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T.C. Memo. 1996-425

UNITED STATES TAX COURT

CHARLES L. FIELDS AND BARBARA S. FIELDS, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 26636-87.

Filed September 19, 1996.

A, a corporation, agreed with P and Y to pay them

commissions on any oil that it purchased in foreign

countries as a result of their efforts. P and Y

organized a Bermudan corporation, to which they

directed the payment of all the commissions. Held:

The commissions attributable to P's services are

taxable to him under the assignment of income doctrine.

Held, further: Ps failed to recognize dividend income

in the amounts set forth by R. Held, further: Ps

failed to recognize interest income in the amounts set

forth by R. Held, further: P is liable for additions

to tax for fraud, and the 3-year period of limitation

under sec. 6501(a), I.R.C., does not bar the assessment

and collection of tax for any of the subject years.

Held, further: P's wife is not an innocent spouse

under sec. 6013(e), I.R.C.

- 2 Lawrence F. Ruggiero and Robert Koppelman, for petitioners.1

Cheryl A. McInroy, Elizabeth A. Maresca, and

Steven D. Tillem, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

LARO, Judge:

Charles L. Fields and Barbara S. Fields

petitioned the Court to redetermine respondent's determinations

with respect to their 1980 through 1982 taxable years.

Respondent determined deficiencies of $525,389, $243,493, and

$1,365 in their 1980, 1981, and 1982 Federal income taxes,

respectively.

Respondent also determined that Mr. Fields was

liable for a:

(1) $262,695 addition to his 1980 tax under

section 6653(b), (2) $121,747 addition to his 1981 tax under

section 6653(b), (3) $683 addition to his 1982 tax under section

6653(b)(1), and (4) time-sensitive addition to his 1982 tax under

section 6653(b)(2) with respect to that year's entire deficiency.

Respondent's determinations are reflected in a notice of

deficiency dated May 14, 1987.

Mr. Ruggiero and Mr. Koppelman entered the case on

Apr. 17, 1995, and May 22, 1995, respectively. Edward J. Daus,

who prepared the subject petition, withdrew as petitioners'

counsel on June 16, 1988. Paul S. Haar entered the case on

petitioners' behalf on Nov. 21, 1989, but withdrew on Feb. 14,

1990. Mr. Haar also withdrew on Jan. 6, 1993, after he had

reentered the case on May 14, 1990.

- 3 We must decide:

Whether petitioners received commission income of

$487,104 and $182,020 in 1980 and 1981, respectively.2

We hold

they did.

Whether petitioners received dividend income of $22,135

and $19,510 in 1980 and 1981, respectively.

We hold they did.

Whether petitioners received interest income of $7,791,

$37,612, and $8,429 in 1980, 1981, and 1982, respectively.

hold they did.

Whether Mr. Fields (petitioner) is liable for additions

to his 1980 through 1982 taxes for fraud.

We hold he is.

Whether the 3-year period of limitation under section

6501(a) bars the assessment and collection of tax for any of the

subject years.

6013(e).

We hold it does not.

Whether Mrs. Fields is an innocent spouse under section

We hold she is not.

Unless otherwise indicated, section references are to the

Internal Revenue Code in effect for the subject years.

Rule

references are to the Tax Court Rules of Practice and Procedure.

Dollar amounts are rounded to the nearest dollar.

The notice of deficiency states that petitioners received

commission income of $825,025 and $307,005 in 1980 and 1981,

respectively. Respondent has conceded that $337,921 and $124,985

of this income for the respective years was attributable to (and

includable in the gross income of) petitioner's business partner,

Dr. Walter F. Young.

- 4 FINDINGS OF FACT3

Overview

General

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

The stipulations and attached exhibits are incorporated herein by

this reference.

Petitioners have been married for the last

33 years, and they resided in Rye, New York, when they filed

their petition herein.

They are cash method taxpayers, and they

signed and filed 1980, 1981, and 1982 Forms 1040, U.S. Individual

Income Tax Return, using the status of "Married filing joint

return".

Their 1980, 1981, and 1982 returns reported taxable

income of $56,847, $71,010, and $5,550, respectively.

Gross (and

adjusted gross) income for the respective years were reported as

$86,153, $107,373, and $37,766.

Wages for the respective years

were reported as $96,412, $111,652, and $40,166.

Petitioner testified at trial. Based on our observation

of petitioner at trial, and following our review of the record as

a whole, we conclude that petitioner's uncorroborated testimony

is largely unreliable. See Kraut v. Commissioner, 527 F.2d 1014,

1019 (2d Cir. 1975), affg. 62 T.C. 420 (1974); Pepi, Inc. v.

Commissioner, 448 F.2d 141, 147 (2d Cir. 1971), affg. 52 T.C.

854 (1969); O'Connor v. Commissioner, 412 F.2d 304, 311 (2d Cir.

1969), affg. in part and revg. in part T.C. Memo. 1967-174;

Tokarski v. Commissioner, 87 T.C. 74, 77 (1986).

- 5 b.

Petitioner

Petitioner is well-educated in the intricacies of the

business world, and he has been deeply involved in that world for

almost 40 years.

He received a bachelor's degree in political

science with a minor in business from Florida A & M University in

1958.

He received a master's degree in business from Columbia

University Graduate School of Business in 1972.

He lectured at

Northwestern University, Harvard University, University of

Chicago, Florida A & M University, and Southern University in

Louisiana, mainly on the procedures and policies for conducting

business in Africa.

He taught as an adjunct professor in

organizational behavior at the Graduate School of Business at

Harvard University.

He consulted for the Commerce Department, on

the topic of conducting business in Africa.

He served as an

executive, during at least the subject years, advising management

on development work and international trading.

National Black MBA Association.

He founded the

He created the first database of

minorities with bachelor's, master's, and Ph.D. degrees.

Sales of Oil

BarSon International Ltd. (BarSon) is a Delaware corporation

that was organized by petitioner and Dr. Walter F. Young (Dr.

Young) on March 4, 1977, to provide consulting services for

American corporations abroad and to entice American construction

- 6 companies to build in Africa.4

Dr. Young and petitioner are

BarSon's president and secretary, respectively, and they each own

50 percent of its stock.

BarSon is a cash method taxpayer, and

its taxable year ends on March 31.

On November 19, 1979, BarSon and Ashland Oil, Inc.

(Ashland), entered a written agreement under which BarSon's

managing directors (petitioner and Dr. Young) or other key

employees would advise Ashland on starting business abroad

(including the requirements for purchasing crude oil in foreign

countries) in exchange for a daily fee of $750 plus expenses.5

The agreement did not contain a provision for Ashland to pay

BarSon commissions on the actual purchase of oil by Ashland.

Petitioner and Dr. Young, on behalf of themselves, entered into a

separate oral agreement with Ashland under which Ashland would

pay commissions to petitioner and Dr. Young for any oil purchased

as a result of their efforts.

Petitioners have never reported

any income on their personal income tax returns for commissions

Dr. Young is the brother of Andrew Young, the U.S.

ambassador to the United Nations during the Carter

administration. The occurrences described below began at or

about the time when Andrew Young led an official U.S. trade

delegation (with petitioner and Dr. Young) to Africa to discuss

oil and other matters.

BarSon and Ashland amended this agreement on Feb. 1, 1981,

to increase the daily rate to $1,250, with a minimum of $15,625

per month. From 1979 until 1981, Ashland paid BarSon at least

$713,765 under this agreement. These payments were deposited

into BarSon's bank accounts.

- 7 paid under the terms of the oral agreement with respect to

petitioner's services.

In an attempt to secure large amounts of crude oil for

Ashland, petitioner and Dr. Young traveled many times to Cameroon

(at the instruction of Ashland), and they met with officials of

Cameroon's national oil company, Société Nationale des

Hydrocarbures (SNH).

In March 1980, Ashland and Cameroon agreed

that Ashland would acquire oil from SNH through Ashland's Bermuda

subsidiary, Ashland (Bermuda) Limited (ABL).

At or about the same time, petitioner and Dr. Young decided

that they wanted to organize a corporation in Bermuda or some

other traditional tax haven to avoid Federal income tax on their

commissions from Ashland.

They contacted the law firm of

Danzansky, Dickey, Tydings, Quint & Gordon (which was merged into

Finley, Kumble, Wagner, Heine, Underberg & Casey on or about

January 1, 1981, and which with its successor will hereinafter be

referred to as Finley Kumble),6 to obtain assistance in

organizing such a corporation.

Following discussions with

petitioner and Dr. Young, Finley Kumble understood that

Although Danzansky, Dickey, Tydings, Quint & Gordon is a

different firm than Finley, Kumble, Wagner, Heine, Underberg

& Casey, the attorneys at these firms who advised petitioner and

Dr. Young were generally the same throughout the relevant period

herein. Robert B. Washington, Jr., one of the principal partners

in charge of the accounts of petitioner, Dr. Young, and the

related entities throughout the relevant time, oversaw and was

actively involved in most (if not all) of the advice that the

firms rendered to petitioner and Dr. Young, either personally or

on behalf of their related entities.

- 8 petitioner and Dr. Young would render valuable management and

consulting services to the foreign corporation as corporate

employees, and that these services would result in substantial

revenue.

Finley Kumble anticipated that the corporation would

distribute the revenue to Dr. Young and petitioner in the form of

salaries over several years.

Finley Kumble believed that,

although the corporation would most likely be a "controlled

foreign corporation" and a "foreign personal holding company", a

careful structuring of the arrangement would allow petitioner and

Dr. Young to escape the U.S. tax until they actually received

their salary payments.

Finley Kumble believed that the

arrangement was subject to attack by the Commissioner under

section 367 or 482, or by arguing doctrines such as:

(1) Substance over form, (2) sham transaction, (3) assignment of

income, or (4) deductibility of compensation.

Finley Kumble

relayed these understandings, anticipations, and beliefs to

petitioner and Dr. Young.

Petitioner and Dr. Young chose to

organize the foreign corporation.

Finley Kumble, on behalf of petitioner and Dr. Young,

contacted Max Quin (Mr. Quin), an attorney with a Bermuda law

firm named Vaucrosson's, to organize the corporation because it

was customary to use Bermudan counsel to organize a Bermudan

corporation.

On or about April 10, 1980, Mr. Quin organized the

corporation for petitioner and Dr. Young under the name of

- 9 Cameroon Atlantis International (CAI).7

Finley Kumble helped Mr.

Quin in the organization by relaying to him information from

petitioner and Dr. Young.

Petitioner was very active in the

organizational process.

CAI's address was Vaucrosson's address in Bermuda, and CAI

was organized under the Companies (Incorporation by Registration)

Act of 1970 (the Act) as an exempt company that could not hold

land.

CAI's initial capital was 12,000 shares of stock with a $1

par value,8 and all of its shares were issued to nominees for

petitioner and Dr. Young.

Permission had been given on April 25,

1980, by Bermuda's Minister of Finance, to incorporate CAI as an

exempt company, and CAI's memorandum of association was deposited

in the Bermudan Office of the Registrar of Companies in

accordance with the provisions of the Act, on April 28, 1980.

Upon its organization, petitioner and Dr. Young transferred to

CAI their contractual right to receive commissions from Ashland

on any barrels of oil purchased as a result of their efforts.

The sales of oil between ABL and Cameroon in 1980 and 1981

were accomplished through the use of back-to-back contracts

involving CAI as an intermediary.

Under these contracts, CAI

contracted with SNH to buy oil at a fixed price, and CAI

CAI changed its name to Atlantis International Ltd.

(Atlantis) on Feb. 14, 1981.

Atlantis increased its share capital to $71,980 on

Apr. 29, 1981.

- 10 contracted to sell that same oil to ABL for the same price plus a

commission of 25 to 30 cents per barrel.9

ABL received 404,968

barrels of oil shipped from Cameroon on March 30, 1980, and ABL

paid CAI a 30-cent-per-barrel commission (totaling $121,490) for

this shipment.

The oil was purchased on the spot market, and

local custom did not allow for a written contract on the

delivery.

On April 10, 1980, CAI agreed to buy 190,000 metric tons of

oil from SNH at a set price, with 120,000 of these metric tons to

be delivered in April 1980 and the balance to be delivered in

May 1980.

On April 21, 1980, ABL agreed with CAI to purchase the

same oil at the same price plus a commission of 30 cents per

barrel.10

Ashland arranged the terms for shipping the oil, it

nominated the vessels used for lifting the oil, and it set the

mode of payment for the oil.

Petitioner and Dr. Young arranged

for ABL's purchase of the oil, and ABL paid them for their

services by paying CAI the spread between the back-to-back

contracts.

Commissions for the shipments under the April

contract totaled $424,157.

On August 8, 1980, CAI agreed to buy 840,000 metric tons of

oil from SNH at a set price, with equal monthly deliveries from

CAI did not have the financial capacity to purchase the

oil from SNH, and CAI had not entered into a consulting or agency

agreement with ABL or Ashland.

ABL received 457,680 barrels of the oil referred to in

this contract on Apr. 15, 1980.

- 11 August 1980 through July 1981.

On August 8, 1980, ABL agreed

with CAI to buy the same oil at the same price plus a commission

of 25 cents per barrel.

Ashland arranged the terms for shipping

the oil, it nominated the vessels used for lifting the oil, and

it set the mode of payment for the oil.

Petitioner and Dr. Young

arranged for ABL's purchase of the oil, and ABL paid them for

their services by paying CAI the spread between the back-to-back

contracts.

Commissions for the shipments under the August

contracts totaled $1,064,424.

The last shipment under the August

contracts was on March 3, 1981.

On January 1, 1981, CAI and ABL entered into a contract for

the monthly purchase and sale of approximately 70,000 metric tons

of oil for the 7-month period ended July 31, 1981.

ABL paid the

set price directly to SNH, and ABL took delivery of the oil

directly from SNH.11

directly to CAI.

ABL paid the per-barrel commissions

Petitioner and Dr. Young arranged for ABL's

purchase of the oil, and ABL paid them for their services by

paying CAI the spread between the back-to-back contracts.

ABL paid commissions to CAI by check.12

All of these checks

were payable to CAI and deposited into CAI's checking account

(the C account) at N.T. Butterfield & Son Bank (Bank) in Bermuda.

ABL put a provision in the back-to-back contracts that

allowed it to pay SNH directly for the oil to ensure itself that

the oil was paid for.

All of the commissions were due to the efforts of

petitioner and Dr. Young.

- 12 The following commission checks were deposited into the C account

during 1980 and 1981:

Date of Payment

Barrels

Commission

Amount

Date Shipped

Apr. 30, 1980

May 12, 1980

May 14, 1980

June 20, 1980

Sept. 17, 1980

Oct. 9, 1980

Nov. 10, 1980

Dec. 11, 1980

Jan. 12, 1981

Feb. 2, 1981

Mar. 6, 1981

Apr. 2, 1981

404,968

457,680

441,837

514,339

546,934

508,128

476,470

516,144

515,671

536,050

515,455

517,336

.30/brl

.25/brl

.27/brl

$121,490

137,304

132,551

154,302

136,733

127,032

119,117

129,036

128,918

144,734

139,173

139,681

1,610,071

3/30/80

4/15/80

4/22/80

5/13/80

8/20/80

9/11/80

10/11/80

11/11/80

12/12/80

1/3/81

2/4/81

3/3/81

Of the total commissions of $1,610,071, BarSon ultimately

received $232,540 and $245,500 of this amount in 1980 and 1981,

respectively, for a total of $478,040.

Approximately $265,000 of

this $478,040 amount was reported on BarSon's 1980 tax return.13

BarSon never reported any other commissions as income on a

Federal income tax return.

The commissions that respondent seeks

to attribute to petitioners have been reduced by the $478,040 of

commissions reported by BarSon.14

Respondent gave petitioners

credit for $245,500 paid to BarSon in its 1981 taxable year,

although BarSon never included this amount in its gross income.

This return reports that BarSon had $571,790 of total

income and $57,483 of taxable income.

Respondent further reduced the commissions reportable by

petitioners for 1980 and 1981 by $337,921 and $124,985,

respectively. See supra note 2.

- 13 3.

Finley Kumble's Legal Advice

On September 26, 1980, attorneys from Finley Kumble met with

petitioner and Dr. Young in Washington, D.C.

Petitioner and Dr.

Young believed that they had a tax problem with respect to funds

brought from Bermuda into the United States, and they requested

assistance from Finley Kumble on this problem.

Petitioner and

Dr. Young informed the attorneys that they (petitioner and

Dr. Young) had drawn approximately $90,000 on CAI's C account for

reasons that included the payment of their personal creditors in

the United States.

Petitioner and Dr. Young produced checks

payable to their creditors in the total amount of $75,000 which

had not been transmitted or cashed.15

Petitioner and Dr. Young

later voided all of these untransmitted and uncashed checks at a

subsequent meeting with Finley Kumble on October 2, 1980.

On October 10, 1980, attorneys from Finley Kumble met with

petitioner and Dr. Young to discuss primarily the tax issues

connected with petitioner and Dr. Young's receipt of the funds.

Finley Kumble recommended that petitioner and Dr. Young ignore

the existence of CAI and report the commissions as income.

By September 1990, petitioner and Dr. Young had actually

withdrawn almost $400,000 from the C account, in addition to the

$75,000 of uncashed drafts, most of which was attributable to

petitioner.

- 14 Petitioner and Dr. Young informed Finley Kumble that they did not

want to ignore CAI's existence.

On October 27, 1980, attorneys from Finley Kumble met again

with petitioner and Dr. Young.

In a letter bearing the same

date, Finley Kumble explained that the organization and operation

of CAI departed dramatically from the basic organization and

operation of a foreign corporation because:

(1) CAI was

organized after the business activity of locating a source of

crude oil was well advanced and (2) CAI's primary business

activities were carried on in the name of BarSon.

Given the

factual pattern of CAI's organization and operation, the letter

stated, the Commissioner could argue that the assignment of

income doctrine required that the income received from ABL be

taxed to BarSon or, alternatively, that section 367 provided that

petitioner and Dr. Young's transfer of their contractual rights

to CAI was a taxable transfer.

Finley Kumble advised that each

theory created a substantial tax exposure to BarSon and to

petitioner and Dr. Young individually.

In a letter to petitioner dated December 9, 1980, Finley

Kumble reiterated its advice that the organization of CAI in

midstream created dangerous ambiguities.

Finley Kumble cautioned

petitioner and Dr. Young that "defensive planning" had been

undertaken to deal with what had already occurred, that there

- 15 were significant risks, and that it was very likely that the

Commissioner would audit petitioner, Dr. Young, and/or one or

more of their related entities.

Finley Kumble reiterated this

warning in a letter to petitioner dated December 15, 1980.

In the letter of October 27, 1980, Finley Kumble also

advised petitioner and Dr. Young that Form 959, Return by an

Officer, Director, or Shareholder with Respect to the

Organization or Reorganization of a Foreign Corporation and

Acquisition of its Stock, should be immediately filed with the

Commissioner to reflect the transfer of their contractual rights

to CAI.

The letter explained that Form 959 must be filed by

persons holding an office (or serving as a director) of a foreign

corporation or owning 5 percent of its stock.

Finley Kumble prepared Forms 959 for petitioner and Dr.

Young.

Finley Kumble gave petitioner his Form 959 at a meeting

in Bermuda, and he signed the form at that time.

Petitioner

never filed this (or any other) Form 959, and he did not ask

Finley Kumble (and Finley Kumble did not assume the legal

responsibility) to file Form 959 on his behalf.

CAI's Interest Accounts

In addition to the C account, CAI had time deposit (TD)

accounts in which money was transferred from the C account to

- 16 earn interest.

CAI also had a set-off account, an escrow

account, and a collateral account.

CAI's funds at the Bank earned interest in the amounts of

$15,582, $75,224, and $16,858 in 1980, 1981 and 1982,

respectively.

Petitioners did not report any interest income

from the Bank on their 1980, 1981, or 1982 returns.

Respondent

determined that petitioners' gross income for the subject years

included half of the interest earned in each year.

Petitioners' Use of BarSon and CAI Funds

In February 1979, petitioners purchased a home in Rye,

New York, for approximately $160,000.

In 1980, they used $18,635

of BarSon's funds to pay for work performed on that home.

Petitioners sold their home in Rye, New York, in July 1994, for

approximately $455,000.

Respondent determined that petitioners

received an $18,635 constructive dividend from BarSon in 1980, on

account of their use of its funds to pay for work done to their

home.

Respondent determined that BarSon's accumulated earnings

and profits (E&P) were $1,322,644 on March 31, 1981.

BarSon reported that it paid $20,000 in business-related

legal fees to Finley Kumble in 1980 and 1981.

Finley Kumble

rendered legal advice to petitioners on personal matters

including the registration requirements for acquiring a boat,

financing the purchase of a house in New York, and preparing a

- 17 home mortgage application.

Respondent determined that $10,000 of

the $20,000 amount was a constructive dividend to petitioners

because the legal advice pertained to petitioners' personal

matters.

Respondent determined that $2,500 of this dividend was

paid in 1980 and the balance in 1981.

Respondent also determined

that petitioners used BarSon's checks in 1980 to pay for $1,000

of their personal expenses, that BarSon paid $2,728 in 1981 for

petitioners' personal promotion expense, that BarSon paid $6,987

in 1981 for petitioners' personal travel, and that petitioners

received a $2,295 constructive dividend from BarSon in 1981,

stemming from their personal use of an automobile.

Petitioner did not personally withdraw money from CAI's

accounts.

Petitioner directed Mr. Quin to send money from CAI's

accounts to designated payees, and Mr. Quin directed the Bank to

disburse CAI's funds according to petitioner's directions.

From

1980 to 1982, most of CAI's disbursements went to petitioner or

to third parties designated by petitioner for his benefit.

In July 1981, CAI formed two new accounts (the A and B

accounts) at the Bank, and the C account remained as CAI's

operating account.

Petitioner controlled the A account, and the

balance therein stemmed from income for his services.

Dr. Young

controlled the B account, and the balance therein stemmed from

income for his services.

Petitioner withdrew $291,936 from the C

- 18 account for his benefit.

Petitioner and Dr. Young withdrew

$247,788 from the C account for the benefit of both; respondent

determined that half of this amount ($123,894) was attributable

to petitioner.

Petitioner borrowed $25,000 from the Bank on December 19,

1980, and $10,000 on October 1, 1981.

Petitioner paid off the

loans with funds from his account at Citibank, and with funds

from the C account, the set-off account, and the A account.

Petitioner caused $31,819 to be withdrawn from the set-off

account and applied to his loans at the Bank.

Petitioners used checks drawn on CAI's C account to pay for

more than $55,000 of renovation to their home in Rye, New York,

in 1980 and 1981.

They used checks drawn from CAI's C account to

pay for more than $9,000 in landscaping at that home in 1980.

They used checks drawn from the C account to pay for more than

$100,000 in interior decoration in 1980 and 1981.

They used

checks drawn on CAI's C account to pay for summer programs for

their children.

They used a check drawn on CAI's C account to

pay for legal services incurred in purchasing undeveloped land in

1980 for more than $100,000.16

Mrs. Fields used checks drawn on

CAI's C account to purchase more than $5,000 of china.

Petitioners planned to spend an additional $217,000 to

build a vacation home, two tennis courts, and a pool on the land,

but they ended up selling the undeveloped land for $450,000.

- 19 Petitioners never reported any of CAI's funds used by them

as income on a personal tax return.

The total amount of CAI

funds in the A, C, and set-off accounts used for petitioners'

benefit totaled $705,107.17

Of this amount, $245,008 was used in

1980, $312,269 was used in 1981, and $147,830 was used in 1982.

Petitioner was aware that he could be charged with income from

CAI and the resulting tax liability.

Reporting Requirements

Petitioners' 1980 through 1982 tax returns were prepared by

their accountant, Seymour Schiller (Mr. Schiller).

In connection

with the preparation of those returns, petitioner did not tell

Mr. Schiller that petitioners had an interest in a foreign

account during the relevant years.

Petitioners indicated on

their 1980 and 1981 tax returns that they did not have such an

interest during 1980 and 1981.

Petitioners did not report on

their 1982 tax return that they had an interest in a foreign

account during 1982.

Petitioners had an interest in CAI's bank

account during each of the subject years.

Mrs. Fields

Mrs. Fields is an educated woman, and she has been involved

in the business world in a limited capacity.

She received a

Respondent seeks to include only $669,124 of this income

in petitioners' gross income.

- 20 bachelor's degree in education from City University of New York

in 1958.

She received a master's degree from City University in

1962, earning 60 credits towards a postgraduate degree.

She taught grade school in New York, New York, from 1967 through

1995.

She worked for Fields, Freeman & Associates (FFA) in 1981,

researching, examining resumes, and making contacts for FFA.

Petitioners owned 100 percent of FFA, and Mrs. Fields was its

vice president and one of its officers.

She was a director of

BarSon, until she resigned due to illness.

She managed

petitioners' household finances, including paying their mortgage

and balancing their checking account.

She was authorized to sign

petitioner's business checking accounts.

She was authorized to

sign checks for FFA.

Mrs. Fields knew that petitioner worked through BarSon, and

that he owned 50 percent of its stock.

She knew that petitioner

had a business relationship with Ashland, and that this

relationship concerned advising African businessmen on the topics

of construction and oil.

She knew that petitioner tried to

secure oil for Ashland, that he had traveled to Cameroon to do

so, and that he had contacted African businessmen on the

procurement of oil.

She knew that one of petitioner's business

associates was a Government official from Cameroon, and that the

relationship between him and petitioner involved oil and Ashland.

- 21 She knew that petitioner had traveled to Bermuda on business, she

accompanied him on at least one occasion, and she knew that he

met with Mr. Quin during that trip.

She entertained petitioner's

business associates at functions in their home.

Mrs. Fields signed a residential loan application stating

that petitioners had a beneficial interest in Atlantis worth

$300,000.

Her children attended a private school in Rye, New

York, in 1980 and 1981, and she knew that tuition cost about

$7,000 a year for each child.

Petitioners purchased a $16,735

boat in 1981.

Mrs. Fields generally did not question petitioner about

their finances.

She relied on him and Mr. Schiller to prepare

their income tax returns correctly, and she did not question the

numbers on the returns.

Mrs. Fields did not ask petitioner if

she could review their tax returns.

She knew that petitioner

would have let her review their returns if she asked.

OPINION

Except with respect to respondent's allegations of fraud,

petitioners must prove that respondent's determinations set forth

in the notice of deficiency are incorrect.

Rule 142(a) and (b);

Welch v. Helvering, 290 U.S. 111, 115 (1933).

Respondent must

prove by clear and convincing evidence that petitioner is liable

for the additions to tax for fraud.

Sec. 7454(a); Rule 142(b).

- 22 With these basic principles in mind, we turn to the issues for

decision.

Issue 1.

Commission Income

Respondent determined that most of the commissions paid by

ABL to CAI were taxable to petitioners.

Respondent primarily

argues that the commissions are taxable to petitioners under the

assignment of income doctrine.

Petitioners argue that the

doctrine prohibiting an assignment of income does not apply to

the facts at hand because petitioner organized CAI upon the

mandate of Ashland.

Petitioners argue that the doctrine is

inapplicable because petitioner was not a shareholder of CAI.

Petitioners argue that Finley Kumble organized CAI on its own

initiative, and that petitioner was ignorant as to CAI's

organization and operation.

Petitioners argue that petitioner

insisted to Finley Kumble that all of the commissions from

petitioner's services be reported by BarSon, that he informed

Finley Kumble that he wanted nothing to do with an "offshore

corporation", and that he fired Finley Kumble (with the exception

of having the firm work on unrelated legal work for BarSon to the

extent of the advanced retainer), when Finley Kumble recommended

to him that he and Dr. Young evade taxes by keeping BarSon's

income offshore.

Petitioner argues that Finley Kumble

established and controlled CAI for Finley Kumble's personal gain.

- 23 We agree with respondent's primary argument.18

It is

hornbook law that the person who earns income is taxed on it.

United States v. Basye, 410 U.S. 441 (1973); Commissioner v.

Culbertson, 337 U.S. 733, 739-740 (1949); Lucas v. Earl, 281 U.S.

111 (1930).

Thus, we must decide who "earned" the commissions

paid by ABL during the years in question.

We bear in mind that

"the true earner cannot always be identified simply by pointing

'to the one actually turning the spade or dribbling the ball'".

Fritschle v. Commissioner, 79 T.C. 152, 155 (1982) (quoting

Johnson v. Commissioner, 78 T.C. 882, 890 (1982), affd. without

published opinion 734 F.2d 20 (9th Cir. 1984)).

We also

recognize the inherent tension between the application of the

assignment of income doctrine in the setting of a closely held

personal service corporation (PSC) and the recognition of a PSC

as a legal entity that is separate from its owners.

Moline

Properties, Inc. v. Commissioner, 319 U.S. 436, 438-439 (1943).

We focus primarily on whether CAI or petitioner controlled

the earning of the disputed commissions.

See Bagley v.

Commissioner, 85 T.C. 663, 675 (1985), affd. 806 F.2d 169 (8th

Cir. 1986); Johnson v. Commissioner, supra at 890-891.

In cases

where the claimed earner is a closely held PSC, such as CAI, this

Accordingly, we do not mention or pass on respondent's

alternative arguments.

- 24 Court has followed a two-prong test under which the PSC is taxed

on the income when:

(1) The service provider is an employee of

the PSC, whom the PSC has the right to direct and control in a

meaningful sense, and (2) the PSC and the service recipient have

a contract or similar indicium recognizing the controlling

position of the PSC.

Leavell v. Commissioner, 104 T.C. 140,

151-152 (1995); Haag v. Commissioner, 88 T.C. 604, 611 (1987),

affd. without published opinion 855 F.2d 855 (8th Cir. 1988);

Bagley v. Commissioner, supra at 675-676; Johnson v.

Commissioner, supra at 893; see also sec. 31.3121(d)-1(c)(2),

Employment Tax Regs.

When either of these prongs is not met, the

individual (rather than the PSC) is taxed on the income.

We apply this test to the facts at hand.

With respect to

the first prong, we look to the record for indicia of an

employment relationship between CAI (the PSC) and petitioner (the

provider of the services that generated the commissions).

We find no employment contract or other evidence of an employment

relationship between the two.

Indeed, petitioner acknowledged at

trial that he was not CAI's employee.

Given the absence of the

necessary employer/employee relationship between petitioner and

CAI, we are unable to conclude that CAI had the ability to direct

or control petitioner's provision of the relevant services in a

meaningful sense so as to satisfy the first prong of the test.

- 25 The thrust of the work concerning the earning of the commissions

was performed prior to the formation of CAI, and many of the

relevant contracts were executed before CAI's memorandum of

association was deposited in the Bermudan Office of the Registrar

of Companies.

Indeed, the contract of April 21, 1980, under

which ABL agreed with CAI to purchase a set amount of oil, was

executed by the parties thereto after some of the oil had already

been delivered on April 15, 1980.

Moreover, following the

organization of CAI, petitioner (and not CAI) controlled the

earning of the disputed commissions.

Petitioner (and not CAI)

dictated the manner in which he was going to provide his services

to ABL, as well as the means by which he would achieve the end

contemplated by the parties to the agreement underlying the

payment of the commissions.

The absence of an employment relationship between BarSon and

CAI is also relevant.

We are unpersuaded from the record at hand

that BarSon (through petitioner and Dr. Young) rendered

consulting services to ABL on behalf of CAI.

We read the record

to show that BarSon (through petitioner and Dr. Young) rendered

consulting services only to Ashland, in accordance with the

consulting agreement between those two corporations.

The

commissions paid to CAI served to compensate petitioner and Dr.

Young for their personal services in effectuating the sale of oil

- 26 to ABL.

These services were not rendered on behalf, or under the

control, of CAI.

We conclude that the first prong of the requisite two-prong

test is not met.19

Accordingly, we hold for respondent.

With

respect to petitioners' arguments for a contrary holding, we find

no credible evidence in the record to persuade us that the

organization of CAI was required by Ashland, or that petitioner

was not a beneficial owner of CAI.

Accordingly, we reject

petitioners' allegations to that effect.20

Issue 2.

Dividend Income

Respondent determined that petitioner received constructive

dividends of $22,125 and $19,510 from BarSon during 1980 and

1981, respectively.

resulted from:

Respondent determined that the 1980 dividend

(1) BarSon's payment of $2,500 to Finley Kumble

for petitioners' personal legal fees, (2) $1,000 in checks drawn

on BarSon's account for petitioners' primary benefit, and

(3) BarSon's payment of $18,635 to contractors for work performed

In this regard, we also find relevant that petitioner and

Dr. Young performed all work necessary to find a source of oil

for Ashland. See Zand v. Commissioner, T.C. Memo. 1996-19 (under

facts similar in some respects to those here, individual taxed as

earner of commissions paid to corporation).

We also reject petitioners' allegations that petitioner

was ignorant on the formation and operation of CAI, being led

astray by the unethical and self-serving conduct of Finley

Kumble. The record (including evidence of petitioner's

education, intelligence, and business acumen) leads us to

conclude that this argument is meritless.

- 27 on petitioners' home.

Respondent determined that the 1981

dividend resulted from:

(1) BarSon's payment of $7,500 to Finley

Kumble for petitioners' personal legal fees, (2) BarSon's payment

of $2,728 for petitioners' personal promotion expense,

(3) BarSon's payment of $6,987 for petitioners' personal travel,

and (4) petitioners' personal use of an automobile ($2,295).

Petitioners allege that:

(1) BarSon's $2,500 payment in 1980 was

for professional fees rendered to BarSon, (2) the $1,000 and

$18,635 amounts were charged to petitioner's loan account, and

later repaid, (3) BarSon's $7,500 payment in 1981 was for

professional fees rendered to BarSon, and (4) the $2,728, $6,987,

and $2,295 amounts were ordinary and necessary business expenses

of BarSon.

We agree with respondent that the subject amounts are

includable in petitioners' gross income as dividends.

A shareholder's gross income includes his or her receipt of any

dividend, regardless of whether the dividend was formally

declared by the corporation.

Sec. 61(a)(7); Loftin & Woodard,

Inc. v. United States, 577 F.2d 1206, 1214 (5th Cir. 1978).

Where a shareholder receives a distribution of corporate funds

for his or her personal benefit, the distribution may be taxed to

the shareholder as a dividend to the extent of the corporation's

earnings and profits.

Ireland v. United States, 621 F.2d 731,

- 28 735 (5th Cir. 1980); Loftin & Woodard, Inc. v. United States,

supra at 1214; Melvin v. Commissioner, 88 T.C. 63 (1987), affd.

894 F.2d 1072 (9th Cir. 1990); see also Old Colony Trust Co. v.

Commissioner, 279 U.S. 716 (1929) (payment of taxes by

corporation constitutes additional income to taxpayer).

Key to

the test of the taxability of a distribution as a dividend is

whether the shareholder receives an economic benefit from the

corporation without any expectation of repayment, and whether the

benefit is primarily of a personal nature, unrelated to the

corporation's business.

Ireland v. United States, supra at 735;

Loftin & Woodard, Inc. v. United States, supra at 1215-1217.

Under the facts at hand, we conclude that petitioners

received an economic benefit from CAI, which they assumed no

obligation to repay.

Petitioners used BarSon's funds for their

personal purposes, and petitioner was a 50-percent shareholder of

the two-shareholder corporation.

Although petitioners claim that

some of these funds (the $1,000 in checks and the $18,635 used

for home improvements) were lent to petitioner by BarSon for his

personal use, the record does not support this naked assertion.

We are unpersuaded that BarSon and petitioners intended for

petitioners to pay back any of the funds that they used for their

personal benefit.

See Litton Business Sys., Inc. v.

Commissioner, 61 T.C. 367, 377 (1973).

Because petitioners used

- 29 BarSon's funds to pay their personal expenses and did not intend

to repay these funds, we sustain respondent's determination on

this issue.21

Issue 3.

Interest Income

Respondent determined that petitioners received taxable

interest of $7,791, $37,612, and $8,429 in 1980, 1981, and 1982,

respectively, from the funds deposited at the Bank.

Petitioners

allege that they did not receive any interest from the Bank

because they never had an interest-bearing account there.

We agree with respondent's determination.

includes interest.

Sec. 61(a)(4).

Gross income

Interest of $15,582, $75,224,

and $16,858 was earned in 1980, 1981, and 1982, respectively, on

the commissions deposited at the Bank.

Petitioner and Dr. Young

had unfettered access to this interest, as well as to the

underlying funds.

Petitioner and Dr. Young controlled the

activities of the accounts.

Given the fact that petitioner was

one of two beneficial owners of the bank accounts that generated

the disputed interest, we sustain respondent's determination that

half of the interest earned on the accounts was realized by him.

Petitioners have also failed to persuade us that any of

the distributions were business expenses of BarSon.

- 30 Issue 4.

Additions to Tax for Fraud

Respondent determined that petitioner was liable for

additions to tax for fraud in each year in issue.

disputes this determination.

Petitioner

Respondent must prove that

petitioner underpaid his taxes in each of the subject years, and

that some part of each underpayment was due to fraud, in order to

sustain her allegations of fraud under:

(1) Section 6653(b), for

petitioner's 1980 and 1981 taxable years,22 and (2) section

6653(b)(1), for petitioner's 1982 taxable year.23

See secs.

As applicable to petitioner's 1980 and 1981 taxable

years, sec. 6653(b) provides: "If any part of any underpayment

* * * of tax required to be shown on a return is due to fraud,

there shall be added to the tax an amount equal to 50 percent of

the underpayment."

Sec. 325(a) of the Tax Equity and Fiscal Responsibility

Act of 1982, Pub. L. 97-248, 96 Stat. 616-617, amended sec.

6653(b) effective for taxes the last day prescribed by law for

the payment of which, without regard to extensions, was after

Sept. 3, 1982. Following its amendment, sec. 6653(b) provides in

relevant part:

(1) In general.--If any part of any underpayment * * *

of tax required to be shown on a return is due to fraud,

there shall be added to the tax an amount equal to 50

percent of the underpayment.

(2) Additional amount for portion attributable to

fraud.--There shall be added to the tax (in addition to the

amount determined under paragraph (1)) an amount equal to

50 percent of the interest payable under section 6601-(A) with respect to the portion of the

underpayment described in paragraph (1) which is

attributable to fraud, and

(B) for the period beginning on the last day

prescribed by law for payment of such underpayment

(continued...)

- 31 6211, 6653(c)(1); sec. 301.6211-1(a), Proced. & Admin. Regs.;

see also Drieborg v. Commissioner, 225 F.2d 216, 219-220 (6th

Cir. 1955) (where fraud is determined for each of several years,

the Commissioner's burden applies separately to each of the

years), affg. in part and revg. in part a Memorandum Opinion of

this Court dated February 24, 1954; Estate of Stein v.

Commissioner, 25 T.C. 940, 959-963 (1956) (same), affd. sub nom.

Levine v. Commissioner, 250 F.2d 798 (2d Cir. 1958); DiLeo v.

Commissioner, 96 T.C. 858 (1991) ("clear and convincing" standard

applies to both prongs of the two-prong test), affd. 959 F.2d 16

(2d Cir. 1992); Parks v. Commissioner, 94 T.C. 654, 663-664

(1990) (same); Hebrank v. Commissioner, 81 T.C. 640 (1983)

(same); Habersham-Bey v. Commissioner, 78 T.C. 304, 312 (1982)

(same), and the cases cited therein.

With respect to section

6653(b)(2), the time-sensitive provision applicable to

petitioner's 1982 taxable year, respondent must also prove the

portion of the deficiency that is attributable to fraud.

Sec.

6653(b)(2); see Cooney v. Commissioner, T.C. Memo. 1994-50.

(...continued)

(determined without regard to any extension) and ending

on the date of the assessment of the tax (or, if

earlier, the date of the payment of the tax).

- 32 a.

Underpayments

The mere fact that we have sustained respondent's deficiency

determination does not mean that petitioner underpaid his taxes

for purposes of the additions to tax for fraud.

Where, as here,

we have sustained respondent's determination of a deficiency

mainly by virtue of petitioners' failure to carry their burden of

proof, we will not allow respondent to rely merely on that

failure to sustain her burden of proving fraud.

We will not

bootstrap a finding of fraud upon a taxpayer's failure to

disprove the Commissioner's deficiency determination.

Parks v. Commissioner, supra at 660-661.

We have carefully reviewed the record.

Following our

review, we conclude that respondent has clearly and convincingly

proven that petitioner underpaid his taxes for each year in

issue.

See sec. 6653(c)(1) (an "underpayment" generally is the

same as a "deficiency" under sec. 6211).

The record clearly

convinces us that petitioner had gross income that was not

reported on his 1980 through 1982 tax returns.

Fraudulent Intent

To establish fraud under section 6653(b) (for 1980 and 1981)

and section 6653(b)(1) (for 1982), respondent must clearly and

convincingly prove that petitioner meant to evade the payment of

taxes.

Douge v. Commissioner, 899 F.2d 164, 168 (2d Cir. 1990);

Kahr v. Commissioner, 414 F.2d 621 (2d Cir. 1969), affg. in part

and revg. in part 48 T.C. 929 (1967); Rowlee v. Commissioner,

- 33 80 T.C. 1111, 1123 (1983).

Whether he meant to do so is a

factual question that must be resolved from the entire record.

DiLeo v. Commissioner, supra at 874; Gajewski v. Commissioner,

67 T.C. 181, 199 (1976), affd. without published opinion 578 F.2d

1383 (8th Cir. 1978).

Affirmative evidence is required to prove

an allegation of fraud because fraud is never imputed or

presumed.

Beaver v. Commissioner, 55 T.C. 85, 92 (1970).

Affirmative evidence includes circumstantial factors rising from

a taxpayer's course of conduct.

Spies v. United States, 317 U.S.

492, 499 (1943); Rowlee v. Commissioner, supra at 1123; Stone v.

Commissioner, 56 T.C. 213, 223-224 (1971).

Circumstantial

factors may show that the taxpayer meant to conceal, mislead, or

otherwise prevent the collection of his or her tax.

Rowlee v.

Commissioner, supra at 1123-1124; Beaver v. Commissioner, supra

at 92-93.

Oft-cited circumstantial factors, generally referred

to as "badges of fraud", include:

(1) Understatement of income,

(2) inadequate records, (3) failure to file tax returns,

(4) implausible or inconsistent explanations of behavior,

(5) concealing assets, (6) failure to cooperate with tax

authorities, (7) engaging in illegal activities, (8) attempting

to conceal activities, (9) dealings in cash, and (10) failing to

make estimated tax payments.

Bradford v. Commissioner, 796 F.2d

303, 307-308 (9th Cir. 1986), affg. T.C. Memo. 1984-601; see also

Meier v. Commissioner, 91 T.C. 273, 297-298 (1988).

- 34 We turn to these factors and analyze the relevant factors

seriatim.

We also discuss other factors that we consider to be

important to our query.

Understatement of Income

Petitioner substantially understated his income for 1980 and

1981 by not reporting his commissions and the interest earned

thereon.

Petitioner also failed to report any of the CAI or

BarSon funds that he used for his personal benefit in each of the

subject years.

Petitioners's consistent and substantial

understatement of income is strong evidence of fraud.

Parks v.

Commissioner, supra at 664; Marcus v. Commissioner, 70 T.C. 562,

577 (1978), affd. without publishied opinion 621 F.2d 439 (5th

Cir. 1980).

ii.

Inadequate Records

Petitioner did not keep records with respect to the

commissions earned by him and paid to CAI.

His failure to

maintain adequate records of this income is indicative of fraud.

Truesdell v. Commissioner, 89 T.C. 1280, 1302 (1987); Gajewski v.

Commissioner, supra at 200.

iii.

Failure to File Tax Returns

Petitioner was advised by Finley Kumble that he had to file

Form 959.

He failed to file Form 959, even though Finley Kumble

prepared this form for him, and he signed it.

We find

petitioner's failure to file Form 959 under the facts contained

herein to be another indicium of fraud.

- 35 iv.

Explanations of Behavior

Petitioner testified that he did not organize CAI, was not a

shareholder or beneficial owner of CAI, did not have a working

knowledge of CAI, and did not have authority to direct

disbursements from CAI.

Petitioner testified that he was led

astray by Finley Kumble as to the organization and operation of

CAI.

Petitioner testified that Finley Kumble organized and

operated CAI for Finley Kumble's personal gain.

Petitioner

testified that he never sought legal advice on the organization

or operation of a foreign corporation, and that he did not

receive any related advice from, or attend any related meeting

with, Finley Kumble on this subject.

The record contains substantial evidence that rebuts

petitioner's testimony.

The record adequately demonstrates that

petitioner sought legal assistance concerning his attempt to

minimize his Federal income taxes with respect to the subject

commissions; that he was actively involved in CAI's organization

in an attempt to minimize his Federal income taxes; that he owned

50 percent of CAI; that he directed the payment of his personal

commissions to CAI, which he knew to be nothing more than a

"paper corporation"; that he instructed Mr. Quin to withdraw

funds from CAI for his (petitioner's) benefit in an evasive and

surreptitious manner; that the funds withdrawn from CAI were not

loans to him; that he knew he had a tax problem with respect to

the commissions; that he knew that the commissions were never

- 36 reported on his returns; that he ignored his attorneys' advice

concerning the proper reporting of his commissions for Federal

income tax purposes; and that he intended to conceal his receipt

of the commissions in an attempt to evade Federal income tax.

Petitioner's attempt to combat this overwhelming evidence against

him with inconsistent and false explanations is further evidence

of his fraud.

The same is true with respect to petitioner's

attempt to place the blame on Finley Kumble for his tax problems.

Attempt to Conceal Activities

Petitioner used nominees to conceal his ownership interest

in CAI.

He used a third party to withdraw substantial funds for

himself and to pay his creditors as part of a scheme to avoid

paying taxes on his earned commissions.

We find both of these

actions to be indicia of fraud.

vi.

Other Factors

Petitioner's Sophistication

A taxpayer's sophistication and experience are relevant in

determining fraudulent intent.

Stephenson v. Commissioner,

79 T.C. 995, 1006 (1982), affd. 748 F.2d 331 (6th Cir. 1984).

Petitioner was a sophisticated and experienced businessman,

especially in the international arena.

We find this factor to be

evidence of fraud under the facts contained herein.

Withholding Information From Tax Preparer

Petitioner's 1980 through 1982 returns contained many false

statements and/or failed to report relevant information.

The

1980 and 1981 returns stated erroneously that petitioner did not

- 37 have an interest in a foreign account during those years.

The

1982 return did not report that petitioners had an interest in a

foreign account during that year.

None of the subject returns

reported the commissions that petitioner earned from ABL, or the

interest earned thereon.

All of these misstatements (or

omissions) are due to the fact that petitioner did not tell his

accountant/tax preparer (Mr. Schiller) that petitioner had an

interest in a foreign account.

evidence of fraud.

We find this factor to be

Korecky v. Commissioner, 781 F.2d 1566, 1569

(11th Cir. 1986), affg. T.C. Memo. 1985-63.

Legal Advice

Petitioner requested and was given legal advice on the

appropriate manner to report his commissions for Federal income

tax purposes.

He deliberately ignored this advice.

We find that

petitioner's lack of regard for Finley Kumble's advice was for

the primary purpose of evading taxes, and we conclude that this

factor supports respondent's determination.

Although not

necessary to our conclusion, we note that fraudulent intent can

be found by reasonable inference drawn from proof that a taxpayer

deliberately closed his or her eyes to what would otherwise have

been obvious to him or her.

In other words, a trier of fact may

infer that an individual knew of his or her evasion of tax from

his or her willful blindness to the existence of that fact.

course, the trier of fact must find that the individual actually

knew of his or her tax evasion.

A showing of mistake,

- 38 negligence, carelessness, recklessness, or even gross negligence

will not, by itself, support such a finding.

United States v.

MacKenzie, 777 F.2d 811, 818-819 (2d Cir. 1985); see also Wright

v. Commissioner, T.C. Memo. 1993-328, affd. without published

opinion 73 F.3d 372 (9th Cir. 1995).

vii.

Conclusion

We find that respondent has clearly and convincingly proven

fraud on the part of petitioner for all years in issue, and we so

hold.

We also find that respondent has clearly and convincingly

proven that petitioner is liable for the time-sensitive provision

for fraud with respect to the total deficiency for 1982.24

Issue 5.

Period of Limitation

Respondent generally must assess tax within 3 years of the

later of the due date of a return or its filing date.

Sec.

6501(a) and (b)(1); Mecom v. Commissioner, 101 T.C. 374, 381

(1993), affd. without published opinion 40 F.3d 385 (5th Cir.

1994).

Because respondent mailed the subject notice of

deficiency to petitioners after this 3-year period, she must rely

on an exception to the general rule to assess Federal taxes for

those years.

As one exception to the general rule, tax owed on a

false or fraudulent return may be assessed at any time.

6501(c)(1).

"Fraud" has the same meaning in section 6501(c)(1),

as in section 6653(b).

Sec.

Ruidoso Racing Association, Inc. v.

We note that all of the deficiency for 1982 stems from

respondent's adjustment to petitioners' interest income.

- 39 Commissioner, 476 F.2d 502, 505, 507 (10th Cir. 1973), affg. in

part and revg. in part. T.C. Memo. 1971-194; Neaderland v.

Commissioner, 52 T.C. 532, 541 (1969), affd. 424 F.2d 639 (2d

Cir. 1970); see also Murphy v. Commissioner, T.C. Memo. 1995-76.

We have just held that the underpayments in petitioners'

income taxes were due to fraud on the part of petitioner for

purposes of section 6653(b).

here.

We need not repeat our analysis

We reject petitioners' claim that the period of limitation

has expired on any of the years in issue.25

Issue 6.

Innocent Spouse

Mrs. Fields alleges that she is an innocent spouse under

section 6013(e).

Mrs. Fields alleges that she was unaware of

petitioner's business activities, and that she had no knowledge

of the subject transactions.

Spouses generally are jointly and severally liable for

income taxes due on a joint Federal income tax return.

Sec.

6013(d)(3); Bliss v. Commissioner, 59 F.3d 374, 377 (2d Cir.

1995), affg. T.C. Memo. 1993-390.

The "innocent spouse"

provision of section 6013(e) relieves a spouse of joint Federal

income tax liability if the following four elements are met:

(1) The spouses filed a joint Federal income tax return, (2) the

return reflected a substantial understatement of tax attributable

Based on this holding, we do not consider respondent's

alternative argument that petitioners' 1980 and 1981 taxable

years are open under the 6-year rule of sec. 6501(e)(1)(A).

- 40 to grossly erroneous items of one spouse, (3) in signing the

return, the alleged innocent spouse did not know, and had no

reason to know, of the substantial understatement, and (4) taking

into account all the facts and circumstances, it would be

inequitable to hold the alleged innocent spouse liable for the

deficiency attributable to the understatement.

Sec. 6013(e)(1);

Friedman v. Commissioner, 53 F.3d 523 (2d Cir. 1995), affg. in

part and revg. in part T.C. Memo. 1993-549; Hayman v.

Commissioner, 992 F.2d 1256, 1259 (2d Cir. 1993), affg. T.C.

Memo. 1992-228.

The claimant of innocent spouse relief, in this

case Mrs. Fields, must prove that each of these elements is

satisfied.

The failure to prove any of these prongs will

preclude innocent spouse relief.

Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933); Bliss v. Commissioner, supra

at 378.

The innocent spouse provision was enacted to remedy

"grave injustice"; however, it is "construed and applied

liberally in favor of the person claiming its benefits."

Bliss

v. Commissioner, supra at 378 (citations and quotation marks

omitted).

The parties focus on the last two prongs of the four-prong

test, and we will do likewise, starting our analysis with the

third prong.

In cases involving the omission of income, such as

the instant case, the fact that an alleged innocent spouse knew

of the transaction that produced the omitted income ordinarily

will prevent him or her from qualifying for innocent spouse

- 41 relief.

Knowledge need not be actual or complete.

The more an

alleged innocent spouse knew about a transaction, the more likely

that he or she knew or had reason to know that the return

contained a substantial understatement. Id.

A spouse has "reason

to know" of an understatement if a reasonably prudent person,

under the circumstances of the alleged innocent spouse at the

time of signing the return, could be expected to know that the

tax liability stated on the return was erroneous, or that further

investigation was warranted.

Id.; Sanders v. United States,

509 F.2d 162 (5th Cir. 1975); Bokum v. Commissioner, 94 T.C. 126,

148 (1990), affd. 992 F.2d 1132 (11th Cir. 1993); Terzian v.

Commissioner, 72 T.C. 1164, 1170 (1979).

Critical factors to

consider in passing on this objective test include:

(1) The

level of education of the alleged innocent spouse, (2) his or her

involvement 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 level of income, standard of

living, and spending patterns, and (4) the "culpable" spouse's

refusal to be forthright about the couple's income.

Bliss v.

Commissioner, supra at 378; Wimpie v. Commissioner, T.C. Memo.

1994-41.

Turning to the facts at hand, we find that Mrs. Fields knew

of the underlying transactions that generated the omitted income

when she signed the subject returns.

The record demonstrates

that Mrs. Fields knew about petitioner's business venture and

- 42 dealings with oil and the extent and magnitude thereof.

Among

other things, we find that Mrs. Fields knew that petitioner

worked as a consultant for Ashland, that he was attempting to

secure crude oil for Ashland, that he traveled abroad extensively

using his various contacts to locate a source of oil, that he

traveled on business to Bermuda and Cameroon, and that his

business pursuits involved Ashland, oil, and a Government

official from Cameroon.

Even if we were to conclude (which we do not) that she did

not know of petitioner's activities at the relevant times, we

believe that she certainly should have known of the

understatement of income on each of the returns when she signed

them.

Mrs. Fields is well educated and intelligent.

She was

actively involved in the family's business and financial affairs.

She knew of the magnitude of petitioners' spending during the

relevant years, including extraordinary expenditures (e.g.,

purchase of a boat, purchase and renovation of homes), and she

knew that the money to pay for these expenses did not come from

petitioners' checking account.

A prudent person in Mrs. Fields'

position would have known that the returns were erroneous or that

further inquiry was warranted.

Perfect knowledge of the family's

financial affairs is not required to satisfy the reason to know

standard.

Shea v. Commissioner, 780 F.2d 561, 567 (6th Cir.

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

- 43 We also believe that the Fieldses' expenditures were lavish

and unusual for a couple reporting 1980, 1981, and 1982 taxable

income of $56,847, $71,010, and $5,550, respectively.

Mrs.

Fields failed to show that petitioner was not forthright about

the omitted income.26

Funds were always available or made

available for all of petitioners' expenditures, yet Mrs. Fields

never asked petitioner about the source of the large amounts of

money that they spent.

She also did not ask him whether the

subject returns were accurate, preferring to assume that they

were.

If she had asked, Mrs. Fields testified, he would have

given her the returns to thoroughly review.

We believe that a

reasonable person in Mrs. Fields' position would have inquired

about the accuracy of the income reported on the returns, given

the facts of this case.

Mrs. Fields cannot turn a blind eye to

her tax obligations and expect innocent spouse relief.

See

Estate of Jackson v. Commissioner, 72 T.C. 356, 361 (1979);

Kenney v. Commissioner, T.C. Memo. 1995-431.

We conclude that Mrs. Fields knew (or should have known)

that the subject returns contained substantial understatements.

Based on this conclusion, Mrs. Fields is not entitled to innocent

spouse relief regardless of whether it would be inequitable to

hold her liable for the subject deficiencies.

We note quickly in

Mrs. Fields failed to establish that petitioner was

evasive or otherwise misled her with respect to the true level of

their income, and we find no evidence that petitioner tried to

hide the unreported income from Mrs. Fields.

- 44 passing, however, that the record fails to support her assertion

that it would be, in light of the factors set forth in Friedman

v. Commissioner, 53 F.3d at 532.