbitrary or without foundation.
                              - 42 -

Helvering v. Taylor, 293 U.S. 507, 515 (1935); Cebollero v.

Commissioner, 967 F.2d 986, 990 (4th Cir. 1992), affg. T.C. Memo.

1990-618.

     On rare occasions, this Court has recognized an exception to

these rules in cases involving unreported income where the

Commissioner introduces no substantive evidence but relies solely

on the presumption of correctness.     Jackson v. Commissioner, 73

T.C. 394, 401 (1979).   In such cases, if the taxpayers challenge

the notice of deficiency on the ground that it is arbitrary, then

the determination is treated as a “naked” assessment and the

presumption of correctness does not attach.     Id.   However, this

is a limited exception, and it does not apply when the

Commissioner has provided a minimal evidentiary foundation.

Petzoldt v. Commissioner, 92 T.C. 661, 687-688 (1989); Fankhanel

v. Commissioner, T.C. Memo. 1998-403, affd. without published

opinion 205 F.3d 1333 (4th Cir. 2000).

     This exception to the presumption of correctness (the

exception) has been widely accepted among the Courts of Appeals.

See Blohm v. Commissioner, 994 F.2d 1542, 1549 (11th Cir. 1993),

affg. T.C. Memo. 1991-636; Dodge v. Commissioner, 981 F.2d 350,

353 (8th Cir. 1992), affg. in part and revg. in part 96 T.C. 172

(1991); Portillo v. Commissioner, 932 F.2d 1128, 1133-1134 (5th

Cir. 1991), affg. in part and revg. in part T.C. Memo. 1990-68;

United States v. Walton, 909 F.2d 915, 919 (6th Cir. 1990); Ruth
                              - 43 -

v. United States, 823 F.2d 1091, 1094 (7th Cir. 1987); Llorente

v. Commissioner, 649 F.2d 152, 156 (2d Cir. 1981), affg. in part

and revg. in part 74 T.C. 260 (1980); Weimerskirch v.

Commissioner, 596 F.2d 358, 362 (9th Cir. 1979), revg. 67 T.C.

672 (1977); Gerardo v. Commissioner, 552 F.2d 549, 554 (3d Cir.

1977), affg. in part and revg. in part T.C. Memo. 1975-341.

     The Court of Appeals for the Fourth Circuit, to which this

case is appealable, has recognized the use of this exception by

other courts but has not had the occasion to expressly adopt or

reject it.   See Williams v. Commissioner, 999 F.2d 760, 763-764

(4th Cir. 1993), affg. T.C. Memo. 1992-153.   Because the Court of

Appeals for the Fourth Circuit has not expressly resolved the

issue of whether the Commissioner’s failure to present a minimal

evidentiary foundation prevents the presumption of correctness

from attaching,5 we apply the rule we stated in Jackson that has


     5
       In Cebollero v. Commissioner, 967 F.2d 986, 990 (4th Cir.
1992), affg. T.C. Memo. 1990-618, the Court of Appeals for the
Fourth Circuit stated:

     in the first phase of a deficiency suit, the issue is
     the arbitrariness of the Commissioner's determination,
     and the taxpayer bears the burden of persuasion by a
     preponderance of the evidence. That burden remains
     with the taxpayer, and never shifts to the government.
     If the taxpayer proves that the determination is
     arbitrary, the presumption of correctness vanishes.* * *
However, the Court of Appeals has not clarified whether the
taxpayer satisfies the initial burden of persuading the court
that the determination is arbitrary by alleging that the
Commissioner has not introduced any substantive evidence and is
relying solely on the presumption of correctness, or if the
                                                   (continued...)
                               - 44 -

been approved by the majority of the Courts of Appeals.     See

Golsen v. Commissioner, 54 T.C. 742, 757 (1970), affd. 445 F.2d

985 (10th Cir. 1971).

     The first requirement for the exception to apply is that the

taxpayers challenge the notice of deficiency on grounds that it

is arbitrary.   In addition to raising the argument, this

generally requires that the taxpayers actually dispute that they

received the unreported income, either by filing a Form 1040 that

they signed under penalty of perjury for the year at issue or by

stating facts that tend to show that they did not in fact receive

the disputed income.    Andrews v. Commissioner, T.C. Memo. 1998-

316; White v. Commissioner, T.C. Memo. 1997-459.    But see Senter

v. Commissioner, T.C. Memo. 1995-311.

     Petitioners have satisfied this requirement.   They allege in

their petition that the notice of deficiency was arbitrary as to

all determinations relating to 1999, and they filed a signed Form

1040 for 1999 that did not include a $15,000 capital gain.

     The second requirement for the exception to apply is that

the Commissioner introduced no substantive evidence but relied

solely on the presumption of correctness.    Jackson v.

Commissioner, supra.    The presumption of correctness will apply



     5
      (...continued)
taxpayer must come forward with substantive evidence that the
determination is arbitrary to satisfy that initial burden.
                              - 45 -

if the Commissioner provides a minimal evidentiary foundation

showing that there is a link between the taxpayers and either the

taxable income or the income-producing activity.   Petzoldt v.

Commissioner, supra; Kaufman v. Commissioner, T.C. Memo. 2003-

262; Fankhanel v. Commissioner, supra; Prindle Intl. Mktg. v.

Commissioner, T.C. Memo. 1998-164, affd. without published

opinion sub nom. Fox v. Commissioner, 229 F.3d 1157 (9th Cir.

2000).

     The only evidence either party submitted regarding the

unreported capital gain issue was a copy of petitioners’ 1999

Form 1040, the examination report, and the notice of deficiency.

In these documents, the only explanation of respondent’s

determination that petitioners received unreported income in 1999

is the following statement made to petitioners in the notice of

deficiency:   “It is determined that you realized a capital gain

in the amount of $15,000.00 for tax year 1999.   Accordingly,

taxable income is increased $15,000.00 for the tax year ending

December 31, 1999.”

     The examination report contains an explanation section for

capital gains and losses, but the entire discussion in that

section relates to Mr. Dunne’s issues with FRC, and there is no

reference to a $15,000 capital gain in 1999 in either the facts

or conclusion of that section.   The examination report did state

in its conclusion that it will be necessary to compute the
                               - 46 -

gain/loss on the sale of the FRC stock, but respondent has not

argued that the alleged unreported income relates to the sale of

Mr. Dunne’s FRC stock.   Because respondent has not shown us any

link between petitioners and either the $15,000 of unreported

income or any income-producing activity that could have generated

a $15,000 capital gain, respondent has not provided the minimal

evidentiary foundation required for the presumption of

correctness to attach on this issue.    Therefore, respondent has

not met the initial burden of showing that petitioners had

unreported income in 1999 that is normally satisfied by the

presumption of correctness, and we find for petitioners on this

issue.   See Foster v. Commissioner, 391 F.2d 727, 735 (4th Cir.

1968), affg. in part and revg. in part T.C. Memo. 1965-246.

VI.   Whether Petitioners are Liable for Additions to Tax Under
      Section 6651(a)(1) for 1997 and 1999

      Section 6651(a)(1) imposes an addition to tax of up to 25

percent of the amount required to be shown as tax for failure to

timely file a Federal income tax return unless the taxpayers show

that the failure was due to reasonable cause and not due to

willful neglect.

      Section 7491(c) places the burden of production on the

Commissioner to show that the imposition of an addition to tax is

appropriate.   To satisfy this burden, the Commissioner must

present sufficient evidence that the particular addition to tax

is appropriate.    Higbee v. Commissioner, 116 T.C. 438, 446
                              - 47 -

(2001).   If the Commissioner makes such a showing, the burden of

proof is on the taxpayers to raise any issues that would negate

the appropriateness of the penalty, such as reasonable cause.

Id.   Reasonable cause exists if the taxpayers “‘exercised

ordinary business care and prudence and [were] nevertheless

unable to file the return within the prescribed time’.”       United

States v. Boyle, 469 U.S. 241, 243 (1985) (quoting sec. 301.6651-

1(c)(1), Proced. & Admin. Regs.).

      The parties stipulated that petitioners did not timely file

their 1997 or 1999 Federal income tax return.    Furthermore, it is

undisputed that petitioners had an obligation to file income tax

returns for 1997 and 1999 under section 6012.    Therefore,

respondent has satisfied the initial burden of producing evidence

to show that the addition to tax is appropriate.

      Petitioners assert three reasons they had reasonable cause

for failing to file their tax returns on time: (1) The ongoing

litigation between Mr. Dunne, Mr. Marcus, and FRC prevented them

from filing on time; (2) they did not receive Mr. Dunne’s

Schedule K-1 in time; and (3) they received legal advice to

exclude FRC’s income from their 1997 return.    Because the 1999

return contained no items that were related to FRC, only the

first reason may provide any reasonable cause for petitioners’

failure to file their 1999 tax return on time.
                              - 48 -

     As we discussed above, the ongoing litigation between Mr.

Dunne, Mr. Marcus, and FRC was not determinative of the issue of

when Mr. Dunne ceased to be a beneficial owner of FRC and the

related income tax consequences.   While we agree that Mr. Dunne’s

shareholder status was a confusing issue, we are not persuaded

that this litigation prevented petitioners from filing their

returns on time.

     Contrary to petitioners’ arguments, being involved in

litigation does not excuse them from filing their Federal income

tax returns on time.   The cases they cite do not support their

argument because petitioners would have been required to file

income tax returns even if they had been awarded nothing under

the arbitration and subsequent litigation, and petitioners were

not suffering from incapacitating illnesses or otherwise disabled

from filing a return during any relevant time.   See Commissioner

v. Walker, 326 F.2d 261 (9th Cir. 1964), affg. in part and revg.

in part 37 T.C. 962 (1962); Adams v. Commissioner, T.C. Memo.

1990-478; Harris v. Commissioner, T.C. Memo. 1969-49.

     Petitioners’ argument that they did not have all of the

necessary records to file their 1997 return because they did not

receive Mr. Dunne’s Schedule K-1 in time is also unpersuasive.

Petitioners correctly point out that the Internal Revenue Manual

(IRM) states that the inability to obtain records may constitute

reasonable cause.   6 Administration, Internal Revenue Manual
                              - 49 -

(CCH), pt. 20.1.1.3.1.2.5, at 45,014 (Aug. 20, 1998).   The IRM

states that whether the inability to obtain necessary records

constitutes reasonable cause depends on the facts and

circumstances in each case, considering factors including:    (1)

Why the records were needed to comply; (2) what steps the

taxpayers took to secure the records; (3) when the taxpayers

became aware that they did not have the necessary records; (4) if

other means were explored to secure the needed information; (5)

why the taxpayers did not estimate the information; (6) if the

taxpayers contacted the IRS   for instructions on what to do about

missing information; and (7) if the taxpayers complied once the

missing information was received.

     The IRM does not help petitioners.   They provided no

explanation as to:   (1) Why they thought that they needed the

Schedule K-1 to file their return if they were taking the

position that Mr. Dunne was not a shareholder in 1997; (2) why

they did not request a Schedule K-1 until April 15, 1998; (3)

whether they considered any other ways of obtaining the

information on the Schedule K-1; (4) why they did not estimate

the information, especially since Mr. Dunne knew about how much

income FRC earned in 1997 and, regardless of that amount,

petitioners took the position that Mr. Dunne was not an FRC

shareholder in 1997; (5) whether they contacted the IRS for

instructions and, if so, whether they followed those
                               - 50 -

instructions; or (6) when they actually received the Schedule K-1

and how long it took them to file their return after receiving

it.

       It is well settled that taxpayers must file timely income

tax returns on the basis of the best information available to

them at the time, and they may file amended returns if necessary.

Estate of Vriniotis v. Commissioner, 79 T.C. 298, 311 (1982);

Elec. & Neon, Inc. v. Commissioner, 56 T.C. 1324, 1342-1344

(1971), affd. without published opinion 496 F.2d 876 (5th Cir.

1974); Ruddel v. Commissioner, T.C. Memo. 1996-125.    Petitioners

knew approximately what FRC’s income was for 1997, and there is

no reason they could not have used that information to timely

file their 1997 tax return and then file an amended return once

they received the Schedule K-1.    Furthermore, petitioners have

not provided us any evidence of when they received the Schedule

K-1.    Thus, we are not convinced that they did not have it in

time to file their 1997 return.    Even if this was the case, the

fact that petitioners filed their 1997 return on September 1,

1999, over a year after it was due after the extension, suggests

that they did not exercise ordinary business care and prudence to

file their return on time.

       Petitioners’ argument that they received legal advice to

exclude the amounts reported on the Schedule K-1 is without

merit.    Whether or not petitioners should have excluded the
                                - 51 -

Schedule K-1 is irrelevant to the issue of whether they were

required to file their returns on time.   Furthermore, even if the

advice had provided a reasonable cause for not filing on time,

the memorandum containing the written advice was dated October 9,

1998, almost two months after petitioners were required to file

their 1997 return.   Thus, it is unlikely that petitioners

actually relied upon any legal advice when making the decision

not to file their 1997 tax return on time.   See Estate of Hinz v.

Commissioner, T.C. Memo. 2000-6.

     Accordingly, we find that petitioners did not have

reasonable cause for failure to file their 1997 and 1999 income

tax returns on time and therefore sustain respondent’s

determination that petitioners are liable for the additions to

tax under section 6651(a)(1).

     To reflect the foregoing and concessions of the parties,


                                          Decision will be entered

                                     under Rule 155.
