IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

________________________________

No. 96-60393

________________________________

REBECCA JO RESER,

Petitioner-Appellant,

versus

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

_________________________________________________

Appeal from the United States Tax Court

_________________________________________________

May 12, 1997

Before JOLLY, JONES and WIENER, Circuit Judges.

WIENER, Circuit Judge:

Petitioner-Appellant Rebecca Jo Reser (Reser) appeals

the Tax Court’s decision disallowing certain deductions

that she and her former husband, Don C. Reser (Don),

claimed on their 1987 and 1988 joint income tax returns.

The deductions represented losses incurred by Don’s

subchapter S corporation for those years. Reser asserts,

in the alternative, that she is not liable for any

deficiency determined by the Tax Court on the 1987 joint
2

return, as she is an innocent spouse, as defined in 26

U.S.C. §6013(e). Although we affirm the Tax Court’s

disallowance of the questioned deductions, we conclude

that Reser is entitled to innocent spouse relief for the

1987 joint return. We therefore reverse the judgment of

the Tax Court insofar as it holds her liable for any

deficiency in tax, including interest, penalties, or

other amounts, attributable to the substantial

understatement of tax on that return. In addition, we

hold, for essentially the same reasons, that she is not

liable for negligence and substantial understatement

penalties attributable to the deficiency on the 1988

joint return.

I.

FACTS AND PROCEEDINGS

Reser is a personal injury defense lawyer who

obtained an undergraduate degree in history from Stanford

University and a law degree from the University of Texas.

Don has an undergraduate degree in economics from

Stanford University, a law degree from the University of

Houston, and a Masters in Business Administration from

the University of Texas. The Resers were married from
 

1The Resers were subject to Texas’ community property regime,

which classifies DRPC as their community property. See Tex. Fam.

Code §5.01 et seq. (West 1993). Pursuant to these rules, Reser is

considered to be the one-half owner of DRPC even though Don is the

only registered shareholder.

 

2See 26 U.S.C. §1362 (1994).

3

1974 until 1991 when they divorced. 

In 1984, Don created a professional corporation, Don

C. Reser, P.C. (DRPC), to broker large real estate

projects. He made an initial capital contribution of

$6,000 and named himself the sole shareholder.1 That same

year, DRPC elected to be taxed under subchapter S of the

Internal Revenue Code (the Code).2 

During the years in question, DRPC’s main business

activity was the offering for sale of Central Park Mall,

a large shopping center in San Antonio, Texas. As a new

corporation, DRPC needed operating capital, so Don and

DRPC together obtained a line of credit from North Frost

Bank of San Antonio, Texas (Frost Bank). The line of

credit was documented by fourteen promissory notes

executed jointly by Don and DRPC in favor of Frost Bank.

The notes were dated from 1985 to 1989, and each was

payable ninety days after its execution. The final note

stated a cumulative principal loan balance of
 

3Don customarily spoke to the secretary for the

senior vice president who approved the line of credit.

4

$467,508.54. Don and DRPC were jointly and severally

liable to Frost Bank for repayment, but the loan was not

collateralized with any property belonging to Don or

DRPC. 

Whenever DRPC needed to draw on the line of credit,

Don would call Frost Bank and request that funds be

deposited directly into DRPC’s account.3 Don had total

discretion with respect to these funds, and he used them

for DRPC’s operating capital as well as for personal

expenses. When Don needed funds for his personal use, he

withdrew them from DRPC’s account.

In 1986, Don and DRPC executed a guaranty agreement

with an individual, Don Test, pursuant to which Test

guaranteed the Frost Bank line of credit and provided

collateral (shares of stock in Genuine Auto Parts

Company) for the loan. In exchange, Don agreed to pay

Test a fee of $14,998.50 for each ninety day period that

his guaranty was outstanding. DRPC’s ledgers for 1987

and 1988 together reflected approximately $82,000 in

guaranty fee payments made to Test. In 1989, Test paid

the balance of the notes to Frost Bank.
5

For each tax year of its corporate existence, DRPC

filed a Form 1120S, the federal tax return for an S

corporation. DRPC reported $257,354 in losses for 1987

and $333,581 in losses for 1988. None dispute that DRPC

actually incurred these losses. 

For the 1987 and 1988 tax years, the Resers filed

joint income tax returns on which they claimed as

deductions the losses that DRPC had reported. The IRS

conducted an audit of those returns, questioning

specifically the deductibility of DRPC’s losses. IRS

Agent Kesha Lange attempted to ascertain Don’s adjusted

basis in DRPC, which, in turn, would determine any

limitation on the Resers’ deductibility of DRPC’s losses.

Don provided Lange with the promissory notes executed in

favor of Frost Bank, the guaranty agreement with Test,

and DRPC’s ledgers. Lange determined that (1) the Frost

Bank loan was made to DRPC, (2) Don could not increase

his basis in DRPC by the amount of the loan proceeds, and

(3) Don had insufficient basis in DRPC to deduct the

losses.

When Lange informed Don of her conclusions, he

asserted for the first time that Frost Bank had loaned
 

4DRPC’s ledgers for 1987 and 1988 reflected one

principal payment and five interest payments to Frost

Bank.

 

5The Commissioner later allowed $36,855 of the loss

deduction for 1987. 

6

the money to him individually and that he, in turn, had

loaned the money to DRPC. Despite Don’s assertions, he

provided no documentation in support of the purported

arrangement. DRPC’s corporate tax returns did not

indicate any indebtedness from DRPC to Don in amounts

corresponding to the Frost Bank loan proceeds, and its

ledgers did not reflect any payments of principal or

interest to Don during 1987 or 1988.4 Neither was there

any evidence that Don had made any principal or interest

repayments to Frost Bank on the loan personally.

In 1991, the IRS issued a notice of deficiency,

disallowing all of the deductions that the Resers had

claimed as DRPC’s losses on their 1987 and 1988 joint

returns.5 Curiously, after the IRS issued the notice of

deficiency, Don produced copies of a series of promissory

notes, allegedly executed by him on behalf of DRPC and

purporting to reflect DRPC’s indebtedness to him in the

amount of the Frost Bank loan. 

The Resers filed a petition in the United States Tax
 

6Prior to trial, the parties entered into a

stipulation of facts which contained certain computations

relating to Don’s basis in DRPC. The computations were

made by IRS Agent Judith A. Lopez who, in auditing the

Resers’ 1989 and 1990 joint income tax returns,

determined that Don’s basis in DRPC was greater than that

determined by Lange in her audit of the 1987 and 1988

joint tax returns. 

 

7The Tax Court concluded also that Don was not liable

for any self-employment tax on a $15,000 payment that

Reser had received in 1987 as a referral fee.

 

8In June 1996, Don filed a notice of appeal, which we

dismissed in August 1996 for lack of prosecution.

7

Court seeking a redetermination of the deficiencies

assessed by the Commissioner. Reser asserted, in the

alternative, that she was an innocent spouse for purposes

of the 1987 joint return, as defined in 26 U.S.C.

§6013(e), and was not liable for any deficiency

determined by the Tax Court.6

The Tax Court (1) concluded that Don did not have

sufficient basis in DRPC to claim its losses as

deductions on the 1987 and 1988 joint returns, (2)

assessed penalties for negligence, substantial

understatements of tax, and failure to file timely, and

(3) denied Reser’s alternative request for innocent

spouse relief.7

Reser alone appealed,8 asserting that the Tax Court
 

9Reser maintains also that the Tax Court erroneously

calculated the 1987 negligence penalty. She did not

appeal the penalty for failure to file timely.

 

10See 26 U.S.C. §6013(e)(1)(flush language)(1994).

The phrase “flush language” is a fairly well-understood

term of statutory construction which is used to refer to

language that is written from margin to margin and that

applies to an entire statutory section as opposed to

language that is indented to designate applicability

limited to a particular subsection or sub-subsection.

8

erred in (1) disallowing the deductions, (2) holding her

liable for negligence and substantial understatement

penalties,9 and (3) denying her innocent spouse relief on

the 1987 joint return.

II.

ANALYSIS

A. The Innocent Spouse Defense

We address first whether Reser qualifies for relief

as an innocent spouse for purposes of the 1987 joint

return, recognizing that a ruling in her favor relieves

her of all liability attributable to the substantial

understatement of tax on that return10 and pretermits our

determination of the other alleged errors concerning that

return. Reser concedes that, for technical reasons, she

is not eligible for innocent spouse relief from the
 

11For the 1988 joint return, Reser failed to meet the

requirement that the liability be greater than 25% of the

adjusted gross income for the preadjustment year. See 26

U.S.C. §6013(e)(4)(B)(1994).

 

12Park v. Commissioner, 25 F.3d 1289, 1291 (5th

Cir.), cert. denied, -- U.S.--, 115 S. Ct. 673 (1994).

 

1326 U.S.C. §6013(a)(1994).

 

1426 U.S.C. §6013(d)(3)(1994); Park, 25 F.3d at 1292.

9

deficiency on the 1988 joint return.11 

1. Standard of review

We review the Tax Court’s determination that a spouse

is not entitled to relief as an innocent spouse under the

clearly erroneous standard.12

2. Applicable law

The Code permits married persons to make “a single

return jointly of income taxes.”13 Spouses who file a

joint return are generally liable jointly and severally

for the tax due on their aggregate income, including

interest and penalties.14 Congress, however, has

statutorily mitigated the harshness of this rule by

enacting the innocent spouse defense. Accordingly, a

taxpayer who qualifies as an innocent spouse is relieved

of liability for the tax, including interest, penalties,

and other amounts, attributable to a deficiency on the
 

1526 U.S.C. §6013(e)(1)(flush language)(1994).

 

1626 U.S.C. §6013(e)(1)(1994); See also Park, 25 F.3d

at 1292; Buchine, 20 F.3d at 180.

 

17Park, 25 F.3d at 1292; Bokum v. Commissioner, 94

T.C. 126, 138 (1990), aff’d on other grounds, 992 F.2d

1132 (11th Cir. 1993).

10

joint return.15 

To assert the innocent spouse defense successfully,

a spouse must establish that (1) a joint return was made

for the taxable year; (2) on that return there is a

substantial understatement of tax attributable to grossly

erroneous items of the other spouse; (3) in signing the

return, the spouse did not know, and had no reason to

know, of such substantial understatement; and, (4) taking

into account all the facts and circumstances, it would be

inequitable to hold the spouse liable for the

deficiency.16 The burden of proof lies with the spouse

seeking relief.17 Stated differently, a spouse’s failure

to prove any one of the statutory elements precludes

relief.

In the instant case, the parties stipulated to the

Tax Court that the Resers filed a joint return for the

1987 tax year on which there is a substantial

understatement of tax. At issue, however, are whether
 

18The grossly erroneous items must be attributable to

the other spouse. See 26 U.S.C. §6013(e)(1)(B)(1994).

As the Commissioner does not contest that the grossly

erroneous items were Don’s, we will assume that this is

not an issue. 

 

19The Tax Court did not address whether the

substantial understatement of tax was attributable to

grossly erroneous items,

and Reser’s appellate brief makes no specific argument on

this point. Reser’s assertion of the innocent spouse

defense in the inconsistent alternative, however,

necessarily assumes a ruling disallowing the Resers’

deductions of DRPC’s losses, thereby establishing this

element of the defense. 

11

(1) the substantial understatement is attributable to

grossly erroneous items, (2) Reser knew or had reason to

know of the substantial understatement, and (3) it would

be inequitable to hold Reser liable.18 We shall consider

each contested element seriatim.

3. Grossly erroneous item

Reser must establish first that the substantial

understatement of tax on the 1987 joint return is

attributable to grossly erroneous items.19 The Code

defines grossly erroneous items, with respect to any

spouse, as:

(A) any item of gross income attributable to

such spouse which is omitted from gross income,

and 

(B) any claim of a deduction, credit, or basis

by such spouse in an amount for which there is
 

2026 U.S.C. §6013(e)(2)(1994) (emphasis added).

 

21Bokum, 94 T.C. at 142 (quoting Belk v.

Commissioner, 93 T.C. 434, 442 (1989)); Douglas v.

Commissioner, 86 T.C. 758, 762-63 (1986); Purcell v.

Commissioner, 826 F.2d 470, 475-76 (6th Cir. 1983), cert.

denied, 485 U.S. 987, 108 S. Ct. 1290 (1988).

12

no basis in fact or law.

20

There is no question that the substantial understatement

is attributable to deductions claimed on the joint return

and not to omissions of income. Thus the relevant

inquiry is whether those deductions have “no basis in

fact or law.” The Code does not define the phrase, “no

basis in fact or law,” but the Tax Court has stated that:

a deduction has no basis in fact when the

expense for which the deduction is claimed was

never, in fact, made. A deduction has no basis

in law when the expense, even if made, does not

qualify as a deductible expense under wellsettled legal principles or when no substantial

legal argument can be made to support its

deductibility. Ordinarily, a deduction having

no basis in fact or in law can be described as

frivolous, fraudulent, or ... phony.21

The deductions clearly have a basis in fact, as it is

undisputed that DRPC actually incurred the losses, that

DRPC is an S corporation, and that Don owned all issued

and outstanding stock in DRPC. Thus Reser must show that
 

22See Bokum, 94 T.C. at 144 (finding grossly

erroneous items where there was no basis in law for the

deductions). 

 

2326 U.S.C. §1366(a)(1994); Underwood v.

Commissioner, 535 F.2d 309, 310 (5th Cir. 1976).

 

2426 U.S.C. §1366(a)(1994); Underwood, 535 F.2d at

310.

13

the deductions have no basis in law.22

a. Applicable law

The income of a corporation that has made a

subchapter S election is not subject to the corporate

income tax; rather, it is taxed pro rata to its

shareholders —— a method commonly known as flow-through

taxation.23 Similarly, any net operating loss incurred by

an S corporation passes through to its shareholders, each

of whom may deduct from his personal gross income his pro

rata share of the corporation’s loss.24 There are,

however, statutory limitations on the deductibility of

losses at the shareholder level. Section 1366(d) of the

Code provides in pertinent part:

The aggregate amount of losses and deductions

taken into account by a shareholder ... for any

taxable year shall not exceed the sum of 

(A) the adjusted basis of the shareholder’s

stock in the S corporation ..., and 

(B) the shareholder’s adjusted basis of any

indebtedness of the S corporation to the
 

2526 U.S.C. §1366(d)(1994).

 

26Harris v. United States, 902 F.2d 439, 443 (5th

Cir. 1990); Underwood, 535 F.2d at 311-12; Leavitt v.

Commissioner, 875 F.2d 420, 422 (4th Cir.), aff’g, 90

T.C. 206 (1988), cert. denied, 493 U.S. 958, 110 S. Ct.

376 (1989); Selfe v. United States, 778 F.2d 769, 772

(11th Cir. 1985).

 

27See e.g. Underwood, 535 F.2d at 312; Harris, 902

F.2d at 445; Leavitt, 875 F.2d at 422; Brown v.

Commissioner, 706 F.2d 755, 756 (6th Cir. 1983); Uri v.

Commissioner, 949 F.2d 371 (10th Cir. 1991); Roesch v.

Commissioner, 57 T.C.M. (CCH) 64, 65 (1989), aff’d, 911

F.2d 724 (4th Cir. 1990). But see Selfe, 778 F.2d at

772-75 (shareholder’s guarantee is sufficient to increase

basis in S corporation if the facts demonstrate that, in

substance, shareholder borrowed funds and subsequently

advanced them to corporation; remanding to Tax Court to

determine whether loan from bank to S corporation was in

reality a loan to shareholder). We are not bound by the

Eleventh Circuit’s decision. 

14

shareholder.25

It is well established that a shareholder cannot increase

his basis in his S corporation stock without making a

corresponding economic outlay.26 Furthermore, courts have

consistently held that when a shareholder personally

guarantees a debt of his S corporation, he may not

increase his adjusted basis in the corporation’s

indebtedness to him unless he makes an economic outlay by

satisfying at least a portion of the guaranteed debt.27

b. No basis in law

In the instant case, Don argued to the Tax Court that
 

28Park v. Commissioner, 25 F.3d 1289, 1291 (5th Cir.

1994); McKnight v. Commissioner, 7 F.3d 447, 450 (5th

Cir. 1993).

15

he had made the requisite economic outlay to increase his

basis in DRPC by the amount of the Frost Bank loan

proceeds. Specifically, he contended that Frost Bank

loaned the money to him individually and that he, in

turn, loaned the money to DRPC. As evidence of the

purported arrangement, Don produced copies of a series of

promissory notes payable to him by DRPC. Rejecting Don’s

argument and implicitly discrediting the notes, the Tax

Court found that (1) there was no evidence of a

legitimate debt between Don and DRPC, (2) Don could not

increase his basis in DRPC by the amount of the Frost

Bank loan proceeds, and (3) Don had insufficient basis in

DRPC to claim its losses as deductions on the joint

returns. We review the factual findings of the Tax Court

for clear error.28

We agree with the Tax Court’s conclusion that there

was no legitimate debt between DRPC and Don corresponding

to the amount of the Frost Bank loan proceeds. First,

the promissory notes payable to Frost Bank were executed

by Don and DRPC together, indicating on their face that
 

29None dispute that Frost Bank would not have made a

loan to DRPC without a guaranty from Don or another

guarantor, as neither Don nor DRPC provided the bank with

collateral, and DRPC had no assets.

16

Frost Bank did not lend the money to Don alone.29 Second,

Frost Bank always deposited the loan proceeds directly

into DRPC’s account. Third, Don, individually, did not

make any repayments on the loan to Frost Bank, but DRPC

made both principal and interest payments to Frost Bank.

Finally, DRPC’s corporate tax returns reflected the notes

as payable to Frost Bank, not to Don, even though the

returns listed other notes payable to Don. 

The only evidence of a debt between Don and DRPC was

a series of promissory notes, purporting to represent

indebtedness from DRPC to Don, which Don produced after

the IRS issued its notice of deficiency. The delayed

appearance of these notes caused the Tax Court to

question their authenticity; and we find no clear error

in the court’s decision to disregard them entirely.

Neither DRPC’s 1987 nor 1988 corporate return reflected

the alleged indebtedness to Don. Furthermore, there is

no evidence that (1) Don ever received or that DRPC ever

paid any interest or principal on these notes or (2) DRPC

made any “loan” repayments to Don. 
 

30Harris, 902 F.2d at 443 (citing Don E. Williams Co.

v. Commissioner, 429 U.S. 569, 97 S. Ct. 856-57 (1977);

Commissioner v. Nat’l Alfalfa Dehydrating & Milling Co.,

417 U.S. 134, 149, 94 S. Ct. 2129, 2137 (1974)). In some

circumstances, however, the IRS may disregard form and

recharacterize a transaction by looking to its substance.

Harris, 902 F.2d at 443 (citing Higgins v. Smith, 308

U.S. 473, 60 S. Ct. 355 (1940)). See also Uri v.

Commissioner, 949 F.2d 371, 373 n.4 (10th Cir. 1991).

For example, in Blum v. Commissioner, 59 T.C. 436, 440

(1972), the Tax Court recognized an exception that

permits a shareholder to question a transaction’s form

when he argues that his guaranty of a corporate debt

should be recast as an equity investment on his part.

17

We find that the parties’ treatment of the Frost Bank

loan, from the time it was entered into until the IRS

issued its notice of deficiency, was wholly consistent

with the unambiguous, credible documentation of the

transaction and entirely inconsistent with the way in

which Don attempted post hoc to recast the transaction to

the Tax Court. Again, the only evidence to the contrary

is a series of promissory notes to which the Tax Court

attributed no probative value. As structured and

otherwise documented, the transaction did not lack

adequate reality or substance. Regrettably for Don,

taxpayers are bound by the form that they have chosen for

the transaction and may not in hindsight recast the

transaction as one that they might have made to obtain

tax advantages.30 We therefore conclude that Don may not
The Tax Court later clarified its decision, however,

noting that the Blum court never reached the debt/equity

issue because the taxpayer failed to carry his burden of

proving that the loan, in substance, was made to him and

not to the corporation. Leavitt v. Commissioner, 90 T.C.

206, 215 (1988). In affirming the Tax Court, the Fourth

Circuit stated that the Code’s provisions limiting the

basis of a subchapter S shareholder to his corporate

investment or outlay could not be circumvented through

the use of debt/equity principles. Leavitt v.

Commissioner, 875 F.2d 420 (4th Cir.), cert. denied, 493

U.S. 958, 110 S. Ct. 376 (1989). In the instant case, in

which Don failed to prove that the bank, in substance,

loaned the money to him and not to DRPC, we will not look

behind the form and structure of the transaction in an

attempt to recharacterize it as an economic outlay. See

Harris, 902 F.2d at 443.

18

increase his basis in DRPC by the amount of the Frost

Bank loan proceeds; consequently, the Resers are not

entitled to deduct DRPC’s losses on their 1987 and 1988

joint returns.

More pertinent to Reser, however, is the favorable

impact of this ruling on the innocent spouse issue. As

we have disallowed the deductions, the conclusion is

inescapable that the substantial understatement of tax on

the 1987 joint return is attributable to grossly

erroneous items. 

4. Know or reason to know

a. Background

Reser must prove next that, in signing the 1987 joint
 

3126 U.S.C. §6013(e)(1)(C)(1994).

 

32Park v. Commissioner, 25 F.3d 1289, 1294 (5th

Cir.), cert. denied, -- U.S.--, 115 S. Ct. 673 (1994);

Sanders v. United States, 509 F.2d 162, 169 (5th Cir.

1975); Hayman v. Commissioner, 992 F.2d 1256, 1261 (2d

Cir. 1993); Erdahl v. Commissioner, 930 F.2d 585, 589

(5th Cir. 1991); Guth v. Commissioner, 897 F.2d 441, 444

(9th Cir. 1990); Quinn v. Commissioner, 524 F.2d 617, 626

(7th Cir. 1975).

19

return, she did not know, and had no reason to know, of

the substantial understatement of tax.31

Courts have generally agreed that when the

substantial understatement of tax liability is

attributable to an omission of income from the joint

return, the relevant inquiry is whether the spouse

seeking relief knew or should have known of an incomeproducing transaction that the other spouse failed to

report.32 In short, in omission of income cases, the

spouse’s knowledge of the underlying transaction which

produced the omitted income is alone sufficient to

preclude innocent spouse relief.

When the substantial understatement is traceable to

erroneous deductions, however, the Tax Court is in

disagreement with some of the circuits as to whether the

“knowledge of the transaction” test is appropriate.

Although we have not addressed this issue in the past, at
 

33See Bliss v. Commissioner, 59 F.3d 374, 378 n.1 (2d

Cir. 1995); Hayman v. Commissioner, 992 F.2d 1256, 1261

(2d Cir. 1993); Friedman v. Commissioner, 53 F.3d 523,

530 (2d Cir. 1995); Resser v. Commissioner, 74 F.3d 1528,

1535-36 (7th Cir. 1996); Erdhal v. Commissioner, 930 F.2d

585, 589 (8th Cir. 1991); See also Kistner v.

Commissioner, 18 F.3d 1521, 1527 (11th Cir. 1994)(citing

Price and Erdhal with approval).

 

34887 F.2d 959 (9th Cir. 1989).

 

3594 T.C. 126 (1990), aff’d on other grounds, 992

F.2d 1132 (11th Cir. 1993).

 

36The Tax Court recently adhered to its position in

Bellour v. Commissioner, 69 T.C.M. (CCH) 3010 (1995)

(denying innocent spouse relief to a wife who knew of the

transaction for which a grossly erroneous tax deduction

was taken on her joint return but not of the tax

consequences of that transaction). The Tax Court

20

least four circuits have expressly rejected application

of the knowledge-of-the-transaction test in erroneous

deductions cases. They have concluded instead that the

proper inquiry is whether the spouse seeking relief knew

or had reason to know that the deduction would give rise

to a substantial understatement.33 The leading case in

this camp is the Ninth Circuit’s decision in Price v.

Commissioner.

34 The Tax Court, however, in Bokum v.

Commissioner,

35 explicitly refused to acquiesce in Price

and continues to apply the knowledge-of-the-transaction

test in omission of income cases and erroneous deduction

cases alike.36 In Bokum, the Tax Court found support for
acknowledges, however, that it will follow Price in cases

appealable to the Ninth Circuit. See Bokum, 94 T.C. at

151 (citing Golsen v. Commissioner, 54 T.C. 742, 756-57

(1970), aff’d, 445 F.2d 985 (10th Cir.), cert. denied,

404 U.S. 940, 92 S. Ct. 284 (1971)). Presumably, the

Golsen rule applies to Tax Court cases appealable to the

other circuits that have followed Price.

 

37“As the Seventh Circuit stated: ‘[t]he knowledge

contemplated by [section 6013(e)] is not knowledge of the

tax consequences of a transaction but rather knowledge of

the transaction itself.’” Bokum, 94 T.C. at 152-53

(quoting Purcell v. Commissioner, 826 F.2d 470, 474 (6th

Cir. 1987), cert. denied, 485 U.S. 987, 108 S. Ct. 1290

(1988)(quoting Quinn v. Commissioner, 524 F.2d 617, 626

(7th Cir. 1975))). 

 

38See Resser v. Commissioner, 74 F.3d 1528 (7th Cir.

1996).

21

its position in the Sixth and Seventh Circuits.37

Significantly, however, since the Tax Court’s decision in

Bokum, the Seventh Circuit has changed its position and

followed Price,

38 and the Sixth Circuit has not had the

opportunity to revisit the issue.

In rejecting the knowledge-of-the-transaction test in

erroneous deduction cases, the Price court was careful

not to discount entirely a spouse’s knowledge of the

underlying transaction. That court stated,

we do not mean to say that a spouse’s knowledge

of the transaction underlying the deduction is

irrelevant. Obviously, the more a spouse knows

about a transaction, ceteris paribus, the more

likely it is that she will know or have reason

to know that the deduction arising from the
 

39Price, 887 F.2d at 963 n.9.

 

40These include (1) the spouse’s level of education,

(2) the spouse’s 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 levels of income, standard of living, and spending

patterns; and (4) the culpable spouse’s evasiveness and

deceit concerning the couple’s finances.

Id. at 965 (citing Stevens v. Commissioner, 872 F.2d

1499, 1505 (11th Cir. 1989)).

 

4125 F.3d 1289 (5th Cir.), cert. denied, -- U.S. --,

115 S. Ct. 673 (1994). In Park, we did not address

whether the two approaches actually espoused different

principles. Id. at 1299 n.3. See also Price, 887 F.2d

at 963 n.9, n.10 (noting the functional similarity

between the two tests). Again we leave that question for

another day.

22

transaction may not be valid. We merely

conclude that standing by itself, such knowledge

does not preclude relief.39

In addition, the court enumerated several factors to

consider in determining whether a spouse had reason to

know of the substantial understatement.40

b. Applicable standard in this circuit

The Price and Bokum approaches intersected for the

first time in this circuit in Park v. Commissioner,

41 an

erroneous deduction case in which the taxpayer argued

that her knowledge of the underlying transactions did not

give her reason to know of the erroneous deductions so as

to destroy the availability of innocent spouse relief.
 

42Park, 25 F.3d at 1298.

 

43Park, 25 F.3d at 1298 (citing Sanders v.

Commissioner, 509 F.2d 162, 167 (5th Cir. 1975)). See

also Price, 887 F.2d at 965 and Bokum, 94 T.C. at 148.

23

Declining to rule specifically on the applicable standard

in this circuit, we concluded that the taxpayer had

reason to know of the substantial understatement under

either approach.42 But we recognized, and the Tax Court

agrees, that the general standard of inquiry concerning

a spouse’s reason to know in both omission of income and

erroneous deduction cases is whether a reasonably prudent

taxpayer in the spouse’s position at the time she signed

the return could be expected to know that the stated

liability was erroneous or that further investigation was

warranted.43 

The facts before us today present the issue, and we

neither can nor care to duck it: We must decide whether

to join the growing number of circuits that have adopted

the Price approach or to follow the Tax Court. But we do

not find this choice problematical —— we conclude that

the Price approach is clearly the better. Thus we hold

that the proper test of a spouse’s knowledge in an

erroneous deduction case is whether the spouse seeking
 

44Friedman v. Commissioner, 53 F.3d 523, 531 (2d Cir.

1995).

24

relief knew or had reason to know that the deduction in

question would give rise to a substantial understatement

of tax on the joint return. We hasten to add, lest there

be doubt, that our decision today does not disturb the

unquestioned application of the knowledge-of-thetransaction test in omission and understatement of income

cases.

If we had chosen instead to apply the knowledge-ofthe-transaction test in erroneous deduction cases, we

would have made it virtually impossible for a spouse ever

to obtain innocent spouse relief in such cases. As the

Price court noted, deductions are conspicuously recorded

on the face of the tax return; therefore, any spouse who,

at a minimum, reads the return will be put on notice that

some transaction gave rise to the deduction.

Furthermore, in the 1980's, it was common knowledge that

investors could legally obtain large tax benefits through

clever investment strategies.44 Thus mere knowledge that

a spouse had invested in a tax shelter would establish

constructive knowledge of a substantial understatement.

Such a result would undermine the objective of the
 

45When the innocent spouse defense was enacted

initially, it provided relief from substantial

understatements attributable to omissions of income only.

In 1984, however, Congress expanded the protection of the

innocent spouse defense, expressly making relief

available for erroneously claimed deductions and credits

also. See Park, 25 F.3d 1289, 1292 (1994).

 

46See Price, 887 F.2d at 965; Stevens v.

Commissioner, 872 F.2d 1499, 1505 (11th Cir. 1989);

Erdahl v. Commissioner, 930 F.2d 585, 590-91 (8th Cir.

1991); Friedman, 53 F.3d at 531; Resser v. Commissioner,

74 F.3d 1528, 1536 (7th Cir. 1996); Bliss v.

Commissioner, 59 F.3d 374, 378 (2d Cir. 1995).

25

innocent spouse defense, which is intended to provide

relief in both erroneous deduction and omission of income

cases.45

In determining a spouse’s reason to know under our

newly adopted standard, the relevant factors to consider

include: (1) the spouse’s level of education; (2) the

spouse’s 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 levels of income, standard of living, and spending

patterns; and (4) the culpable spouse’s evasiveness and

deceit concerning the couple’s finances.46 

Nevertheless, when the spouse seeking relief knows

sufficient facts such that a reasonably prudent taxpayer

in his position would be led to question the legitimacy
 

47Hayman v. Commissioner, 992 F.2d 1256, 1262 (2d

Cir. 1993); Stevens, 872 F.2d at 1506; Levin v.

Commissioner, 53 T.C.M. (CCH) 6 (1987); Cohen v.

Commissioner, 54 T.C.M. (CCH) 944 (1987).

26

of the deductions, he has a duty to make further inquiry.

Tax returns setting forth “dramatic deductions” will

generally put a reasonable taxpayer on notice that

further investigation is warranted.47 A spouse who has

a duty to inquire but fails to do so may be charged with

constructive knowledge of the substantial understatement

and thus precluded from obtaining innocent spouse relief.

c. Did Reser have reason to know?

The Tax Court denied Reser’s claim for innocent

spouse relief on the sole ground that she had either

reason to know that the stated liability was erroneous or

a duty to make further investigation. When we consider

Reser’s actual knowledge and the four relevant factors,

we are convinced that the Tax Court’s conclusion was

clearly erroneous. Reser had no reason to know that the

deductions in question would give rise to a substantial

understatement. Neither did she have a duty to inquire

as to the propriety of the deductions. 

i. Actual knowledge

When Reser signed the joint returns, she thought that
 

48In 1988, she and Don borrowed jointly $50,000 from

Fidelity Bank and invested these funds in DRPC. That

same year she allowed Don to withdraw (on penalty for

early withdrawal) over $13,000 from two of her IRA’s and

invest those funds in DRPC.

27

she and Don together had invested sufficient funds in

DRPC to cover the losses claimed as deductions.

Specifically, she (1) had advanced significant amounts of

her personal funds for the operating expenses of DRPC;

(2) knew that Don had obtained a line of credit from

Frost Bank and had invested the funds in DRPC; and (3)

knew that Don had written checks on their joint account

to DRPC that totaled approximately $135,000.48 In

addition, she was the sole producer of income reported by

the Resers in 1987 and 1988. And, importantly, she

legitimately anticipated substantial start-up losses,

which are typical in such a corporation’s initial years

of operation and which did in fact occur. Reser

testified at trial:

Well, I understood that Don was starting up his

business in these years, and that these were

losses incurred in the start-up of the business,

and I believed in his abilities with his

background in economics from Stanford, a

master’s in accounting, and a law degree, and

his business acumen, that this was a business --

this was normal starting up a business, that

there would be losses, and eventually hopefully

profits. 
 

49Reser reported income from her full-time law

practice of $194,000 in 1987 (but testified that she did

not “take home” that much) and $114,000 in 1988.

28

ii. Relevant factors

The relevant factors that we are to consider indicate

that Reser did not know and did not have reason to know

that the deductions in question would give rise to a

substantial understatement on the 1987 joint return.

First, Reser’s education, albeit advanced, provided her

with no special knowledge of complex tax issues such as

basis computation. She had a background in history and

practiced personal injury law. Second, Reser was not

personally involved with DRPC’s business and financial

affairs to any significant degree; rather, she was

engaged full-time in her law practice and was the

family’s sole source of financial support.49 In addition,

she gave birth to their second child in 1987. Third, the

record is devoid of evidence of lavish or unusual

expenditures compared to the Resers’ normal standard of

living and spending patterns, which exhibits no notable

changes during the years in question. To the contrary,

they invested most of Reser’s income into DRPC and

consumed the rest on the family’s living expenses. In
29

addition, they incurred substantial debt when borrowing

money to invest in DRPC. And ultimately, the Resers

divorced, and Don filed for bankruptcy. Finally, Reser

cannot be penalized for Don’s discredited efforts to

recast the Frost Bank loan in a tax-favorable light.

Indeed, Reser was not even aware of the second set of

“promissory notes” until 1991, several years after she

had signed the 1987 joint return.

d. Duty to inquire

We are equally convinced that the Tax Court clearly

erred in determining under the instant circumstances that

Reser had a duty to inquire as to the propriety of the

deductions. This is not the typical “dramatic

deductions” case in which a cursory review of the return

should have alerted Reser that the deductions might not

be legitimate. Given Reser’s personal knowledge that she

and Don had made large infusions of capital into DRPC and

that DRPC had generated no income, nothing about the

deductions would have put Reser on notice that further

inquiry was necessary.

In addition, the Commissioner and the Tax Court both

concede that the losses were legitimate deductions at the
30

corporate level; that they produced net losses at the

corporate level for tax purposes; that generally S

corporation losses pass through to the shareholders; and

that the only question is whether the losses are

deductible at the level of these particular shareholders

due to the basis limitation, which, in turn, rests on the

hypertechnical determination whether Don borrowed funds

from Frost Bank and loaned them to his corporation (in

which case his basis would increase dollar for dollar) or

the corporation was the borrower (in which case Don’s

basis would not be increased). This case demonstrates

that the determination of basis, which limits the

deductibility of the losses, is an extremely difficult

and technical process. The issue has been hotly

contested and vigorously fought throughout, and even two

of the IRS’s own agents arrived at different calculations

of Don’s basis in DRPC for 1987. We would not expect

Reser to question such arguably legitimate, close-call

deductions. Moreover, there can be no doubt that,

even if Reser had conducted further inquiry, she would

have gotten responses that corresponded exactly to the

information as reported on the 1987 joint return. The
 

50Burnside & Reshebarger, the firm that prepared

DRPC’s 1987 corporate return, refused at the last minute

to prepare the 1987 joint return because of a fee

dispute. The record is unclear as to the cause of the

fee dispute. The Resers’ 1988 joint income tax return

was prepared by CPA Stewart Goodson, senior manager in

the tax department at Ernst & Young, L.L.P., and signed

by CPA Houston Bryan, a partner at that firm. Goodson

obtained the necessary information concerning DRPC from

John Gwaltney, the comptroller-accountant for DRPC. In

the course of two conversations and one meeting with

Goodson, Gwaltney provided Goodson with DRPC’s financial

statements which listed various loans payable by DRPC.

Gwaltney instructed Goodson that the loans were actually

payable to Don individually. Gwaltney also provided

Goodson with DRPC’s tax returns for 1987 and 1988 and

asked Goodson to determine the Resers’ basis in DRPC for

purposes of claiming DRPC’s losses as deductions. 

31

Resers’ 1987 joint tax return was prepared by CPA Duane

DuLong, who concluded that the Resers were entitled to

deduct DRPC’s losses.50 Don testified at trial that when

he filed the 1987 and 1988 joint returns, he believed

that he had treated DRPC’s losses correctly in claiming

them as deductions. And John Gwaltney, DRPC’s

comptroller-accountant, instructed the CPA who prepared

the 1988 joint return that the Frost Bank loans were

payable to Don individually.

Had Reser asked Don, Gwaltney, or DuLong about the

deductions, they would have told her what they believed

—— that DRPC’s losses were properly deductible in full.

Neither the court nor the law will penalize Reser for
 

5126 U.S.C. §6013(e)(1)(D)(1994).

 

52Buchine v. Commissioner, 20 F.3d 173, 181 (5th Cir.

1994).

 

5326 C.F.R. §1.6013-5(b) (1996).

32

failing to perform the hollow act of asking questions,

the answers to which would have provided no new or

different information. 

5. Inequity

Reser must establish last that it would be

inequitable to hold her liable for the tax deficiency on

the 1987 joint return.51 The inequity question is one of

fact,52 and even though we do not ordinarily determine

questions of fact for the first time on appeal, both

parties expressly conceded at oral argument that we could

decide the issue based on the information in the record.

With the parties’ acquiescence and in the interest of

judicial economy, we undertake this task. 

The Code and the regulations instruct that inequity

is to be determined on the basis of all of the facts and

circumstances.53 The most important factor in determining

inequity is whether the spouse seeking relief

“significantly benefitted” from the understatement of
 

54Buchine, 20 F.3d at 181 (citing Belk v.

Commissioner, 93 T.C. 434, 440 (1989)).

 

5526 C.F.R. §1.6013-5(b)(1996).

 

56Id. A transfer of property not traceable to items

omitted from income does not constitute a benefit.

Ferrarese v. Commissioner, 66 T.C.M. (CCH) 596 (1993),

aff’d, 43 F.3d 679 (11th Cir. 1994).

 

57Stiteler v. Commissioner, 69 T.C.M. (CCH) 2975

(1995), aff’d, 108 F.3d 339 (9th Cir. 1997).

 

58Purificato v. Commissioner, 64 T.C.M. (CCH) 942

(1992), aff’d, 9 F.3d 290 (3d Cir. 1993), cert. denied,

511 U.S. 1018, 114 S. Ct. 1398 (1994). 

 

5926 C.F.R. §1.6013-5(b); Flynn v. Commissioner, 93

T.C. 355, 367 (1989).

33

tax.54 The regulations provide that the benefit may be

direct or indirect but caution that normal support is not

a benefit.55 

A direct or indirect benefit may be evidenced by (1)

a transfer of property,56 (2) a spouse’s receipt of more

than she otherwise would as part of a divorce

settlement,57 or (3) an accumulation of savings or other

assets in lieu of present consumption.58 This list,

however, is not exclusive.

Other factors to consider in determining inequity

include (1) whether the spouse seeking relief has been

deserted or divorced or separated from the other spouse59
 

60Sanders v. Commissioner, 509 F.2d 162, 167 n.16

(5th Cir. 1975).

 

61Belk v. Commissioner, 93 T.C. 434 (1989).

34

and (2) the probable hardships that would befall the

spouse seeking relief if she were not relieved.60

The record reveals that Reser did not significantly

benefit from the substantial understatement in tax.

During the marriage, the Resers did not accumulate any

savings or other assets. They invested their sole source

of income, Reser’s earnings from her legal practice, in

DRPC and became indebted to various sources in their

efforts to keep DRPC afloat. Instead of experiencing a

benefit, their standard of living actually fell.61

Furthermore, the Resers are now divorced, and there is no

record evidence that Reser received more than she

otherwise would have as part of the divorce settlement.

Taking into account all of the facts and circumstances,

we find that it would be inequitable to hold Reser liable

for the deficiency. 

Reser has borne her burden of establishing every

element of the innocent spouse defense. We therefore

hold that she is entitled to innocent spouse relief for

purposes of the 1987 joint return.
 

62As we have concluded that Reser is an innocent

spouse for purposes of the 1987 joint return, she is

automatically relieved of liability for the 1987

negligence penalty. Therefore, we need not address

whether the Tax Court erroneously calculated that

penalty. In addition, we note that the Tax Court’s

decision did not charge Reser with liability for the 50%

interest penalty for the 1988 joint return. See 26

U.S.C. §6653(a)(1)(B)(1994). Thus for the

1988 joint return only the 5% negligence penalty is

before us. 

 

63Westbrook v. Commissioner, 68 F.3d 868, 880 (5th

Cir. 1995); Portillo v. Commissioner, 932 F.2d 1128, 1135

(5th Cir. 1991), rev’d on other grounds, 988 F.2d 27 (5th

Cir. 1993).

35

B. Negligence Penalty

We turn now to the 1988 joint return, which contains

a substantial understatement of tax for which Reser

concedes —— on the basis of a technicality —— she is not

entitled to relief as an innocent spouse. As we have

already concluded that the Tax Court properly disallowed

Don and Reser’s deductions of DRPC’s losses, we shall

address only whether Reser should be held liable for the

negligence and substantial understatement penalties

attributable to the deficiency on the 1988 joint return.62

We consider the negligence penalty first.

The Tax Court’s determination of negligence is a

factual finding which we review for clear error.63

Section 6653(a)(1) of the Code imposes an addition to
 

6426 U.S.C. §6653(a)(1)(1994).

 

65See 26 U.S.C. §6653(a)(3)(1994); Durrett v.

Commissioner, 71 F.3d 515, 518 (5th Cir. 1996);

Westbrook, 68 F.3d at 880 (quoting Heasley v.

Commissioner, 902 F.2d 380, 383 (5th Cir. 1990)).

 

66Westbrook, 68 F.3d at 880; Portillo, 932 F.2d at

1135.

 

67Chamberlain v. Commissioner, 66 F.3d 729, 733 (5th

Cir. 1992).

36

tax equal to 5% of the entire underpayment if any portion

of such underpayment is due to negligence.64

“‘Negligence’ includes any failure to make a reasonable

attempt to comply with the tax code, including the lack

of due care or the failure to do what a reasonable or

ordinarily prudent person would do under the

circumstances.”65 The taxpayer bears the burden of

establishing the absence of negligence.66

The relevant inquiry for the imposition of a

negligence penalty is whether the taxpayer acted

reasonably in claiming the loss.67 The Tax Court found

that Reser’s reliance on Stewart Goodson, the CPA who

prepared the 1988 joint return, was not reasonable, as

based on inaccurate information, in light of its decision

that there was no separate loan from Don to DRPC. We

find clear error in this conclusion of the Tax Court.
 

68See supra at Part II (A)(4).

 

69Id.

 

70Id. at 732 (quoting United States v. Boyle, 469

U.S. 241, 251 105 S. Ct. 687, 692-93 (1985)).

37

For the same reasons that we concluded that Reser did not

have reason to know of the substantial understatement on

the 1987 joint return,68 we conclude that she acted

reasonably in relying on the professionals who prepared

the 1988 joint return. In fact, but for her failure to

meet a technical requirement, she would have been an

innocent spouse for purposes of the 1988 joint return.

Goodson and Bryan, two CPA’s at a national accounting

firm, both agreed that the Resers’ basis in DRPC was

sufficient to claim the losses as deductions. As we

stated in Chamberlain v. Commissioner,

69 “[t]o require the

taxpayer to challenge the [expert], to seek a ‘second

opinion,’ or try to monitor [the expert] on the

provisions of the Code himself would nullify the very

purpose of seeking the advice of a presumed expert in the

first place.”70 Furthermore, Reser was wholly unaware of

Don’s belated attempt to recast the Frost Bank loan to

his tax advantage.

We conclude that Reser was not negligent with respect
 

7126 U.S.C. §6661(a)(1994). That section also

provides for a reduction of the understatement if there

was substantial authority for the taxpayer’s treatment of

the item causing the understatement. 26 U.S.C.

§6661(b)(2)(B)(I)(1994). The Tax Court concluded that

there was no substantial authority for Don to increase

his basis in DRPC by the amount of the Frost Bank loan

proceeds, and we find no error in this determination.

The only authority for allowing a shareholder to increase

his basis in a corporation when he guarantees a debt of

the corporation is the Eleventh Circuit’s decision in

Selfe v. Commissioner, 778 F.2d 769 (11th Cir. 1985).

But we are not bound by another circuit’s decision.

Furthermore, the Tax Court rejected that case in Leavitt

v. Commissioner, 90 T.C. 206 (1988)(decided February

1988), aff’d, 875 F.2d 420 (1989)(decided May 1989), well

over a year before the Resers filed their 1988 joint

return (filed October 1989). 

 

7226 U.S.C. §6661(c)(1994).

38

to the 1988 joint return and, therefore, is not liable

for the negligence penalty.

C. Substantial Understatement Penalty

Finally, we address the substantial understatement

penalty. Section 6661 provides for an addition to tax

equal to 25% of the amount of any underpayment

attributable to a substantial understatement of tax.71

A taxpayer may be granted relief from all or any

part of the addition to tax, however, if he shows that

there was reasonable cause for the understatement (or

part thereof) and that he acted in good faith.72 The

regulations provide that reliance on the advice of a
 

7326 C.F.R. §1.666-6(b); Heasley, 902 F.2d at 385.

39

professional, such as an accountant, or on other facts

may constitute a showing of reasonable cause and good

faith if, under all of the circumstances, such reliance

was reasonable and the taxpayer acted in good faith.73 We

have just concluded that Reser acted reasonably in

relying on the professionals who prepared the 1988 joint

return and would have been an innocent spouse for

purposes of that return but for her failure to meet a

technical requirement. As relief from the substantial

understatement penalty does not depend on the taxpayer’s

ability to meet the technical requirement that was fatal

to Reser’s innocent spouse defense for the 1988 joint

return, we exonerate her from liability for this penalty.

Any other conclusion would be absurdly inconsistent with

our earlier holdings.

III.

CONCLUSION

As there was no legitimate debt between Don and DRPC,

we conclude that Don was not entitled to increase his

basis in DRPC by the amount of the Frost Bank loan

proceeds. Consequently, we affirm the Tax Court’s
40

holding that the Resers could not properly deduct DRPC’s

losses on their 1987 and 1988 joint tax returns. 

We conclude also that Reser is entitled to relief as

an innocent spouse for the 1987 joint return and,

therefore, reverse the Tax Court’s contrary holding.

First, the disallowed deductions are grossly erroneous

items and create the substantial understatement of tax on

the 1987 joint return. Second, Reser neither knew nor

had reason to know that the deductions claimed on the

1987 joint return would give rise to a substantial

understatement of tax. Neither did she have a duty to

inquire as to the propriety of the deductions, as any

further inquiry would have been informatively futile

under the discrete facts of this case. Finally, it would

be inequitable to hold Reser liable for the tax

deficiency.

Significantly, we hold that henceforth in erroneous

deduction cases in this circuit, the proper inquiry

concerning a spouse’s knowledge is whether the spouse

seeking relief knew or had reason to know that the

deductions in question would give rise to a substantial

understatement, not whether he knew or had reason to know
41

of the existence of the underlying transaction. 

Lastly, we hold that Reser is not liable for the

negligence and substantial understatement penalties

attributable to the deficiency on the 1988 joint return.

For the foregoing reasons, we affirm the Tax Court’s

decision disallowing the Resers’ deductions of DRPC’s

losses on the 1987 and 1988 joint returns, but we reverse

the judgment of the Tax Court insofar as it holds Reser

liable for (1) the deficiency in tax, including

penalties, interest, and other amounts, attributable to

the substantial understatement of tax on the 1987 joint

return and (2) the negligence and substantial

understatement penalties attributable to the deficiency

on the 1988 joint return; and we hold that she is not

liable for the same.

AFFIRMED in part; REVERSED and RENDERED in part.