Chernomordikov v. Commissioner

Lamborghinis, Ferraris, and Zero Tax Returns

The stakes were high for Mark and Jessica Chernomordikov, who faced a tax bill potentially reaching into the millions. At issue were substantial deficiencies and hefty fraud penalties assessed by the IRS for the tax years 2012 through 2014. The IRS determined that Mr. Chernomordikov owed $1,713,102, $4,525,267, and $2,881,315 in deficiencies for 2012, 2013, and 2014, respectively, along with corresponding fraud penalties under Section 6651(f), which imposes a penalty for fraudulent failure to file a tax return. For those same years, the penalties totaled $1,241,999, $3,280,819 and $2,088,953, respectively. Mrs. Chernomordikov faced her own set of challenges, with deficiencies of $2,170,145 and $1,321,524 for 2013 and 2014, as well as associated penalties. While the Tax Court ultimately sustained the substantial tax deficiencies, it delivered a significant blow to the IRS, determining that the agency failed to meet its burden of proof regarding the fraudulent failure to file penalties under Section 6651(f) because they failed to call a key witness.

The Cash Business and the 'Tax Specialist'

Following the determination of substantial tax deficiencies against Mr. and Mrs. Chernomordikov, with associated penalties, for tax years 2012 through 2014, the Tax Court shifted its focus to the specifics of Mr. Chernomordikov's business dealings.

The issues in these cases primarily stemmed from Mr. Chernomordikov’s involvement with ONY Sales, an online electronics vendor. Before his stepfather's death in August 2011, Mr. Chernomordikov had limited involvement. Afterward, he stepped in to assist his mother, the sole shareholder, in running the business. During the tax years in question, he managed ONY Sales while his mother took a backseat. Notably, he did not receive a formal paycheck but used ONY Sales funds for personal expenses. Mr. Chernomordikov rarely sought or received receipts or invoices from suppliers like Alfonso Rueda and Marco Orozco and, following his stepfather's practice, usually paid for products in cash. He also regularly withdrew large sums of cash from ONY Sales’ bank accounts, using his own Social Security number for currency transaction reports, as required by 31 U.S.C. § 5313, which mandates reporting cash withdrawals of $10,000 or more. He also indirectly paid suppliers, transferring $825,000 from ONY Sales accounts to escrow accounts to fund the purchase of houses for Messrs. Rueda and Orozco. The IRS conceded these transfers were not income to Mr. Chernomordikov. Despite not owning ONY Sales, he treated its funds as his own in 2012 and 2013. He used these funds to acquire luxury vehicles, including a Lamborghini, a Ferrari, a Rolls Royce, and a Mercedes-Benz. Between 2013 and 2015, he also lent $1.7 million from ONY Sales’ funds to his friend, Alex Lowry, who owned a used car dealership, Elite Motor Cars, without a formal loan agreement.

Mr. Chernomordikov was also involved in other ventures, including ONY Homes, LLC, formed in September 2013, which focused on flipping houses and developing residential property. He and his wife each held a 50% membership interest in ONY Homes.

For bookkeeping and tax return preparation from 2011 through 2016, Mr. Chernomordikov engaged Melvin Lee and Golden Bay Tax & Bookkeeping Services. Crizaline Nueve and Cristella Ocampo were the bookkeepers at Golden Bay. Mr. Lee, a former IRS Revenue Agent presenting himself as a tax specialist and Enrolled Agent, was later investigated by the IRS Criminal Investigation Division for tax crimes. Golden Bay used QuickBooks to manage ONY Sales’ financials. Mr. Chernomordikov provided some documentation, such as bank statements, but did not supply receipts related to ONY Sales’ cost of goods sold. Mr. Lee participated in preparing individual tax returns for Mr. Chernomordikov and Ms. Sarnova, as well as Forms 1120, U.S. Corporation Income Tax Return, for ONY Sales. Draft engagement letters with Golden Bay stipulated fees for certain services, with some tax services priced as a percentage of the tax savings.

While Mr. Chernomordikov filed a 2011 Form 1040, U.S. Individual Income Tax Return, reporting $19,939 from cancellation of indebtedness, prepared by Mr. Lee, he did not file Forms 1040 or pay individual income tax for 2012 through 2014. Mrs. Chernomordikov did not file Forms 1040 or pay her individual income tax for 2013 and 2014. The IRS then prepared substitutes for returns (SFR) for the years the Chernomordikovs did not file. Draft tax returns prepared by Mr. Lee and Golden Bay for the Chernomordikovs, including Forms 1040 for 2013 and 2014 and Forms 1065, U.S. Return of Partnership Income, for ONY Homes, were never filed.

Analysis: Bank Deposits and the 'Personal Piggybank'

The core of the IRS's case rested on its assertion that the Chernomordikovs had substantial unreported income stemming from their businesses, ONY Sales and ONY Homes. To prove this, the IRS employed the bank deposits method, a technique permitted under Section 446(b). Section 446(b) states that if a taxpayer does not maintain adequate books and records, the IRS can calculate income "by any method which, in [the IRS's] opinion, does clearly reflect income.”

The Tax Court explained that bank deposits are considered prima facie evidence of income, citing Tokarski v. Commissioner, 87 T.C. 74, 77 (1986). Furthermore, the bank deposits method is an acceptable way for the IRS to reconstruct a taxpayer's income when records are lacking (Clayton v. Commissioner, 102 T.C. 632, 645 (1994)). The court noted that the IRS doesn't need to identify the specific source of each deposit but must consider any non-taxable sources or deductible expenses the IRS knows about.

In this case, the IRS presented bank statements and deposit records showing that the Chernomordikovs controlled and used various bank accounts. This evidence, according to the court, established that the Chernomordikovs received unreported income.

The Chernomordikovs countered that the bank accounts belonged to ONY Sales, not them personally, and that Mr. Chernomordikov didn't even own ONY Sales. However, the court rejected this argument, referencing Mr. Chernomordikov's own testimony that he “didn’t really feel like there was a difference” between ONY Sales’ bank accounts and his personal accounts. He even admitted to using ONY Sales' funds for personal expenses.

The court stated that this admission undermined the argument that cash withdrawals were for "cost of goods sold" (COGS). Instead, the court sided with the IRS, characterizing the withdrawals as taxable income. The court found the IRS's bank deposits analysis to be well-supported and accepted the income reconstruction as reasonable. The court also stated that the Chernomordikovs did not offer evidence to prove the bank deposits analyses were unfair or flawed. Thus, the income stuck.

The 'Missing Witness' Trap: Why the Fraud Penalty Failed

Even with the court siding with the IRS on the unreported income, the agency didn't secure a complete victory. The IRS also sought to impose a hefty addition to tax under Section 6651(f) for fraudulent failure to file tax returns for 2012 and 2013. Section 6651(f) significantly increases the penalty for failing to file a tax return if that failure is due to fraud, raising it to 15% of the tax required to be shown on the return for each month the return is not filed, up to a maximum of 75%. This is a stark contrast to the standard failure-to-file penalty under Section 6651(a)(1), which is 5% per month, capped at 25%.

To impose the fraud penalty under Section 6651(f), the IRS must meet a stringent burden of proof. Unlike typical civil tax disputes where the taxpayer generally bears the burden, the IRS must prove fraud by "clear and convincing evidence," as dictated by Section 7454(a) and Tax Court Rule 142(b). This means the IRS had to demonstrate that Mr. Chernomordikov failed to file his returns with the specific intent to evade taxes.

In evaluating fraudulent intent, courts often consider "badges of fraud," which are circumstantial indicators of an intent to conceal, mislead, or otherwise prevent the collection of taxes. These badges can include things like underreporting income, failing to keep adequate records, providing implausible explanations, concealing assets, or dealing extensively in cash.

Here, the IRS presented evidence of several badges of fraud, including Chernomordikov's failure to report income, inadequate record-keeping, inconsistent explanations, and extensive cash dealings. However, the court found the IRS's evidence unconvincing, particularly because of a key evidentiary gap: the absence of testimony from Mr. Lee, Chernomordikov's accountant.

The IRS had subpoenaed Mr. Lee but then told him he didn't need to appear unless called. Neither the IRS nor Chernomordikov ultimately called him to testify. This decision proved critical. The court noted that Mr. Lee's testimony could have shed light on Chernomordikov's understanding of his filing obligations and whether he intentionally avoided filing to evade taxes.

The IRS seemingly attempted to circumvent this evidentiary gap by invoking a principle stemming from Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946). Under the Wichita Terminal doctrine, a court may draw an adverse inference against a party who fails to call a witness under their control whose testimony would naturally favor their case. The IRS appeared to argue that because Chernomordikov didn't call his own accountant, the court should presume Lee's testimony would have been unfavorable to Chernomordikov, thus supporting a finding of fraud.

The court rejected this argument, emphasizing that the IRS also had the power to call Mr. Lee as a witness since they subpoenaed him. Because the witness was available to both sides, the court declined to draw any adverse inference from his absence.

Ultimately, the Tax Court held that the IRS failed to prove fraudulent intent by clear and convincing evidence. The court acknowledged Chernomordikov's lack of sophistication and education, distinguishing his case from others where taxpayers with extensive financial or legal backgrounds were found liable for fraud. Without Mr. Lee's testimony to provide context and clarity, the court refused to infer fraudulent intent, particularly against a taxpayer who appeared to lack a thorough understanding of his tax obligations. Thus, the IRS's attempt to impose the fraud penalty failed.

Impact: An Expensive Lesson on Burden of Proof

The failure to convince the court of reasonable cause for non-compliance proved costly. While Mr. Chernomordikov dodged the severe fraud penalty under Section 6651(f), which imposes a penalty for fraudulent failure to file a tax return, he wasn't entirely in the clear. He remained liable for additions to tax under Section 6651(a)(1), which addresses the failure to timely file a return, and Section 6651(a)(2), which penalizes the failure to pay the tax shown on a return. The court found that claiming reliance on Mr. Lee or Golden Gate was not reasonable cause for failing to file or pay taxes. Mr. Chernomordikov knew he wasn't making tax payments and couldn't shift the blame for his inaction. Similarly, Mrs. Chernomordikov failed to provide sufficient explanation or evidence of efforts to comply with tax laws.

The court also upheld the additions to tax for failure to make estimated tax payments under Section 6654(a), which imposes a penalty on individuals who underpay their estimated tax. The court determined Mr. Chernomordikov was liable for this penalty for 2012. For 2013, the court had to calculate the required annual payment considering the stipulated Married Filing Jointly status. The court determined the penalty was applicable to both petitioners for 2013.

Despite the penalties, there was a minor victory: The court stipulated that Mr. and Mrs. Chernomordikov were entitled to Married Filing Jointly status for 2013, impacting the calculation of their tax liability.

The practical takeaway from this case is stark: Even though the IRS's procedural misstep regarding the witness, Mr. Lee, saved the Chernomordikovs from the harshest fraud penalties, they are still on the hook for millions in back taxes, interest, and failure-to-file and failure-to-pay penalties. This highlights the critical importance of maintaining proper records, understanding one's tax obligations, and exercising due diligence, especially when engaging "tax specialists."