                  T.C. Memo. 2003-188



                UNITED STATES TAX COURT



         MARY CATHERINE PIERCE, Petitioner v.
     COMMISSIONER OF INTERNAL REVENUE, Respondent



Docket No. 8557-01.             Filed June 30, 2003.



          P seeks relief, under sec. 6015, I.R.C.,
     from income tax liabilities that were
     assessed in accord with this Court’s holding
     in an earlier opinion. In this proceeding, P
     failed to plead, as an affirmative defense,
     collateral estoppel as to one of the factual
     issues in controversy, as required in Rule 39
     of this Court’s Rules of Practice and
     Procedure. P orally raised collateral
     estoppel in her opening statement at the
     beginning of the trial, and R did not object
     or address the question of collateral
     estoppel until R did so in his posttrial
     brief. No additional evidence is required to
     decide whether any holding in our prior
     opinion would result in an estoppel. Rule
     41(b)(1) of this Court’s Rules of Practice
     and Procedure provides that an issue may be
     tried by implied consent where the issue was
     not specifically pleaded. R contends that
     P’s failure to specifically plead an
                               - 2 -

          affirmative defense results in waiver of the
          defense. P contends that collateral estoppel
          was placed in controversy with R’s implied
          consent.

                Held: The requirement of Rule 39 of this
          Court’s Rules of Practice and Procedure to plead
          an affirmative defense is satisfied in this case
          by the implied consent principles of Rule 41 of
          this Court’s Rules of Practice and Procedure, and
          it is

               Held further: Respondent is not
          collaterally estopped from denying that P did
          not know or had no reason to know of the
          understatement, and it is

               Held further: P had reason to know of
          the understatement and it would not be
          inequitable to hold that P is not entitled to
          relief from joint liabilities under sec.
          6015, I.R.C.



          Robert J. Percy, for petitioner.

          Robert E. Marum and Michael J. Proto, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     GERBER, Judge:   Petitioner seeks relief from joint and

several income tax liability under section 6015.1   The income tax

liability derives from income tax deficiencies that were assessed

in accordance with this Court’s holding in Pierce v.

Commissioner, T.C. Memo. 1997-411 (Pierce I) as follows:


     1
       All section references are to the Internal Revenue Code,
and all Rule references are to the Tax Court Rules of Practice
and Procedure, unless otherwise indicated.
                                 - 3 -

                 Year            Deficiency

                 1984              $3,513
                 1986              71,974
                 1987             539,914
                 1988             527,851
                 1989             102,323

     Respondent determined that petitioner is not entitled to

relief from joint and several liability under section 6015(b).

Petitioner timely filed a petition seeking review of respondent’s

determination.    The issues we consider are:   (1) Whether an

affirmative defense may be placed in issue under the principle of

implied consent, (2) whether the holding in an earlier opinion

results in respondent’s being collaterally estopped to deny that

petitioner did not know or have reason to know of an

understatement, and (3) whether petitioner is eligible for relief

from joint and several liability under section 6015(b).

                          FINDINGS OF FACT2

     Petitioner resided in Windsor, Connecticut, at the time her

petition was filed.     She completed high school and attended

college for 1 year.     Petitioner married Gary Pierce on November

26, 1966, and they were married at all times pertinent to this

case.    During the years at issue, Mr. Pierce was the sole

shareholder of Mary Catherine Development Corp. (Mary Catherine).

Initially, Mary Catherine purchased unimproved land, developed



     2
       The parties’ stipulation of facts is incorporated by this
reference.
                                - 4 -

and improved it, and then sold the improved realty.   To better

track costs, the business of Mary Catherine was divided amongst

three separate companies.   In addition to Mary Catherine,

Derekseth Corp. (Derekseth) and Deanne Lynn Realty Co. (Deanne

Lynn Realty) were incorporated.   Mary Catherine bought unimproved

land with the intent of making it suitable for housing

construction.    Mary Catherine would then sell the improved land

to Derekseth, which in turn would construct houses for sale.

Upon completion, Deanne Lynn Realty would act as Derekseth’s

agent and market the finished houses.

     Petitioner was the corporate secretary of Mary Catherine.

In this role, she signed various business documents, including,

but not limited to, corporate resolutions and tax returns.

Corporate documents were prepared by Mary Catherine’s attorneys

or controller.   Petitioner relied on explanations provided by Mr.

Pierce as to the content of documents instead of reading them

herself before signing.   One such document was a corporate

resolution signed by petitioner on September 15, 1988.    The

resolution gave Mr. Pierce the authority to “purchase, sell,

assign, mortgage, lease or convey any and all of the real or

personal property of every kind and description of said

corporation, on such terms as he may deem advisable” and to

“execute all deeds, mortgages, releases, leases, or other

instruments necessary to carry into effect” said transactions.
                               - 5 -

In addition to serving as an officer and signing documents for

Mary Catherine, petitioner occasionally acted as a secretary,

opened mail, answered phones, and picked out carpet or tile for

some model homes.   Petitioner also occasionally worked as a part-

time dental assistant.

      During 1989, Mary Catherine owned several unimproved

parcels of land including “the Ridge” in East Granby,

Connecticut, and “Minnechaug” in Glastonbury, Connecticut.

During 1989, the Connecticut real estate market experienced a

severe decline resulting in significant reductions in the values

of both the Ridge and Minnechaug.   Because of severe declines in

the value of real estate, the Federal Deposit Insurance

Corporation (FDIC) required the banks holding mortgages on the

Ridge and Minnechaug to obtain new appraisals.   The new

appraisals reflected lower values, and the banks were required to

reduce the stated values of the properties for regulatory

purposes.   Similarly, Mary Catherine was expected to reflect the

reduction in the values of real estate on its financial

statements.

     Following the advice of its accountants, Mary Catherine

reduced the value of the Ridge as reflected on its December 31,

1989, financial statements and the value of Minnechaug as

reflected on its December 31, 1990, financial statements.    On its

1989 and 1990 Forms 1120S, U.S. Income Tax Return for an S
                               - 6 -

Corporation, Mary Catherine claimed corresponding net operating

losses (NOLs) attributable to the reductions in value.     As a

result of the NOLs claimed on Mary Catherine’s returns, the

Pierces claimed flowthrough losses on their 1989, 1990, and 1991

personal Federal income tax returns.    They then carried back

those losses to obtain refunds of the taxes they had paid for

1984 and 1986 through 1989.3

     Respondent determined that the Pierces were not entitled to

the claimed losses and resulting refunds.   As a result,

respondent determined deficiencies of $3,513, $71,974, $539,914,

$527,851, and $102,323 in the Pierces’ income tax for the years

1984, 1986, 1987, 1988, and 1989, respectively.   The Pierces

filed a petition with this Court (docket No. 6226-94) on April

18, 1994, alleging error with respect to respondent’s

determination of income tax deficiencies.

     The deficiency proceeding was consolidated with another

case, relating to a tax year not in issue in the current

controversy.   Following the consolidated trial, we held that:

(1) Mary Catherine was not entitled to the losses from writedowns

of the values of the Ridge and Minnechaug, (2) the Pierces were

liable for the income tax deficiencies determined by respondent,

and (3) the Pierces were not liable for the accuracy-related


     3
       For purposes of deciding this case only a general
description of these transactions is required. For more detailed
explanations, see Pierce v. Commissioner, T.C. Memo. 1997-411.
                               - 7 -

penalties on account of their good faith reliance on their

accountants.   See Pierce v. Commissioner, T.C. Memo. 1997-411.

On November 14, 1997, the Court entered its decision, and on

March 23, 1998, respondent assessed the deficiencies pursuant to

this Court’s decision.

     On January 24, 1995, after the petition had been filed

regarding the disallowance of the losses that generated the

Pierces’ refunds, Mr. Pierce transferred to petitioner the title

to property located at 9 Deanne Lynn Circle for $1.    The property

was encumbered by a mortgage held by Ulster Savings Bank with a

balance of $184,605 as of January 10, 1996.   On November 12,

1997, after this Court’s opinion and 2 days before entry of the

decision holding the Pierces liable for large income tax

deficiencies, Mr. Pierce transferred business property located at

2643 Day Hill Road in Windsor, Connecticut, to petitioner for no

consideration.   The Day Hill Road property was encumbered by a

mortgage of $197,000, held by the Savings Bank of Manchester.

     On October 31, 1991, MCU Financial Corp. (MCU) was

incorporated as a C corporation.   Petitioner has been the sole

shareholder and president of MCU from its inception.

     On November 27, 1992, DDC Limited Partnership (DDC) was

formed.   The general partners were Derek and C. David Weeks, each

of whom held a 1-percent interest in the partnership. Petitioner

was the only limited partner, with a 98-percent interest in the
                                - 8 -

partnership.    The capital contributions of the general partners

were $5,000 each, and petitioner’s capital contribution was

$490,000.    Petitioner made her $490,000 capital contribution

after the Pierces had received substantial income tax refunds

based on the claimed losses.

       On January 28, 1993, Seth Co., Inc. (Sethco), was

incorporated with Mr. Pierce as its president and petitioner’s

son, Derek Pierce, as its sole shareholder.    Sethco’s place of

business was 5 Amanda Drive in Manchester, Connecticut.    Both

petitioner’s son and Mr. Pierce received annual salaries from

Sethco.    In exchange for assuming Derek Seth’s trade debt to

subcontractors, Sethco received Derek Seth’s heavy equipment,

some office equipment, and the use of Derek Seth’s business name.

       On May 13, 1998, petitioner transferred her interest in

properties at 9 Deanne Lynn Circle and at 2643 Day Hill Road to

DDC.    Petitioner received $1 in consideration for each transfer.

The Day Hill Road property was destroyed by fire on June 1, 1998.

The insurance proceeds were distributed as follows:    (1) The

mortgage holder was paid the balance due on the mortgage, (2)

$77,710 was paid to DDC, and (3) $97,000 was paid to Sethco for

loss of contents.

       On May 15, 2000, Sethco conveyed property at 5 Amanda Drive,

Manchester, Connecticut, to DDC in exchange for a $300,000

payment, which represented the property’s fair market value.
                                - 9 -

Sethco then remitted the $300,000 to DDC as partial payment

on Sethco’s loan from DDC.    Sethco continued to use this property

as its place of business.

     Between 1992 and 2001 several loan transactions occurred

among petitioner, MCU, DDC, and Sethco.    From 1992 through 1998,

MCU’s yearend financial statements reflected “Loans from

Stockholder” with balances ranging from $414,200 to $705,200.

From 1993 through 1998, MCU’s yearend financial statements

reflected “Notes Receivable--DDC” with balances ranging from

$33,150 to $536,947.    From 1995 through 1998, MCU’s yearend

financial statements reflected “Notes Receivable--Sethco” with

balances ranging from $47,000 to $235,336.

     DDC’s 1993 through 1998 annual financial statements

reflected notes payable to the limited partner in the total

amount of $310,000.    DDC’s 1997 and 1998 annual financial

statements reflected notes receivable from Sethco in the total

amounts of $319,617 and $321,843, respectively.    Sethco’s 2001

bankruptcy petition reflected an unsecured nonpriority debt to

DDC in the amount of $1,385,641.    In addition, the bankruptcy

petition reflects that Sethco made a $300,000 payment to DDC on

May 4, 2001.

     On December 22, 1993, Mary Catherine, Mr. Pierce, and

petitioner filed a complaint in the Connecticut Superior Court

against their accountants Alec R. Bobrow, David S. Bobrow, Alan
                                - 10 -

J. Nathan, and Ronald Mamrosh.     The complaint alleged breach of

contract and negligence relating to the accountants’ preparation

of the 1989 and 1990 tax returns of Mary Catherine and the

Pierces.     The suit was settled on January 28, 1999, for $900,000.

Richard Weinstein, attorney for the plaintiffs, received $135,000

as his fee, and $1,217.87 was paid as costs to the arbitrator/

mediator.     In a signed agreement, Sethco was assigned the

potential proceeds of litigation in return for paying litigation

costs.   The net proceeds of $763,782.13 were paid to Sethco

pursuant to the assignment agreement.

                                OPINION

     The primary issue we consider is whether petitioner is

eligible for relief from joint and several liability.     Section

6015(b)(1) provides for spousal relief from joint and several

liability if the following requirements are met:

             (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;

          (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
                               - 11 -

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

     All of the requirements must be met, and failure to meet

even one of the requirements is a bar to relief.   Sec.

6015(b)(1); Alt v. Commissioner, 119 T.C. 306, 313 (2002).

Respondent concedes that petitioner has satisfied the

requirements of subparagraphs (A), (B), and (E) of section

6015(b)(1).    Therefore, we must decide whether petitioner has met

the requirements of subparagraphs (C) and (D), to wit:    Whether

petitioner, when signing the return, knew or had reason to know

that there was a substantial understatement and/or whether,

taking into account all of the facts and circumstances, it would

be inequitable to hold petitioner liable for the understatement.

      Petitioner contends, in the alternative, that respondent, on

the basis of the holding of a prior case, is collaterally

estopped from denying that she did not know or have a reason to

know of the understatements and/or that she is entitled to relief

based on the facts presented in this case.   We begin our

consideration here with the question of collateral estoppel.

I.   Is Respondent Collaterally Estopped?

      A.   In General

      Petitioner argues that respondent is collaterally estopped

from denying that petitioner did not know or have reason to know
                               - 12 -

that the claimed deductions would give rise to a substantial

understatement.   Specifically, petitioner contends that our

holding in Pierce I, that the Pierces were not liable for

negligence penalties because of their reliance on the advice of

their accountants/return preparers, is tantamount to showing that

petitioner was uninformed or had no reason to know about tax

matters.    Petitioner, however, did not plead collateral estoppel

as an affirmative defense in her petition.    The defense of

collateral estoppel was raised, for the first time, in

petitioner’s opening statement at the beginning of the trial.

      Respondent did not object at the time petitioner raised

collateral estoppel.    However, on brief respondent argued that he

is not collaterally estopped because petitioner failed to plead

collateral estoppel as an affirmative defense as required by Rule

39.   Respondent argues that petitioner’s failure to plead

collateral estoppel is, in effect, a waiver of that defense.

Petitioner contends that the issue of collateral estoppel is in

controversy because of respondent’s implied consent in accord

with Rule 41(b)(1).    Alternatively, respondent argues that

petitioner failed to meet the procedural or substantive

requirements for collateral estoppel.

      B.   Implied Consent

      Rules 34 and 36 provide for the initial pleadings, by which

most issues are placed in controversy.    Rule 34(b)(4) requires
                               - 13 -

the pleading of concise assignments for each and every error that

a petitioner may allege was committed by the Commissioner.     That

Rule provides further that “Any issue not raised in the

assignments of error shall be deemed to be conceded.”    Likewise,

Rule 36 generally provides that the Commissioner make specific

admissions or denials of a petitioner’s allegations.    In addition

to the basic pleading requirements, Rule 39 requires that a party

must plead any matter constituting an avoidance or affirmative

defense, including collateral estoppel.   See also Jefferson v.

Commissioner, 50 T.C. 963, 966-967 (1968) (and cases cited

thereat).

     With respect to all pleadings and amendments thereto, Rule

41(b)(1) provides that an issue may be tried by implied consent

if the issue was not raised in the parties’ pleadings.    In

appropriate circumstances, an issue that was not expressly

pleaded, but was tried by consent of the parties, may be treated

in all respects as if raised in the pleadings.   Rule 41(b)(1);

LeFever v. Commissioner, 103 T.C. 525, 538-539 (1994), affd. 100

F.3d 778 (10th Cir. 1996).

     This Court has held that implied consent can be used to

satisfy the pleading requirements of Rules 34 and 36, pertaining

to petitions and answers.    We have permitted the amendment of a

pleading under Rule 41(a) with respect to a matter which we found

was tried by consent.   Little has been written, however,
                              - 14 -

concerning the concept of implied consent in the context of Rule

41(b)(1) in connection with the Rule 39 requirement to plead

affirmative defenses.

     Where there is a failure to plead an affirmative defense,

such as collateral estoppel, courts have held that the defense

has been waived.   See, e.g., Pinto Trucking Serv., Inc. v. Motor

Dispatch, Inc., 649 F.2d 530, 534 (7th Cir. 1981); Standish v.

Polish Roman Catholic Union of Am., 484 F.2d 713, 721 (7th Cir.

1973).   The waiver of an unpleaded affirmative defense is, in

some respects, parallel to the requirement in Rule 34 that any

issue not raised in the assignments of error be deemed conceded.

See, e.g., Lilley v. Commissioner, T.C. Memo. 1989-602.

     The procedural rules require the pleading of affirmative

defenses to provide “the opposing party notice of the plea of

estoppel and a chance to argue, if he can, why the imposition of

an estoppel would be inappropriate.”     Blonder-Tongue Labs. v.

University of Ill. Found., 402 U.S. 313, 350 (1971).    Otherwise,

a party raising an affirmative defense, could “‘lie behind a log’

and ambush * * * [an opposing party] with an unexpected defense”

causing unfair surprise and prejudice.     Ingraham v. United

States, 808 F.2d 1075, 1079 (5th Cir. 1987).

     The Court of Appeals for the Fifth Circuit has addressed

whether an affirmative defense (res judicata) was tried with

implied consent of the parties.   United States v. Shanbaum, 10
                             - 15 -

F.3d 305, 312 (5th Cir. 1994).     The Court of Appeals held that

the issue of res judicata may be tried by implied consent.        In

reaching its holding, the Court of Appeals considered factors

similar to those that this Court has considered with respect to

the use of implied consent in circumstances where pleading

requirements for matters other than affirmative defenses were

involved.

     In arriving at its holding, the Court of Appeals considered

“whether the parties recognized that the unpleaded issue entered

the case at trial, whether the evidence that supports the

unpleaded issue was introduced at trial without objection, and

whether a finding of trial by consent prejudiced the opposing

party’s opportunity to respond.”     United States v. Shanbaum,

supra at 312-313 (citing Haught v. Maceluch, 681 F.2d 291, 305-

306 (5th Cir. 1982)); Jimenez v. The Tuna Vessel “Granada”, 652

F.2d 415, 421 (5th Cir. 1981); see also Markwardt v.

Commissioner, 64 T.C. 989, 997 (1975) (and cases cited thereat).

     Similarly, this Court, in deciding whether to apply the

principle of implied consent, has considered whether the consent

results in unfair surprise or prejudice toward the consenting

party and prevents that party from presenting evidence that might

have been introduced if the issue had been timely raised.    See

Krist v. Commissioner, T.C. Memo. 2001-140; McGee v.

Commissioner, T.C. Memo. 2000-308.
                               - 16 -

     In employing the concept of implied consent in the setting

of this case, there is no reason to make a distinction between

allegations of error and affirmative defenses.    Accordingly, the

implied consent provisions of Rule 41(b)(1) can be applied to

satisfy the Rule 39 requirement to plead or allege avoidances and

affirmative defenses.

     Next, we consider whether the issue of collateral estoppel

was tried with respondent’s implied consent.    Respondent became

aware that petitioner was relying on collateral estoppel when the

affirmative defense was raised in petitioner’s opening statement

at the beginning of the trial.    In his responsive opening

statement, respondent did not address the question of collateral

estoppel.   Respondent objected to collateral estoppel, for the

first time, in his posttrial brief.

     The question of collateral estoppel, as argued by

petitioner, is wholly dependent upon this Court’s prior opinion

concerning the identical parties and taxable year(s) as we

consider in the current proceeding.     Therefore, there was no need

for petitioner or respondent to present additional evidence or

question witnesses.    Respondent would be estopped only if an

issue resolved in our prior opinion met the requirements for

collateral estoppel.    Accordingly, respondent was not surprised

or prejudiced.   Respondent had every opportunity to fully address

the merits of collateral estoppel on brief and did so.    We hold
                                - 17 -

that the issue of collateral estoppel was tried with respondent’s

implied consent.   Rule 41(b)(1).

     C.   Collateral Estoppel

     We now consider whether respondent is collaterally estopped

from asserting that petitioner had reason to know of the

substantial understatement.     Petitioner contends that our holding

in Pierce I, that the Pierces were not negligent and they

reasonably relied upon their accountant/return preparer, is

tantamount to finding or holding that petitioner had no reason to

know of the understatement for purposes of section 6015(b)(1)(C).

     The doctrine of collateral estoppel is intended to preclude

parties from litigating issues that were necessarily decided in a

prior suit.   Johnston v. Commissioner, 119 T.C. 27, 33 (2002).

In Peck v. Commissioner, 90 T.C. 162, 166 (1988), affd. 904 F.2d

525 (9th Cir. 1990), this Court, implementing the factors

established by the Supreme Court in Montana v. United States, 440

U.S. 147, 155 (1979), established five conditions preliminary to

the factual application of collateral estoppel:

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

respects with 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.
                               - 18 -

     (4) The parties must actually have litigated the issues and

the resolution of these issues must have been essential to the

prior decision.

     (5) The controlling facts and applicable legal rules must

remain unchanged from those in the prior litigation.

     Arguably, petitioner has satisfied the more procedural of

the five conditions in that a final judgment was rendered in

Pierce I, the parties are identical in both cases, and the

controlling facts and applicable legal rules have not changed.

Further, the negligence issue, which petitioner asserts is the

same as that being decided in the current case, was litigated and

essential to the Pierce I decision.     However, petitioner does not

satisfy the one substantive condition that is the core

requirement for application of collateral estoppel.

     Collateral estoppel promotes judicial economy by preventing

successive litigation of identical issues.    The issue in the

current case is not, in all respects, identical with the issue

decided in Pierce I and, therefore, does not satisfy this

condition for application of collateral estoppel.    The issue

litigated in Pierce I was whether petitioner and Mr. Pierce were

liable for negligence penalties provided for in section

6662(b)(1).    Negligence, as defined in section 6662(c), includes

“any failure to make a reasonable attempt to comply with the * *

* [Code]”.    Negligence also includes a “lack of due care or
                                  - 19 -

failure to do what a reasonable and ordinarily prudent person

would do in a similar situation”.       Niedringhaus v. Commissioner,

99 T.C. 202, 221 (1992).       More particularly, petitioner and her

husband claimed that they were not negligent because they relied

upon their accountant’s advice and tax return preparation skills.

     The issue we consider in the current case is whether

petitioner did not know or have reason to know that there was an

understatement on her joint tax return.       This inquiry is distinct

from the negligence inquiry in Pierce I and involves a different

and more complex standard.       In Pierce I we held that petitioner’s

and her husband’s reliance on their accountant was reasonable and

that, therefore, the negligence penalty did not apply to her or

her husband.4      Petitioner contends that our holding also

implicitly includes a finding that petitioner had no reason to

know.       In Pierce I, however, we did not find as a fact or hold

that petitioner “did not have a reason to know of the

understatement.”       The issues in Pierce I and the current case are

not identical and so do not provide a basis for issue preclusion

and cannot be used to assert collateral estoppel as an

affirmative defense in this case.


        4
       Although the Pierces’ reliance on their accountant was
reasonable, it proved to be unwarranted as evidenced by the
Pierces’ receipt of $900,000 from their accountant in settlement
of the Pierces’ contract and negligence claims in connection with
the professional advice and preparation of their income tax
returns.
                               - 20 -



      Accordingly, we proceed to consider whether petitioner knew

or had reason to know of the substantial understatement.

II.   Whether Petitioner Knew or Had Reason To Know of the
      Substantial Understatement

      A.   In General

      In 1998 section 6013(e) was repealed, and section 6015

replaced it.5    The requirement of section 6015(b)(1)(C) is

similar to the requirement of former section 6013(e)(1)(C) in

that both provisions require a spouse who is seeking relief to

establish that “in signing the return, he or she did not know,

and had no reason to know” of the understatement.    Because of the

similarities, analysis in opinions concerning section

6013(e)(1)(C) is instructive for our analysis of section

6015(b)(1)(C).    See Jonson v. Commissioner, 118 T.C. 106 (2002);

Butler v. Commissioner, 114 T.C. 276, 283 (2000).

      B.   The “Reason To Know” Standard To Be Followed in This
           Case

      In deciding “reason to know” cases, the Court of Appeals for

the Ninth Circuit has made the distinction that in erroneous

deduction cases, unlike omission of income cases, mere knowledge

of a transaction underlying a deduction, by itself, is not enough

to deny innocent spouse relief.    See Price v. Commissioner, 887

      5
       Sec. 6015 was added by sec. 3201(a) of the Internal
Revenue Service Restructuring and Reform Act of 1998, Pub. L.
105-206, 112 Stat. 685, 734. Sec. 6015 is effective with respect
to any tax liability arising after July 22, 1998, and any tax
liability arising on or before July 22, 1998, that is unpaid on
that date.
                                  - 21 -

F.2d 959 (9th Cir. 1989).      The Court of Appeals in Price adopted

the standard that a spouse has “reason to know” of a substantial

understatement if “a reasonably prudent taxpayer in her position

at the time she signed the return could be expected to know that

the return contained the substantial understatement.”6        Id. at

965.

           Any appeal of our decision by petitioner would normally lie

with the Court of Appeals for the Second Circuit.      The Court of

Appeals for the Second Circuit has adopted the Court of Appeals

for the Ninth Circuit’s “reason to know” standard for erroneous

deduction cases.      See Hayman v. Commissioner, 992 F.2d 1256, 1261

(2d Cir. 1993), affg. T.C. Memo. 1992-228.      Because the

underlying tax liability is based on erroneous deductions, we

apply the standard set forth in Price v. Commissioner, supra, and

adopted in Hayman v. Commissioner, supra at 1261.       See Golsen v.

Commissioner, 54 T.C. 742 (1970), affd. 445 F.2d 985 (10th Cir.

1971).



       6
       In omission of income cases courts consistently apply a
standard denying innocent spouse relief to taxpayers who have
reason to know of the transaction underlying the understatement
of tax. See Jonson v. Commissioner, 118 T.C. 106, 116 (2002).
Several Courts of Appeals, however, have adopted the standard of
Price v. Commissioner, 887 F.2d 959 (9th Cir. 1989), in erroneous
deduction cases. See Reser v. Commissioner, 112 F.3d 1258 (5th
Cir. 1997), affg. in part and revg. in part T.C. Memo. 1995-572;
Resser v. Commissioner, 74 F.3d 1528 (7th Cir. 1996), revg. T.C.
Memo. 1994-241; Kistner v. Commissioner, 18 F.3d 1521 (11th Cir.
1994), revg. and remanding T.C. Memo. 1991-463; Erdahl v.
Commissioner, 930 F.2d 585, 589 (8th Cir. 1991), revg. and
remanding T.C. Memo. 1990-101. But see Bokum v. Commissioner 94
T.C. 126, 151 (1990), affd. 992 F.2d 1132 (11th Cir. 1993).
                               - 22 -

     The following factors have been considered to decide whether

a spouse seeking relief had “reason to know”:    (1) The spouse’s

level of education; (2) the involvement of the spouse in the

family’s business and financial affairs; (3) the presence of

expenditures that appear lavish or unusual when compared to the

family’s past levels of income, standard of living, and spending

patterns; and (4) whether the culpable spouse was evasive and

deceitful concerning the couple’s finances.     Hayman v.

Commissioner, supra at 1261.

     Under the holding in Price v. Commissioner, supra, a spouse

may not rely upon ignorance of the law as the basis for relief.

Concerning that point, the Court of Appeals for the Ninth Circuit

explained that

     if a spouse knows virtually all of the facts pertaining
     to the transaction which underlies the substantial
     understatement, her defense in essence is premised
     solely on ignorance of law. In such a scenario,
     regardless of whether the spouse possesses knowledge of
     the tax consequences of the item at issue, she is
     considered as a matter of law to have reason to know of
     the substantial understatement and thereby is
     effectively precluded from establishing to the
     contrary. [Citations omitted.]

Price v. Commissioner, supra at 964.

     In Hayman v. Commissioner, supra at 1262, the Court of

Appeals for the Second Circuit elaborated on this point as

follows:   “In order to qualify * * * [for section 6015 relief]

the spouse must establish that she is unaware of the
                              - 23 -



circumstances that gave rise to the error on the tax return, not

merely of the tax consequences flowing from those circumstances.”

     C.   Did Petitioner Have Reason To Know of the Substantial
          Understatement?

     After applying the standard followed by the Court of Appeals

for the Second Circuit and considering the relevant factors, we

hold that petitioner had reason to know of the substantial

understatements.   Petitioner was, to some extent, unsophisticated

in business, lacked a formal business education, and had a

relatively insignificant role in the business and financial

affairs of Mary Catherine and the related entities.   Petitioner’s

lack of business acumen, however, was not an impediment to her

knowledge and understanding of the facts pertaining to the

transaction which underlies the substantial understatement.

     The deductions petitioner and Mr. Pierce claimed were based

on a reduction in value of real estate holdings.   Those

reductions were reflected in financial statements for business

purposes, but no taxable event (i.e., sale or exchange) had

occurred as of the time the deductions were claimed on the

Federal tax returns.   Petitioner did not need business acumen to

understand all of the facts pertaining to the transaction.    The

loss deductions the Pierces claimed were relatively simple in

form and effect and were not the result of some complex series of

transactions.   The Pierces were aware of the claimed real estate

losses, and they may have been under the mistaken impression that
                               - 24 -

the losses would result in rightful tax refunds.       Petitioner’s

mere lack of understanding of the legal or tax consequences

pertaining to the claimed losses is insufficient, by itself, to

afford petitioner relief from the resulting liability.

     Petitioner made several expenditures that were relatively

“unusual or lavish” when compared to the Pierces’ past or normal

spending patterns.    After the receipt of the tax refunds,

petitioner contributed $490,000 of capital to DDC.       In addition,

loans from shareholder balances on MCU’s yearend financial

statements ranged from $414,200 to $705,200 during the period

1992 to 1998.7   DDC’s financial statements reflected a $310,000

note payable to the limited partner (petitioner) for its yearend

financial statements for 1993 through 1998.

     Petitioner contends that the contributions of capital were

from her savings.    She also contends that the loan balances shown

as due her on the books of MCU and DDC could be attributable to

accumulated or accrued interest on existing loans and liability

transactions other than loans.    We find curious, however,

petitioner’s contention that she had enough money in personal

savings to fund these transactions.     The only other source of

petitioner’s income mentioned in the record (outside her

involvement with Mary Catherine) was her position as a part-time

dental assistant.    More significantly, petitioner did not provide



     7
         Petitioner was the sole shareholder of MCU.
                              - 25 -

her personal savings records to document her alleged capability

to make capital contributions and/or loans in the relatively

large amounts reflected in the business records.   Finally, the

object of the transfer of assets to petitioner and the creation

of new entities, of which she was reflected as sole shareholder

or 98-percent limited partner, admittedly was to shield assets

from creditors of the Pierces and their business entities.

     Lastly, Mr. Pierce openly discussed business matters with

petitioner, and he provided her with an explanation of any

document he asked petitioner to sign.   In addition, Mr. Pierce

was not found to be a “culpable” spouse.   Both petitioner and Mr.

Pierce relied on their accountants to properly assess the

validity of the NOL deductions that were ultimately disallowed.

In such situations:

     Where the understatement results from “a
     misapprehension of the income tax laws by the preparers
     of the tax returns and the signatory parties,” both
     husband and wife are perceived to be “innocent” and
     there is “no inequity in holding them both to joint and
     separate liability”. * * *

Hayman v. Commissioner, 992 F.2d at 1262 (quoting McCoy v.

Commissioner, 57 T.C. 732, 735 (1972)).

     Petitioner was fully aware of the facts underlying the

transactions.   In essence, her defense is premised solely on

ignorance of the law.   Consequently, under the governing

precedent she is considered to know or have reason to know of the

substantial understatement.
                              - 26 -

     In that regard, petitioner’s knowledge was more than

cursory.   As the events surrounding the value writedowns

unfolded, Mr. Pierce used petitioner as a “sounding board” and

explained to her the circumstances that precipitated the

writedowns.   He also explained the effects of the writedowns on

the business.   The record reflects that it was Mr. Pierce’s usual

and normal practice to provide petitioner with explanations of

business documents she signed, including the tax returns.

     In particular, petitioner was aware that Mary Catherine was

in a precarious financial position because of the severe declines

in real estate values.   At the time of signing the tax returns,

she also knew that the net operating loss deductions taken in

connection with the decline in real estate values would result in

significant refunds.

      In addition, the facts surrounding the reasons for the

claimed losses were fully divulged and explained on disclosure

statements which were made a part of the tax returns.   The first

page of the Pierces’ 1989 and 1990 tax returns listed loss

deductions of approximately $2.2 million and $2 million.    The

disclosure statements were in narrative form and provided

complete details of the circumstances surrounding the deductions,

including information such as a description of Mary Catherine’s

business activity, the specifics relating to the decline in real

estate values, the revised appraisals of the properties, and the
                               - 27 -

details underlying the writedowns.       A taxpayer who signs a return

is deemed to have constructive knowledge of its contents, even if

the taxpayer did not read the return.       See id. (citing Schmidt v.

United States, 5 Cl. Ct. 24, 27 (1984)).

       Considering the relevant factors, a reasonably prudent

person in petitioner’s position at the time she signed the return

would be expected to know that the return contained the potential

for a substantial understatement.       In addition, because

petitioner was fully aware of the facts underlying the

transaction which gave rise to the substantial understatement,

petitioner’s defense is based exclusively on her ignorance of the

law.    Accordingly, we hold that petitioner had knowledge or

reason to know of the substantial understatement.

III.    Would It Be Inequitable To Hold Petitioner Liable for the
        Tax Liabilities?

       Although our holding that petitioner had reason to know is

fatal to her claim for relief, we note that it is not inequitable

to deny her relief in this case.    Whether it is inequitable to

hold a spouse liable for a deficiency is to be determined by

taking into account all of the underlying facts and

circumstances.    Sec. 6015(b)(1)(D).    Two material factors most

often 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
                              - 28 -

on the part of the other spouse.”   Jonson v. Commissioner, 118

T.C. at 119 (citing Hayman v. Commissioner, supra at 1262).

Normal support is not considered a significant benefit.     Hayman

v. Commissioner, supra at 1262 (citing Flynn v. Commissioner 93

T.C. 355, 367 (1989)).

     Petitioner received significant benefits from the refunds.

The refunds enabled her to contribute capital and lend funds to

the newly created business entities.   Further, the Pierces’

failure to report the correct tax liability did not result from

any concealing, overreaching, or wrongful conduct on the part of

Mr. Pierce.   Holding the Pierces jointly and severally liable for

the tax deficiency is not inequitable.

     Lastly, the objectives of the innocent spouse provisions

would not be well served if petitioner was afforded relief in the

circumstances we consider.   When enacting these relief

provisions, Congress expressed concern about the possibility that

taxpayers could hide behind or otherwise abuse these provisions.

The Senate report in connection with the Internal Revenue Service

Restructuring and Reform Act of 1998, Pub. L. 105-206, sec.

3201(a), 112 Stat. 734, contained the explanation that “The

Committee is concerned that taxpayers not be allowed to abuse

these rules * * * by transferring assets for the purpose of

avoiding the payment of tax by the use of this election.”    S.

Rept. 105-174, at 55-56 (1998), 1998-3 C.B. 537, 591-592.
                              - 29 -

      Because petitioner relied solely on Mr. Pierce’s

explanations, she may not have completely understood the legal

consequences of her signing documents creating DDC and MCU,

lending money between these business entities, and transferring

property between herself and the business entities.    However, the

ultimate object of these transactions was to shield assets from

creditors, which ultimately included the Internal Revenue

Service.   The granting of relief to petitioner in these

circumstances would permit the Pierces to shield themselves from

Federal tax liabilities by using section 6015.

     Accordingly, we hold that petitioner has not satisfied the

requirements under section 6015(b)(1)(C) or (D) and is not

entitled to relief from joint and several liability for the tax

years at issue.

     To reflect the foregoing,

                                      Decision will be entered

                                 under Rule 155.
