Chernomordikov v. Commissioner

Lamborghinis, Cash, and a $10 Million Tax Bill

The IRS sought over $10 million in taxes and penalties for tax years 2012-2014 from Mark Chernomordikov, alleging fraud and massive unreported income that funded a lavish lifestyle featuring Ferraris and Lamborghinis. At the heart of the dispute lies a central tension: Chernomordikov claimed he was merely following the cash-heavy business practices instilled by his late stepfather, while the IRS relied on a bank deposit analysis to demonstrate substantial unreported income. While the Tax Court ultimately upheld the tax liability and assessed negligence penalties, it notably rejected the fraud penalties under Section 6651(f) because the IRS failed to prove fraudulent intent by clear and convincing evidence, a failure largely attributed to a 'missing witness' – the taxpayer's former tax preparer.

From Eyeglasses to Electronics: The Cash Economy of ONY Sales

The facts unfolded with Mark Chernomordikov, an immigrant from Azerbaijan, who initially held various sales positions, including selling eyeglasses, cars, and conducting door-to-door sales to optical stores. His involvement with ONY Sales, an online electronics retailer, was initially minimal, primarily assisting with paperwork while his stepfather ran the business. Following his stepfather's death in August 2011, Chernomordikov stepped in to help his mother, who had become the sole shareholder, manage ONY Sales.

During the tax years in question, Chernomordikov effectively ran the business, with his mother having no active role. Notably, he did not draw a regular paycheck from ONY Sales. Instead, he used the company's funds to cover personal expenses, blurring the lines between business and personal finances. Chernomordikov's business practices mirrored those of his late stepfather: a preference for cash transactions and a lack of detailed record-keeping. He frequently bypassed receipts or invoices when dealing with suppliers like Alfonso Rueda and Marco Orozco, often paying for products in cash without questioning the suppliers' preference for this method.

He regularly withdrew significant sums of cash from ONY Sales' bank accounts. To do this, he used his own Social Security number for the currency transaction reports required for cash withdrawals of $10,000 or more, as mandated by 31 U.S.C. § 5313 (which requires banks to report large cash transactions). Chernomordikov also indirectly paid suppliers, transferring $825,000 from ONY Sales’ accounts to escrow accounts to facilitate the purchase of houses for Rueda and Orozco. The IRS later conceded that these transfers did not constitute income to Chernomordikov personally.

Despite not owning an equity interest in ONY Sales, Chernomordikov treated the company's funds as his own in 2012 and 2013, expressing that he "didn’t really feel like there was a difference." This manifested in the use of ONY Sales' funds to acquire luxury vehicles, including a Lamborghini, a Ferrari, a Rolls Royce, and a Mercedes-Benz. Further illustrating the commingling of funds, Chernomordikov lent $1.7 million from ONY Sales to his friend, Alex Lowry, who owned a used car dealership called Elite Motor Cars, between 2013 and 2015, without establishing a formal written loan agreement.

For bookkeeping and tax return preparation, Chernomordikov engaged Melvin Lee and Golden Bay Tax & Bookkeeping Services. Golden Bay, staffed with bookkeepers like Crizaline Nueve and Cristella Ocampo, used QuickBooks to manage ONY Sales' finances. Lee, a former IRS Revenue Agent who presented himself as a tax specialist and Enrolled Agent, was later investigated for tax crimes by the IRS Criminal Investigation Division. Chernomordikov provided some financial documentation, such as bank statements, to Golden Bay, but notably omitted receipts related to ONY Sales’ cost of goods sold. While Lee and Golden Bay prepared some individual tax returns for Chernomordikov and corporate returns for ONY Sales, significant issues arose with the accuracy and filing of these returns.

The Analysis: Bank Deposits and the 'Use of Funds'

The court next addressed the IRS's determination of unreported income, a central point of contention in the case. Because Mr. Chernomordikov failed to maintain adequate books and records as required by Section 6001, which mandates taxpayers keep records establishing the amount of their gross income, the IRS reconstructed his income using the "bank deposits method." This method, deemed permissible by the Tax Court in Clayton v. Commissioner, 102 T.C. 632, 645 (1994), treats bank deposits as prima facie evidence of income.

The IRS introduced bank account statements and deposit records demonstrating Mr. and Mrs. Chernomordikov’s control over various accounts. The court emphasized that gross income, as defined in Section 61(a), includes "all income from whatever source derived," encompassing all accessions to wealth over which the taxpayer has complete control, citing Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). Control exists, the court noted, when the taxpayer is free to use the funds at will, referencing Cortes v. Commissioner, T.C. Memo. 2014-181.

Further solidifying its position, the court invoked the "use of funds" doctrine. This principle states that using company funds for personal purposes demonstrates dominion and control, even if the account is titled in another name, as illustrated in Edwards v. Commissioner, T.C. Memo. 2016-117. Mr. Chernomordikov's admission that he "used the money from ONY Sales for personal expenses" directly undermined his argument that cash withdrawals represented cost of goods sold (COGS). This admission supported the IRS's characterization of these withdrawals as taxable income.

The court then rejected the taxpayer's attempt to reduce his income by claiming Cost of Goods Sold (COGS). COGS is an offset subtracted from gross receipts to determine gross income. While legitimate COGS can reduce taxable income, the taxpayer bears the burden of substantiating these costs with sufficient records, as required by Section 6001 and Treasury Regulations. Mr. Chernomordikov presented no documentation to support his COGS claims. The court stated it had no basis to estimate these costs. The court implicitly rejected the application of the Cohan rule, which allows for the estimation of expenses when exact records are unavailable, because Mr. Chernomordikov provided no credible evidence or rational basis upon which to base such an estimate. In essence, the court found that Mr. Chernomordikov failed to prove that the deposits were not income to him, thus upholding the IRS's assessment of unreported income.

Procedural Twist: The Stipulation Trap

The court then addressed the thorny issue of Mr. and Mrs. Chernomordikov's filing status for 2013. Taxpayers can only file jointly if they actually file a joint return, according to Section 6013(a) and Treasury Regulation § 1.6013-1(a). Since the Chernomordikovs did not file a return for 2013, they would normally not be eligible for the lower tax rates afforded to those who are married filing jointly under Section 1(a)(1).

Here, however, the Tax Court asserted its authority over the IRS based on a pre-trial stipulation. The court highlighted that before the trial commenced, both parties signed a "Stipulation of Settled Issues," explicitly stating that the Chernomordikovs were "entitled to 'married filing jointly' filing status for the 2013 tax year." Rule 91(e) dictates stipulations of fact are generally binding.

Despite this prior agreement, the IRS argued in its post-trial brief that the Chernomordikovs should be considered "married filing separately," which would result in a higher tax liability. The court sharply rebuked this attempt to renege on the stipulation. Citing Stamos v. Commissioner, 87 T.C. 1451, 1454, 1456 (1986), the court emphasized that stipulations are binding and enforceable. Because the IRS offered no valid justification for being relieved of its obligation under the stipulation, the Tax Court held the IRS to it, affirming the Chernomordikovs' right to file as "married filing jointly." This determination directly impacts the applicable tax rates and, consequently, the total tax owed. This represents a consequential exercise of judicial power, preventing the IRS from changing its position after a formal agreement had been reached.

The Missing Witness: Why the Fraud Penalty Failed

As the previous section demonstrated, the Tax Court upheld the IRS's determination of unreported income while also preventing the IRS from retroactively changing the Chernomordikovs' filing status to "married filing separately" after stipulating to "married filing jointly." This determination directly impacts the applicable tax rates and, consequently, the total tax owed. This represents a consequential exercise of judicial power, preventing the IRS from changing its position after a formal agreement had been reached.

The court then turned to the more serious question of penalties, specifically addressing the absence of a key figure: the tax preparer, Melvin Lee. The IRS argued that because the Chernomordikovs did not call Mr. Lee as a witness, the court should presume his testimony would be unfavorable to them. This argument invoked the principle established in Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946), where a court may draw an adverse inference when a party fails to call a witness under their control who would naturally provide favorable testimony.

However, the Tax Court rejected this argument. The court noted that the IRS itself had listed Mr. Lee as a potential witness and even served him with a subpoena, but ultimately chose not to call him. Since Mr. Lee was potentially available to both sides, the court concluded that "no presumptions can or should be drawn about Mr. Lee’s hypothetical testimony." Instead, the court stated it would consider his absence "insofar as it may relate to the burden of proof each party must meet."

This evidentiary ruling had significant implications for the IRS's attempt to impose a fraud penalty under Section 6651(f). Section 6651(f) increases the penalty for failure to file a tax return from 5% per month (up to a maximum of 25%) under Section 6651(a)(1) to 15% per month (up to a maximum of 75%) if the failure to file is due to fraud. To impose the fraud penalty, the IRS must prove by "clear and convincing evidence" that the taxpayer failed to file "because of fraudulent intent."

The court found that the IRS failed to meet this burden. While the IRS presented evidence of unreported income, inadequate record-keeping, and extensive cash dealings, the court found that Mr. Chernomordikov's "lack of education and sophistication" was a key factor. The court contrasted this case with Fiore v. Commissioner, T.C. Memo. 2013-21, where the taxpayer was a tax attorney with an accounting background. In that case, the court found that the taxpayer's education and experience made it more likely that he was aware of his tax obligations and intentionally evaded them.

Critically, the court emphasized that "Respondent’s failure to call Mr. Lee leaves a hole in respondent’s proof of fraud by clear and convincing evidence that we cannot fill with an inference." Without Lee's testimony, the IRS could not definitively establish that Mr. Chernomordikov acted with fraudulent intent, as opposed to mere negligence or reliance on questionable advice.

This outcome is notable because the court did uphold the failure to file penalty under Section 6651(a)(1), as well as the failure to pay penalty under Section 6651(a)(2). The key difference is that for these penalties, the burden is on the taxpayer to prove "reasonable cause" for the failure to file or pay. Since the Chernomordikovs could not demonstrate reasonable cause, they were liable for these penalties, even though the IRS could not prove fraud.

Conclusion: The Price of Negligence

In the final tally, the Chernomordikovs face a substantial tax bill stemming from unreported income, a consequence of ONY Sales' cash-heavy operations and their inadequate record-keeping. They are liable for the underlying tax deficiencies as determined by the court using the bank deposits method. They also owe penalties under Section 6651(a)(1), which imposes a penalty for failing to file a tax return, and Section 6651(a)(2), which imposes a penalty for failing to pay taxes when due. The rate is 5% per month of the unpaid tax, capped at 25% in the aggregate for both penalties.

However, they dodged the more severe fraud penalties under Section 6651(f), which applies a 15% per month penalty, capped at 75%, when a failure to file is fraudulent. To impose this penalty, the IRS bears the burden of proving fraudulent intent by clear and convincing evidence, which it failed to do here. The court found the IRS's case weakened by its own decision not to call the tax preparer as a witness, negating any adverse inference the IRS sought to draw from his absence under the rule in Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946). That rule generally allows the court to draw an adverse inference when a party fails to call a witness who is uniquely positioned to provide relevant, favorable testimony.

For practitioners, this case underscores several key points. First, stipulations are binding. Second, the IRS faces a high bar when trying to prove fraud, particularly when the taxpayer's actions, while negligent, do not clearly demonstrate an intent to deceive. Finally, simply having messy books, while detrimental to a taxpayer's case, isn't enough to prove fraudulent intent, especially when a potentially informative witness like the tax preparer is available to both sides but not called to testify.