UNITED STATES TAX COURT

T.C. Memo. 1997-513

UNITED STATES TAX COURT

MAURICE D. AND ELINOR TAYLOR, Petitioners v.

COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 5218-95.

Filed November 17, 1997.

Paula M. Junghans and Caroline D. Klepper, for petitioners.

Richard A. Stone, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS,

Judge:

Respondent

determined

the

following

deficiencies, additions, and penalties with respect to petitioners'

Federal income taxes:

- 2 -

Year

1988

1989

1990

Deficiency

$178,198

40,454

36,405

Additions to Tax & Penalties

Sec.

Sec.

Sec.

6651(a)(1)

6653(b)(1)

6663

--$133,649

--$10,114

--$30,341

9,101

--27,304

Respondent seeks, in the event the Court does not sustain the fraud

determination

for

1988,

additions

to

tax

for

negligence

or

disregard of rules or regulations pursuant to section 6653(a)(1),

substantial understatement of tax pursuant to section 6661(a), and

failure to timely file a Federal tax return pursuant to section

6651(a)(1).

Additionally, in the event the Court does not sustain

the fraud determinations for 1989 and 1990, respondent seeks

accuracy-related penalties pursuant to section 6662 for negligence

or disregard of rules or regulations or substantial understatement

of tax.

The 1988 deficiency arises from respondent's determination

that petitioners had unreported income from a grocery/convenience

store business, a jewelry business, a check-kiting scheme, an

individual retirement account distribution, and interest from bank

accounts. The 1989 deficiency arises from unreported income of the

grocery/convenience store business and from gambling, and the 1990

deficiency arises from unreported income of the grocery/convenience

store business, gambling winnings, and interest.

For all 3 years

in issue, deficiencies were also determined for failure to report

self-employment taxes with respect to the unreported income from

petitioners' business activities.

- 3 After concessions,1 the following issues remain for decision:

(1) Whether Maurice D. Taylor (petitioner) received $280,698 (or

any lesser amount) of income from a check-kiting scheme in 1988;2

(2) whether petitioner is liable for the fraud addition to tax

pursuant

to

section

6653(b)(1)

for

1988

and

fraud

penalties

pursuant to section 6663 for 1989 and 1990; (3) whether Elinor

Taylor (Mrs. Taylor) is entitled to innocent spouse relief pursuant

to section 6013(e) for each year in issue; and (4) in the event the

Court does not sustain respondent's determinations of the fraud

addition to tax or penalties, whether petitioners are liable for

additions to tax or accuracy-related penalties for negligence,

substantial understatement, and failure to file.

All section references are to the Internal Revenue Code as in

effect for the years in issue, unless otherwise indicated.

All

1

The parties stipulate that petitioners had net income

from the grocery/convenience store business of $72,919 in 1988,

$102,370 in 1989, and $87,877 in 1990. Respondent concedes that

petitioners had no net income from the jewelry business and that

Mrs. Taylor is not liable for the fraud additions to tax and

penalties. Petitioners concede respondent's determinations with

respect to the individual retirement account distribution,

interest income, and gambling winnings. Petitioners further

concede that the net income from the grocery/convenience store

business is subject to self-employment taxes for each year in

issue. Finally, petitioners concede that they are liable for the

additions to tax for failure to timely file their 1989 and 1990

Federal income tax returns pursuant to sec. 6651(a)(1).

2

In the notice of deficiency, respondent determined

unreported income of $300,698 from a check-kiting scheme in 1988.

At trial, respondent conceded that $20,000 of the $300,698

related to attorney's fees and thus reduced the amount of

unreported income from the check-kiting scheme to $280,698.

- 4 Rule

references

Practice

and

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

The

Procedure.

are

to

the

Tax

Court

Rules

of

All dollar amounts are rounded.

FINDINGS OF FACT

stipulation of facts and the attached exhibits are incorporated

herein by this reference.

Background

Petitioners, husband and wife, resided in Baltimore, Maryland,

at the time they filed their petition.

have three children.

several

small

They married in 1968 and

For over 25 years, petitioner operated

businesses

in

the

Baltimore

area,

including

a

grocery/convenience store. During the period in issue, Mrs. Taylor

remained at home and took care of the children.

Grocery/Convenience Store Business

In 1969 or 1970, petitioner began operating a "mom and pop"

grocery/convenience store under the name M&E, Inc. (Despite its

name, M&E, Inc., was a sole proprietorship of petitioner.) Many of

petitioner's

business

records

were

in

disarray.

Bills

for

business expenses were kept in boxes, and daily gross receipts were

recorded on a calendar.

Mrs. Taylor began working in the store sometime in 1990 when

petitioner's criminal problems resulting from his check-kiting

scheme (discussed infra) overwhelmed him.

Following petitioner's

incarceration in January 1991, Mrs. Taylor ran the store with one

- 5 of her sons 7 days a week, operating the cash register, taking

inventory, depositing receipts, and writing checks to pay the

store's creditors.

Check-Kiting Scheme

In late 1980 or early 1981, petitioner began a check-kiting

scheme.

Check kiting involves writing checks on a bank account

that has insufficient funds and depositing those checks into an

account at another bank (the second bank).

The credit received at

the second bank for the deposited checks is then used to issue

checks from the account at the second bank.

The check kiter relies

on the time (the "float time") it takes a bank (the second bank) to

process checks for deposit and payment.

The check kiter uses the

float time (normally 3 days) to cover the "bad" checks.

In the

case at hand, petitioner's check-kiting scheme primarily involved

accounts at Irvington Federal Savings & Loan (Irvington Federal)3

and Commercial & Farmers Bank (Commercial & Farmers).

During the

years at issue, petitioner kited as much as $60,000 in checks per

day.

Occasionally petitioner used check-cashing services to obtain

cash needed to keep his check-kiting scheme afloat.

In general,

these services charged 2-1/2 percent of the amount of the check.

At other times, in order to obtain cash,

3

petitioner wrote checks

Irvington Federal Savings & Loan accounts were taken

over by the Resolution Trust Corporation in February 1992.

- 6 to purchase gold Krugerrand coins at a premium, then sold the coins

to a dealer at a discount of 5 to 8 percent.

Petitioner was aware of the requirement that banks report

deposits of $10,000 or more and often made efforts to evade making

deposits in those amounts.

To support his check-kiting scheme and to pay off debts,

petitioner borrowed funds. He borrowed approximately $100,000 from

his father-in-law, of which Mrs. Taylor was unaware, and from

several other individuals.

Petitioner was unable to repay all of

his debts and often used funds borrowed from one person to pay what

he owed to others.

In July 1988, after a Commercial & Farmers bank officer

notified petitioner that his account at that bank would be frozen,

and that his checks would no longer be honored, petitioner knew

that

his

check-kiting

scheme

was

on

the

verge

of

collapse.

Petitioner then, for the first time, informed Mrs. Taylor of his

check-kiting activities.

The Taylors went to Irvington Federal to

liquidate both the family checking account and Mrs. Taylor's

savings account. Petitioner then went (without Mrs. Taylor) to the

Irvington Federal branch where the president of the bank, William

Ottey, maintained his office. Petitioner informed Mr. Ottey of his

check-kiting activities and the action taken by Commercial &

Farmers with regard to petitioner's account.

Petitioner told Mr.

Ottey that as a result of Commercial & Farmers' decision to freeze

- 7 his account, Irvington Federal would be left holding a number of

dishonored checks.4 Petitioner showed Mr. Ottey a spreadsheet that

detailed petitioner's check-kiting activity and told him that

Commercial & Farmers checks worth approximately $163,000 were going

to bounce.

Several days later, petitioner and Mrs. Taylor executed two

confessed judgment promissory notes totaling $170,000 (one in the

name of M&E, Inc., and one in petitioners' names, each dated July

21, 1988) to repay Irvington Federal for the bounced checks.

To

secure the repayment of these notes, petitioners executed mortgages

against their home and two business properties.

No evidence was

presented as to petitioners' equity in the properties upon which

the mortgages were given.

Although Mr. Ottey considered the $170,000 to be partial

restitution for the losses incurred by Irvington Federal as a

result of petitioner's check-kiting scheme, petitioners' payments

pursuant to the notes were structured by Mr. Ottey as payments

pursuant to a line of credit.

4

The line of credit statement

These checks were drawn on petitioner's Commercial &

Farmers account and deposited into his Irvington Federal account

in order to create a positive balance which petitioner used in

turn to draw checks on his Irvington Federal account. Because

Commercial & Farmers froze petitioner's account, Irvington

Federal could not present the Commercial & Farmers checks, which

were deposited into petitioner's Irvington Federal account, for

payment. Thus, Irvington Federal was left holding worthless

Commercial & Farmers checks which Irvington Federal had already

cleared for payment.

- 8 indicated that the line of credit was for $280,698; interest at 2

percent above prime would be charged; and no monthly fixed payments

were required.

(Petitioners disputed the amount of liability

($280,698) Irvington Federal claimed petitioner owed it.)

In March 1990 as part of a plea agreement with the U.S.

Attorney's

Office,

structuring

cash

petitioner

transactions

pled

to

guilty

circumvent

to

one

the

count

$10,000

of

cash

deposit reporting requirements. Judgment was entered in November

1990, and petitioner was sentenced to 12 months' incarceration. He

served 6 months in the Federal prison in Allenwood, Pennsylvania

(from January through June 1991), and was thereafter transferred to

a halfway house to serve the remainder of his sentence on work

release.

The plea agreement with the U.S. Attorney's Office stipulated

that the check-kiting scheme caused Irvington Federal to suffer a

loss of $170,000 to $280,000, and that Mr. Taylor agreed to make

restitution. Pursuant to the judgment entered by the U.S. District

Court for the District of Maryland, petitioner agreed to file any

delinquent Federal and State income tax returns.

Petitioners' Lifestyle

Throughout the years in issue, petitioners maintained a modest

lifestyle.

They resided in the house they purchased in 1977; the

mortgage payments were approximately $400 per month.

Petitioners

owned two cars, a 1983 or 1984 pickup truck and a late-1970's model

- 9 Ford station wagon, both of which were financed. Also, petitioners

coowned a beach house in Annapolis, Maryland, which was sold in

1984 or 1985.

Mrs. Taylor handled the family finances.

She maintained the

family checking account and paid the household expenses out of the

weekly $500 given to her by petitioner.

Petitioners'

Baltimore

County

three

and

children

were

attended

members

of

a

public

schools

local

swim

in

club.

Occasionally, petitioners went on short family vacations to Ocean

City, Maryland.

Petitioner did not purchase any jewelry, furs, or similar

luxury items for Mrs. Taylor during the years in issue.

Filing of Federal Tax Returns

In January 1992, following petitioner's release from the

halfway house, petitioner and his accountant, Daniel Mules, met

with Revenue Officer Mario Scilipoti to discuss the filing of

delinquent returns for both the grocery/convenience store and

petitioners. Petitioner informed Revenue Officer Scilipoti that he

believed the grocery/convenience store suffered losses during the

years

in

issue.

Petitioner

further

informed

Revenue

Officer

Scilipoti that although the records for the grocery/convenience

store were in disarray, he had some documents that he could use for

filing

the

returns.

Petitioner

also

informed

Revenue

Officer

- 10 Scilipoti of his criminal conviction relating to his check-kiting

scheme.

Revenue Officer Scilipoti told petitioner and Mr. Mules to

prepare the delinquent returns from information available and that

if all the records were not complete, to file amended returns when

the necessary information became available.

Petitioner provided Mr. Mules with records for preparing

petitioners' delinquent returns for 1988, 1989, and 1990, which did

not

include

business.

records

Petitioner

regarding

did

not

the

grocery/convenience

ask

Mr.

consequences of the check-kiting scheme.

signing

the

petitioner.

joint

returns,

Mr.

Mules

Mules

about

store

the

tax

After preparing and

hand-delivered

them

to

Mr. Mules never discussed the preparation of the

returns with Mrs. Taylor.

Mr. Mules did not expect to prepare

amended returns for petitioners if and when the grocery/convenience

store business records were discovered, and petitioner told Mr.

Mules that he would hand-deliver the original returns to Revenue

Officer Scilipoti.

Rather than delivering the signed returns to Revenue Officer

Scilipoti, petitioners mailed joint Federal tax returns for 1988,

1989, and 1990 to the Internal Revenue Service (IRS) Center in

Philadelphia. The returns were received on January 29, 1992.

The

1988 return reported gross income before adjustments of $13,298.

The 1989 return reported gross income before adjustments of $8,842.

- 11 The 1990 return reported gross income before adjustments of $5,791.

Petitioners never filed amended returns.

Mrs. Taylor knew that petitioners had not filed tax returns

for the years in issue. In January 1992, when she signed the

delinquent

returns,

petitioner's

Mrs.

check-kiting

Taylor

knew

scheme.

She

about

also

the

existence

knew

about

of

the

grocery/convenience store business but never questioned why income

from that business was not reported on the delinquent returns.

Notice of Deficiency

In the notice of deficiency, respondent determined unreported

net income from the grocery/convenience store business through an

analysis of the bank deposits, ledger notations, Department of

Treasury statistics, and industry guidelines.

The unreported net

income was determined to be $72,919 for 1988, $102,370 for 1989,

and $87,877 for 1990.

Respondent further determined petitioners

had unreported income in 1988 from petitioner's check-kiting scheme

in the amount of $300,698.5

Respondent determined that petitioners were liable for the

fraud addition to tax for 1988, or in the event respondent's fraud

determination is not sustained, an addition to tax for negligence

or disregard of rules or regulations, an addition to tax for

substantial understatement of tax, and an addition to tax for

failure to timely file a Federal tax return.

5

See supra note 2.

For 1989 and 1990,

- 12 respondent determined that petitioners were liable for the fraud

penalties, and in the event respondent's fraud determinations are

not sustained, accuracy-related penalties pursuant to section 6662

for negligence or disregard of rules or regulations or substantial

understatement of tax.

OPINION

Issue 1.

1988 Check-Kiting Income

The first issue for decision is whether petitioners must

recognize $280,698 (or any lesser amount) of income for 1988 as a

result of petitioner's check-kiting scheme.

Petitioners assert

that Irvington Federal's shortfall from the check-kiting scheme was

$170,000,

not

$280,698,

and

that

because

the

shortfall

was

converted to a loan upon the execution of the confessed judgment

promissory notes and mortgages in July 1988, the proceeds from the

scheme are not taxable.

Respondent counters that the notes and

mortgages represented restitution, not a loan.

Gross

income

means

income

from

including income from illegal sources.

States,

whatever

source

derived,

Sec. 61; James v. United

366 U.S. 213 (1961); Rutkin v. United States, 343 U.S. 130

(1952); United States v. Rosenthal, 470 F.2d 837 (2d Cir. 1972);

Moore v. United States, 412 F.2d 974 (5th Cir. 1969); Peters v.

Commissioner, 51 T.C. 226 (1968); McSpadden v. Commissioner, 50

T.C. 478 (1968).

Generally, check kiting does not produce taxable

income because it merely involves a "merry-go-round" of funds from

- 13 one account to another. Teichner v. Commissioner, 453 F.2d 944 (2d

Cir. 1972), revg. and remanding on other grounds T.C. Memo. 1970311; Forster v. Commissioner, T.C. Memo. 1961-281.

However, when

the check-kiting scheme results in bounced checks of the taxpayer

and creates a loss to the financial institutions whose funds were

drawn upon in the scheme, income from the check-kiting scheme is

includable by the taxpayer.

Romer v. Commissioner, T.C. Memo.

1996-287; Bradshaw v. Commissioner, T.C. Memo. 1996-123.

Petitioner concedes that he was engaged in a check-kiting

scheme through July 1988 when it collapsed due to Commercial &

Farmers' refusal to honor future checks presented by petitioner for

deposit.

But petitioner contends that the check-kiting scheme was

converted to a loan arrangement in July 1988 when petitioners

executed promissory notes and mortgages in favor of Irvington

Federal.

Hence, petitioners assert that the proceeds from the

check-kiting scheme do not constitute taxable income.

Respondent

argues that the agreement reached between petitioner and Irvington

Federal in July 1988 cannot be characterized as a loan, but rather

as a plan of restitution.

Alternatively, respondent argues that

even if the agreement between Irvington Federal and petitioner

could be characterized as a loan, that agreement cannot alter the

taxability of the diverted funds to petitioner, i.e., inclusion of

the amount of such funds as income, because the agreement was made

- 14 after the check-kiting scheme collapsed and the bank incurred

losses.

For a transaction to be deemed a loan (and thus nontaxable),

the parties must have intended, at the time the transaction was

entered, that the money advanced be repaid.

Moore v. United

States, supra at 978; Commissioner v. Makransky, 321 F.2d 598, 600

(3d Cir. 1963), affg. 36 T.C. 446 (1961); Leaf v. Commissioner, 33

T.C. 1093, 1096 (1960), affd. 295 F.2d 503 (6th Cir. 1961); Kreimer

v. Commissioner, T.C. Memo. 1983-672.

The converse is also true:

When a taxpayer acquires earnings, lawfully or

unlawfully, without the consensual recognition, express

or implied, of an obligation to repay and without

restriction as to their disposition, "he has received

income which he is required to return, even though it may

still be claimed that he is not entitled to retain the

money, and even though he may still be adjudged liable to

restore its equivalent."

James v. United States, supra at 219 (quoting North Am. Oil Consol.

v. Burnet, 286 U.S. 417, 424 (1932)).

With respect to the case at hand, from the inception of

petitioner's check-kiting scheme in 1980 or 1981 through the day

the

scheme

collapsed

in

July

1988,

consented to petitioner's overdraws.

Irvington

Federal

never

See Romer v. Commissioner,

supra. Indeed, Mr. Ottey, Irvington Federal's president, testified

that neither he nor the bank was aware of the check-kiting scheme

until petitioner notified them of it in July 1988.

was introduced to contradict this testimony.

And no evidence

Thus, it is clear

that no loan agreement was made between petitioner and Irvington

- 15 Federal with respect to the check-kiting scheme before July 1988.

And at that time, it was apparent that Irvington Federal would

suffer a loss as a result of petitioner's check-kiting scheme.

In Buff v. Commissioner, 58 T.C. 224, 232 (1972), revd. 496

F.2d 847 (2d Cir. 1974), we held that where a taxpayer embezzled

funds and "there is a 'consensual recognition' of indebtedness

within the

same

taxable

year,

formalized

by

a

confession

judgment," the embezzled funds are not included in income.

facts in Buff were as follows:

his employer.

immediately

The

The taxpayer embezzled funds from

Upon discovery of the embezzlement, the taxpayer

admitted

the

embezzlement.

He

signed

confessed

judgments "for a debt justly due to the plaintiff [employer]".

at 225.

of

Id.

The taxpayer further agreed to continue working for the

employer and to pay $25 per week for repayment of the debt.

He

also borrowed $1,000 which he used to repay part of the debt.

We recognized in Buff that parties to a transaction, dealing

at arm's length, may alter, amend, or revoke a transaction so as to

change its character for tax purposes if their action takes place

within

the

consensual

same

taxable

recognition

of

year.

We

thus

indebtedness

held

therein

existed

such

that

that

a

the

embezzled funds were not includable in the taxpayer's income.

The facts in Buff are distinguishable from those herein.

First, Irvington Federal never agreed to treat the repayment of the

check-kiting scheme losses as a debt.

Mr. Ottey testified that he

- 16 considered the repayments restitution for the losses Irvington

Federal incurred, not a loan.

The line of credit format employed

by Mr. Ottey was solely for the bank's internal accounting use.

Further, the confessed judgments signed by petitioners do not

characterize the repayments as "debt" as in Buff, but only as

"advances"

(namely,

the

overdrawn

funds).

Moreover,

we

are

cognizant of the fact that petitioner's plea agreement with the

U.S. Attorney's Office with respect to his cash structuring charge

required petitioner to make restitution to Irvington Federal.

Second, there is no evidence that petitioners would have

qualified

for

a

loan

from

Irvington

Federal.

See

Quinn

v.

Commissioner, 62 T.C. 223, 229 (1974), affd. 524 F.2d 617 (7th Cir.

1975) (holding that no loan transaction occurred and embezzled

funds were includable in income where the savings and loan could

not make a loan to the taxpayer under State law).

There is no

evidence that the bank conducted a check of petitioners' creditworthiness

before

the

executed.

Additionally,

confessed

there

is

judgments

no

and

evidence

mortgages

of

a

were

continued

relationship between petitioners and Irvington Federal outside of

the restitution payments, whereas in Buff the taxpayer continued to

work for the employer for 1 month.

We

do

not

believe

petitioners'

July

1988

execution

of

confessed judgment notes and mortgages to cover the bank's losses

was intended by the parties to create a consensual loan between

- 17 Irvington Federal and petitioners so as to convert the check-kiting

scheme to a debt arrangement.

Consequently, we hold that the amount

of the bounced checks--the amount of the loss Irvington Federal

sustained--must be included in petitioners' income.

We

now

petitioners'

turn

to

the

amount

income;

i.e.,

the

that

must

amount

of

be

the

included

bank's

in

loss.

Petitioners assert that Irvington Federal suffered approximately

$170,000

in

losses

from

petitioner's

check-kiting

Respondent claims that the losses totaled $280,698.

scheme.

These amounts

are at the opposite ends of the range stipulated in petitioner's

plea agreement with the U.S. Attorney's Office with respect to the

cash-structuring charge.

Petitioner claims that $170,000 is the correct amount because

that is the amount reflected in the confessed judgment promissory

notes

and

mortgages

executed

by

the

parties

in

July

1988.

Additionally, petitioner testified that when he presented Mr. Ottey

with the spreadsheet of his check-kiting activity, he told Mr.

Ottey that the total losses were approximately $163,000.

Mr. Ottey testified that Irvington Federal suffered a $280,000

loss and that $170,000 represented the maximum Irvington Federal

could secure from petitioners' assets on foreclosure.

Mr. Ottey

claimed that the balance of the losses, $110,000, was written off

by the bank and placed in a loss reserve account.

- 18 Mr. Ottey's testimony failed to persuade us that Irvington

Federal suffered a $280,000 loss.

Based on the record, we find

that the bank's loss from petitioner's check-kiting scheme was

$183,229.

This amount represents the total Irvington Federal

checks that Commercial & Farmers dishonored on July 13, 1988.

After reducing the $183,229 by $20,000 to reflect attorneys' fees

conceded by respondent, we hold that petitioners had unreported

income of $163,229 in 1988 from petitioner's check-kiting scheme.

Petitioners are entitled to relief for repayments to Irvington

Federal with regard to the dishonored checks.

States, 366 U.S. at 219-220.

See James v. United

Taxpayers are permitted to deduct

from income the amount of actual repayments made to the embezzled

party in the year of repayment. Ianniello v. Commissioner, 98 T.C.

165, 174 (1992).6

The character of the repayments as a loan or

restitution here is irrelevant.

If the taxpayer proves the actual

repayment of the embezzled funds, he is entitled to treat those

repayments

as

losses

under

section

165(c)(2).7

Mais

v.

6

There is no evidence to suggest that petitioners were

not cash basis taxpayers. Consequently, any amount repaid is

deductible in the year of repayment. See Whitaker v.

Commissioner, 259 F.2d 379, 382 (5th Cir. 1958), affg. 27 T.C.

399 (1956).

7

SEC. 165.

LOSSES.

(a) General Rule.--There shall be

allowed as a deduction any loss sustained

during the taxable year and not compensated

for by insurance or otherwise.

(continued...)

- 19 Commissioner, 51 T.C. 494, 497-498 (1968); Rev. Rul. 65-254, 1965-2

C.B. 50.8

Petitioner made repayments of at least $11,942 in 1988,

$33,693 in 1989, and $19,029 in 1990. These amounts were reported

on Forms 1098 sent to the IRS and petitioners by Irvington Federal.

The forms indicate that they are interest payments made pursuant to

the line of credit set up by Mr. Ottey to recover the losses from

the check-kiting scheme.

Mr. Ottey, however, testified that the

line of credit structure was only a bookkeeping mechanism to keep

track of both petitioner's restitution payments and Irvington

Federal's loss of interest income.

Mr. Ottey claims that his loan

officer mistakenly sent out the Forms 1098, and that the bank did

not report interest income to itself from any of petitioners'

payments.

Further, petitioner testified that he never agreed to a

7

(...continued)

*

*

*

*

*

*

*

(c) Limitation on Losses of

Individuals.--In the case of an individual,

the deduction under subsection (a) shall be

limited to-*

*

*

*

*

*

*

(2) losses incurred in any

transaction entered into for

profit, though not connected with a

trade or business * * *

8

A revenue ruling reflects the Commissioner's position

on an issue and is not binding on the Court. See Stark v.

Commissioner, 86 T.C. 243, 250-251 (1986).

- 20 line of credit format and that he never designated the payments as

principal or interest.

Petitioner asserts that he paid as much $1,000 per week to

Irvington Federal, with a $25,000 initial payment. Mr. Ottey

acknowledged that at times petitioner paid as much as $1,000 a week

and in 1988 petitioner paid "a total of maybe $50,000".

Mr. Ottey

further acknowledged that as of the date of petitioner's sentencing

(November 20, 1990), petitioner had repaid $91,804 to Irvington

Federal.

On the basis of the record, we conclude that petitioner made

restitution to Irvington Federal as follows: $39,082 in 1988,

$33,693 in 1989, and $19,029 in 1990.

Consequently, we hold that

petitioners are entitled to reduce their income for each of the

years in issue by those respective amounts.

Issue 2.

Fraud Addition to Tax and Penalties

The second issue for decision is whether petitioner is liable

for the fraud addition to tax or penalties for each year in issue.

Respondent determined the fraud addition to tax for 1988 pursuant

to

section

6653(b)(1)

and

pursuant to section 6663.

fraud

penalties

for

1989

and

1990

Petitioner asserts that he lacked the

necessary intent to evade taxes.

Respondent has the burden of proving fraud by clear and

convincing evidence.

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

Respondent must

show that the taxpayer intended to evade taxes known to be owing by

- 21 conduct intended to conceal, mislead, or otherwise prevent the

collection of such taxes.

Rowlee v. Commissioner, 80 T.C. 1111,

1123 (1983). Fraud can never be presumed. Beaver v. Commissioner,

55 T.C. 85, 92 (1970).

Fraud may be proven by circumstantial

evidence, Stone v. Commissioner, 56 T.C. 213, 223-224 (1971), and

the Court may consider the taxpayer's entire course of conduct,

Rowlee v. Commissioner, supra at 1123.

To prove fraud, respondent relies primarily on petitioners'

failure to report the income from the grocery/convenience store

business, as well as the check-kiting scheme, on their original

delinquent returns or on amended returns. Respondent asserts that:

(1) Petitioner did not file the delinquent returns with Revenue

Officer Scilipoti in order to hide the fact that no income was

reported

from

the

grocery/convenience

store

business;

(2)

petitioner had sufficient records from his calendar of daily gross

receipts and boxes of bills to calculate his net income from the

grocery/convenience store business; (3) petitioner knew from his

lifestyle

that

he

had

earned

substantial

profits

from

his

grocery/convenience store business; and (4) petitioner knew he had

income from his check-kiting scheme.

Respondent's assertions are not supported by the evidence.

First, we find credible petitioner's belief that he had no profits

from the grocery/convenience store business and that his lack of

adequate

books

and

records

prevented

him

from

establishing

- 22 otherwise.

Petitioner's

disarray is also credible.

testimony

that

the

records

were

in

The lack of organized records, given

petitioner's criminal problems during the years in issue, does not

reflect an intent to evade taxes. See Marinzulich v. Commissioner,

31 T.C. 487 (1958); Ouellette v. Commissioner, T.C. Memo. 1971-98.

Second, we believe petitioner never understood that he was supposed

to file the delinquent returns directly with Revenue Officer

Scilipoti, as respondent contends. In this regard, Revenue Officer

Scilipoti

testified

only

that

it

was

his

standard

operating

procedure to ask taxpayers to submit delinquent returns directly to

him.

Revenue

Officer

specifically

told

returns

him.

to

Scilipoti

petitioner

to

Additionally,

did

not

hand-deliver

there

was

testify

that

he

petitioners'

tax

never

understanding about the filing of amended returns.

any

clear

Mr. Mules

testified that he did not expect to prepare them, and petitioner

testified that he was not aware of his obligation to file amended

returns.

The failure to file amended returns does not evince an

intent to evade taxes. Broadhead v. Commissioner, T.C. Memo. 1955328.

Third, apparently relying on the notes and mortgages executed

in favor of Irvington Federal, petitioner did not know that the

check-kiting scheme resulted in taxable income, and apparently

Revenue Officer Scilipoti did not recognize the issue either.

The

lack of knowledge that ill-gotten gains are taxable tends to show

- 23 lack of intent to evade taxes.

Memo. 1985-234;

Cipparone v. Commissioner, T.C.

Hauser v. Commissioner, T.C. Memo. 1970-207.

We also find significant petitioner's attempt to promptly

resolve his tax problems following his release from Federal prison

and

the

halfway

house.

He

did

not

evade

Revenue

Officer

Scilipoti's request to meet; moreover, in less than 2 weeks after

the meeting, petitioners filed their delinquent returns.

On the basis of all the facts and circumstances, we hold that

respondent has failed to prove by clear and convincing evidence

that petitioner intended to evade taxes and defraud the Government

for the years in issue.

Issue 3.

The

Innocent Spouse Relief

third

issue

for

decision

is

whether

Mrs.

Taylor

is

entitled to innocent spouse relief pursuant to section 6013(e).

Mrs. Taylor claims that she is entitled to such relief for each

year in issue.

Respondent contends that Mrs. Taylor fails two of

the four requirements for relief.

Spouses who file a joint income tax return generally are

jointly and severally liable for its accuracy and the tax due,

including any additional taxes, interest, or penalties determined

on audit of the return.

Sec. 6013(d)(3).

However, pursuant to

section 6013(e), a spouse (commonly referred to as an innocent

spouse) can be relieved of tax liability if that spouse proves: (1)

A joint income tax return was filed; (2) the return contained a

- 24 substantial understatement of tax attributable to grossly erroneous

items of the other spouse; (3) in signing the return, the spouse

seeking relief did not know, and had no reason to know, of the

substantial understatement; and (4) under the circumstances it

would be inequitable to hold the spouse seeking relief liable for

the understatement. Sec. 6013(e). The spouse seeking relief bears

the burden of proving that each of the four elements of the statute

has been satisfied, and failure to satisfy any one of the elements

will prevent innocent spouse relief.

Purcell v. Commissioner, 826

F.2d 470, 473 (6th Cir. 1987), affg. 86 T.C. 228 (1986); Bokum v.

Commissioner, 94 T.C. 126, 138-139 (1990), affd. 992 F.2d 1132

(11th Cir. 1993).

Respondent concedes that Mrs. Taylor has satisfied the first

two statutory requirements for innocent spouse relief.

Mrs. Taylor asserts that she did not know, nor had reason to

know, of the substantial understatement of income.

To establish

this claim, Mrs. Taylor must prove that she was unaware of the

circumstances that gave rise to the omission of income.

See

Purcell v. Commissioner, 86 T.C. at 238. She must demonstrate lack

of both actual and constructive knowledge of the omission such that

a reasonable person could not have been expected to know that the

tax liability stated was erroneous or that further inquiry was

necessary.

See Stevens v. Commissioner, 872 F.2d 1499, 1504-1505

(11th Cir. 1989), affg. T.C. Memo. 1988-63.

- 25 The record is clear that Mrs. Taylor knew of the substantial

understatement of income from both petitioner's check-kiting scheme

and the grocery/convenience store business.

Mrs. Taylor admitted

at trial that she was told by petitioner of the check-kiting scheme

in July 1988, approximately 3-1/2 years prior to the filing of the

delinquent returns.

This fact prevents Mrs. Taylor from obtaining

innocent spouse relief with respect to the check-kiting income in

1988.

See Krause v. Commissioner, T.C. Memo. 1991-13;

Newton v.

Commissioner, T.C. Memo. 1990-606; Bents v. Commissioner, T.C.

Memo. 1990-487.

Although Mrs. Taylor may not have known the tax

consequences of the check-kiting scheme, that ignorance is no basis

for

relief.

See

Krause

v.

Commissioner,

supra;

Newton

v.

Commissioner, supra; Trimmer v. Commissioner, T.C. Memo. 1983-131.

With respect to the grocery/convenience store business, Mrs.

Taylor was fully aware that this business existed during 1988,

1989, and 1990, and she even worked in the store for a short period

during 1990 and much of 1991.

believed

from

her

Although Mrs. Taylor may have

conversations

with

petitioner

that

the

grocery/convenience store was operating at a loss during the years

in issue, she knew from her participation in the business that the

grocery/convenience store was generating gross receipts.

Mrs.

Taylor made deposits of cash receipts and wrote checks to creditors

while working at the store.

She testified, however, that she did

not review the joint returns she signed, and thus she never had

- 26 reason to know that the grocery/convenience store income was not

reported.

Taxpayers have an obligation to review tax returns before

signing them, and they are ordinarily charged with constructive

knowledge of the contents of the returns if they do not review

them.

Hayman v. Commissioner, 992 F.2d 1256, 1262 (2d Cir. 1993),

affg. T.C. Memo. 1992-228. Taxpayers generally cannot turn a blind

eye to what is disclosed on the tax return and plead ignorance.

Edmondson

v.

T.C.

Memo.

1996-393;

Cohen

v.

of,

and

involvement

in,

the

business

put

of

the

Commissioner,

Commissioner, T.C. Memo. 1987-537.

Mrs.

Taylor's

grocery/convenience

knowledge

store

her

on

notice

unreported income, even though petitioner may have suggested to her

that the business was losing money.

T.C. Memo. 1986-483.

See Alberts v. Commissioner,

When that income was omitted from the joint

returns, Mrs. Taylor had a duty to inquire of petitioner as to the

reporting of that income.

Memo. 1996-223.

See Zimmerman v. Commissioner, T.C.

Petitioner's financial and criminal problems

should have also prompted Mrs. Taylor to review the joint returns.

See Starr v. Commissioner, T.C. Memo. 1995-190, affd. without

published opinion 99 F.3d 1146 (9th Cir. 1996).

Mrs. Taylor presented no evidence supporting her innocent

spouse claim with respect to the other items of income (which

- 27 petitioners conceded, see supra note 1) and thus failed to meet her

burden of proof with respect to those items.

Rule 142(a).

Thus, we hold that Mrs. Taylor is not entitled to innocent

spouse relief and is liable for the deficiencies for the years in

issue.

Issue 4.

File

Negligence, Substantial Understatement, and Failure To

The final issue for decision is whether petitioners are liable

for additions to tax for negligence or disregard of rules or

regulations

pursuant

to

section

6653(a)(1),

substantial

understatement of tax pursuant to section 6661(a), and failure to

file their Federal tax return pursuant to section 6651(a)(1) for

1988; and whether petitioners are liable for accuracy-related

penalties pursuant to section 6662 for negligence or disregard of

rules or regulations, or substantial understatement of tax for 1989

and 1990.

Respondent made these determinations as an alternative

to the fraud addition to tax and penalties.

For 1988, section 6653(a)(1) imposes an addition to tax equal

to 5 percent of the underpayment if any part of the underpayment is

attributable to negligence or disregard of rules or regulations.

"Negligence" means any failure to make a reasonable attempt to

comply with the Internal Revenue Code, and "disregard" includes any

careless, reckless, or intentional disregard.

Sec. 6653(a)(3).

For 1988, section 6661(a) imposes an addition to tax equal to 25

percent of

the

amount

of

any

underpayment

attributable

to a

- 28 substantial

understatement

of

income

tax.

A

substantial

understatement means an understatement which exceeds the greater of

10 percent of the tax required to be shown on the return or $5,000.

Sec. 6661(b)(1).

Finally, section 6651(a)(1) imposes an addition

to tax of 5 percent of the tax required to be shown on the return

for each month or fraction thereof for which a return is not filed,

not to exceed 25 percent.

An exception is made where the failure

to file the return is due to reasonable cause not the result of

willful neglect.

For 1989 and 1990, section 6662(a) imposes an accuracy-related

penalty of an amount equal to 20 percent of the portion of the

underpayment attributable to negligence or disregard of rules or

regulations, or to a substantial understatement of tax.

Negligence is defined as a lack of due care or failure to do

what a reasonable person would do under the circumstances.

v. Commissioner, 85 T.C. 934, 947 (1985).

Neely

A taxpayer is not liable

for negligence or disregard of rules or regulations, or substantial

understatement of tax, if he shows that he acted with reasonable

cause and in good faith with respect to the underpayment in issue.

Sec. 6664(c).

The most important factor in determining reasonable

cause is the extent of the taxpayer's effort to assess the proper

tax liability.

Sec. 1.6664-4(b), Income Tax Regs.

The reasonable

cause exception applies only to returns due after December 31, 1989

(without regard to extensions).

Omnibus Budget Reconciliation Act

- 29 of 1989 (OBRA), Pub. L. 101-239, sec. 7721(a), 103 Stat. 2106,

2395.

Petitioners assert that they are not liable for the addition

to tax and accuracy-related penalties for negligence or disregard

of rules or regulations, or substantial understatement of tax,

because of their state of upheaval during the investigation and

prosecution of petitioner for his check-kiting activity.

With respect to 1988, the reasonable cause exception does not

apply.

for

OBRA sec. 7721(a).

the

addition

to

tax

Thus for 1988, petitioners are liable

for

negligence

pursuant

to

section

6653(a)(1) and the addition to tax for substantial understatement

of tax pursuant to section 6661(a).

Petitioners presented no

evidence with respect to the failure to timely file their 1988

Federal tax return, and thus they are liable for the addition to

tax pursuant to section 6651(a)(1).

Rule 142(a).

With respect to 1988, 1989, and 1990, petitioners made an

inadequate

Although

effort

their

to

determine

business

records

their

proper

tax

were

generally

in

liability.

disarray,

petitioners had some grocery/convenience store records that could

have been presented to their accountant, Mr. Mules, or to Revenue

Officer Scilipoti, including the box of bills and the calendar

reflecting daily gross receipts.

These records were presented to

petitioners' attorney and to the IRS in the course of the IRS's

audit.

Petitioner's preoccupation with his criminal problems does

- 30 not

excuse

the

failure

to

report

income

from

grocery/convenience store business or any other item.

Inc. v. Commissioner, T.C. Memo. 1984-232.

the

See Kenroy,

The failure to keep

adequate records, in contravention of section 6001, supports the

imposition of the negligence addition to tax and the accuracyrelated penalty. See Maguire v. Commissioner, T.C. Memo. 1996-145;

Tabbi

v.

Commissioner,

T.C.

Memo.

1995-463;

Simonelli

v.

Commissioner, T.C. Memo. 1985-12.

Finally, petitioners made no efforts to obtain professional

advice to determine the tax consequences of the check-kiting scheme

before filing their tax returns.

They never asked either their

accountant or a tax attorney about how to report those activities.

Given their lack of knowledge of the tax law, petitioners should

have sought advice about the tax implications of the check-kiting

scheme.

Cf. Krause v. Commissioner, T.C. Memo. 1991-13.

Thus, for 1988, we hold that petitioners are liable for

additions

regulations

to

tax

for

pursuant

negligence

to

section

or

disregard

6653(a)(1),

of

rules

or

substantial

understatement of tax pursuant to section 6661(a)(1), and failure

to timely file their return.

For 1989 and 1990, we hold that

petitioners are liable for the accuracy-related penalties for

negligence or disregard of rules or regulations pursuant to section

6662.

- 31 To reflect the foregoing and the concessions of the parties,

Decision will be entered

under Rule 155.