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Do I Have To Pay Taxes On Illegal Income?

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Anyone deliberately involved in criminal activities such as obtaining stolen goods, selling drugs or money laundering knows the obvious risks. The police can arrest you, the prosecutor can charge you with a crime, and the court (if it finds you guilty) can assess heavy fines or even send you to prison. These are the inherent dangers. However, did you know that failing to report income from these illegal activities can result in the Internal Revenue Service assessing a substantial tax bill against you?

Wait a minute, how can the IRS tax on income that the taxpayer had no legal right to possess in the first place? The Internal Revenue Code explicitly defines "gross income" as "all income from whatever source derived." 26 U.S.C. ยง61(a). The United States Supreme Court determined that gross income exists when there are "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion." Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431; 75 S. Ct. 473; 99 L. Ed. 483 (1955). "All sources" includes those that are both legal and illegal.

Illegal income is reportable on Form 1040, Schedule 1, Line 21 of your individual tax return. Although it is unlikely that the IRS would ever receive Form 1099 or Form W-2 from anyone involved in the taxpayer's illegal activity, the government can certainly initiate an audit if they suspect a taxpayer is living beyond his or her means. For example, a taxpayer claiming only $50,000.00 of income per year is unlikely to afford his $1 million mansion and a fleet of luxury cars unless he was getting revenue from other unreported sources. In addition, criminal prosecutions are a matter of public record and the Internal Revenue Service does pay attention if someone is charged in federal court for crimes involving embezzlement or larceny of significant amounts of money or property. Additional criminal charges for tax evasion are sure to follow after revenue agents take a closer look.

In the event of a conviction, the criminal trial judge is likely to order that the taxpayer pay restitution to the victim to make them whole from the crime. Even if this repayment is ordered, the stolen funds are still taxable income. In James v. United States, 366 U.S. 213; 81 S.Ct. 1052; 6 L.Ed.2s 246 (1961), the taxpayer, a union official, embezzled $738,000.00 from his union and an insurance company between 1951 and 1954. The U.S. Supreme Court held that embezzled money is includable in gross income for the tax year it was acquired even if the taxpayer had no legal right to retain it and was obligated to pay it back. Id at 221-222. "Just as the honest taxpayer may deduct any amount repaid in the year in which the repayment is made... if, when, and to the extent that the victim recovers back the misappropriated funds, there is, of course, a reduction in the embezzler's income." Id at 220. Even if the illegal income is subject to repayment to the victim, the taxpayer must still pay federal income taxes upon it.

However, if the crime occurred through the operation of a trade or business, then the taxpayer may be able to claim a deduction against the illegal income for necessary expenses. 26 U.S.C. 162(a) allows "as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." In Commissioner v. Tellier, 383 U.S. 687 (1966), the taxpayer was a securities dealer "engaged in the business of underwriting the public sale of stock offerings and purchasing securities for resale to customers." In 1956, he was convicted of securities fraud, mail fraud and conspiracy to commit those crimes. The taxpayer incurred $22,964.20 in attorney fees and legal expenses for his unsuccessful criminal defense that he claimed as a deduction on his 1956 federal income taxes. The IRS disallowed this claim and the matter ultimately proceeded to the nation's highest court. The U.S. Supreme Court noted that the Internal Revenue Code did not specifically prohibit this type of business deduction.  "[O]nly where the allowance of a deduction would frustrate sharply defined national or state policies proscribing particular types of conduct" would the disallowance be upheld. Id at 693-694. "No public policy is offended when a man faced with serious criminal charges employs a lawyer to help in his defense." Id at 694. Therefore, this tax deduction was allowed.

To prevent offenders from profiting on crime, Congress has passed legislation prohibiting taxpayers from deducting certain ordinary and necessary expenses related to illegal activities. These include, but are not limited to:

  • Illegal Bribes: "No deduction shall be allowed.... For any payment made, directly or indirectly, to an official or employee of any government, or of any agency or instrumentality of any government, if the payment constitutes an illegal bribe or kickback or, if the payment is to an official or employee of a foreign government, the payment is unlawful under the Foreign Corrupt Practices Act of 1977." 26 U.S.C. 162(c)(1).
  • Illegal Kickbacks: "No deduction shall be allowed... for any payment... which subjects the payor to a criminal penalty or the loss of license or privilege to engage in a trade or business. ...[A] kickback includes a payment in consideration of the referral of a client, patient, or customer." 26 U.S.C. 162(c)(2).
  • Fines and Penalties: "...[N]o deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law." 26 U.S.C. 162(f)(1). However, the taxpayer may deduct any amounts that constitutes "restitution (including remediation of property) for damage or harm which was or may be caused by the violation of any law or the potential violation of any law, or is paid to come into compliance with any law which was violated or otherwise involved in the investigation or inquiry" into the illegal activity. 26 U.S.C. 162(f)(2).
  • Expenditures in Connection with the Illegal Sale of Drugs: "No deduction or credit shall be allowed for any amount paid or incurred during the taxable year in carrying on any trade or business if such trade or business (or the activities with comprise such trade or business) consists of trafficking in controlled substances (within the meaning of schedule I and II of the Controlled Substances Act) which is prohibited by federal law or the law of any state in which such trade or business is conducted." 26 U.S.C. 280E. This includes the sale of any illegal drug under federal law such as cocaine, heroin and marijuana. It doesn't even matter if marijuana is sold or distributed as part of a lawful medical marijuana program under state law.

Can the taxpayer hide behind the shield of the Fifth Amendment to avoid filing a return? Can the Internal Revenue Code require the taxpayer to disclose illegal income sources that can cause a criminal prosecution? In United States v. Sullivan, 274 U.S. 259 (1927), the U.S. Supreme Court ruled that the Fifth Amendment does not shield a taxpayer from filing an information return on income acquired from illegal sales of liquor. "If the form of return provided called for answers that the defendant was privileged from making, he could have raised the objection in the return, but could not on that account refuse to make any return at all." Id at 263. "In this case, the defendant did not even make a declaration, he simply abstained from making a return." Id at 264. The taxpayer must pay taxes on the income, but can avoid self-incrimination by not disclosing the source on the tax return.

The penalties for tax evasion are serious and can result in heavy fines or a prison sentence. A tax attorney can advise the taxpayer how to best proceed regarding illegal income sources while minimizing the risks of criminal prosecution or scrutiny from the IRS. If you have any questions regarding any aspect of federal taxation, do not hesitate to contact the lawyers at Kershaw, Vititoe & Jedinak PLC for assistance today.

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