Business Courses/Federal Income TaxesCourse
- AuthorPeter Crain
Peter works as a franchise and business consultant, and has a background of diverse business experience before that. He holds an MBA in Pharmaceutical and Healthcare Business from University of the Sciences in Philadelphia as well as a Bachelor of Music from West Chester University.
View bio - InstructorMartin Gibbs
Martin has 22 years experience in Information Systems and Information Technology, has a PhD in Information Technology Management, and a master's degree in Information Systems Management. He is an adjunct professor of computer science and computer programming.
View bio
Learn about the reporting of illegal income to the IRS, including consequences for not reporting. Explore why deductions cannot be claimed on illegal income.Updated: 11/21/2023
Table of Contents
- How Does the IRS Tax Illegal Income?
- How Are Deductions Handled with Illegal Income?
- What Are the Consequences of Reporting Illegal Income?
- Lesson Summary
Frequently Asked Questions
What is considered illegal income?
Illegal income is derived from illegal activities. This can include drug deals, bribery, stolen goods, and fraud. If it generates income it's still taxable.
Can you file taxes on illegal income?
Illegal income is required to be reported regardless of how it was acquired. It is not the IRS's job to prosecute crimes that aren't tax related.
Does the IRS care about illegal income?
The IRS cares that illegal income is included in the gross income of an individual. The Fifth Amendment protects the person declaring the income from self-incrimination.
Can you go to jail for not reporting income to IRS?
Tax evasion is a crime that the IRS takes seriously. It can include fines and jail time depending on the severity of the case.
Table of Contents
- How Does the IRS Tax Illegal Income?
- How Are Deductions Handled with Illegal Income?
- What Are the Consequences of Reporting Illegal Income?
- Lesson Summary
Every year the IRS wants to know how much money a person or business makes in order to figure out how much is owed in taxes. What if that money were acquired via illegal activities? The IRS wants to know about that illegal income as well. Whether it is legitimately earned or not the IRS still wants their cut. It may seem ridiculous, but the IRS does have a tax code for stolen property and stolen property income. While the income may be illegal, avoiding taxes is also quite illegal and could warrant a more severe punishment than the original crime potentially. Technically the Fifth Amendment does protect those who have reported illegal income from being reported for the source of that income, though there are loopholes that could be used to do so.
The kinds of illegal income and property that must be reported to the IRS on a 1040 form include:
- Bribes
- Income from scams
- Embezzlement
- Income from sales of illegal goods like drugs
- Stolen property
It seems counterintuitive for the IRS to want to take money from ill-gotten gains, but there is money in criminal enterprise and the federal government will let the appropriate agencies handle the crime itself. It is the sole duty of the IRS to enforce the current tax code, and that code currently says that illegal income should be taxed regardless of how it was made.
An instance of how this would work is if the CFO of a company is earning a six-figure salary, but is also taking money from other parts of the company and embezzling an extra $100,000 per year from company assets. They will have to still report the $100,000 as illegal income on top of the amount of money they earned on payroll.
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There are rules to how illegal income is handled when it comes to deductions. The point of tax deductions is to alleviate the overall amount owed via qualifying circ*mstances. The IRS does not allow for illegal business expenses to be deducted from personal income taxes. As our CFO friend is reporting his embezzled income, he decides it would be nice not to owe the full amount of that $100,000 in taxes so he decides to claim the bribes that he paid to another business in order to earn a contract for his company. Unfortunately, this is also an illegal activity that was committed so the recipient of that bribe will need to report it on their taxes, but it cannot be claimed as a deductible expense.
Some examples of what cannot be deducted include:
- Buying illegal goods
- Paying bribes
- Paying for illegal services
- Kickbacks
- Expenses incurred trafficking drugs
The IRS does allow for deductions on illegal income that are reasonable in the course of doing business as long as they are legitimate expenses. Legal fees are an example of a deduction that could be claimed successfully on illegal income. There have been a few cases tried before the Supreme Court that have successfully argued that there are business expenses that are not directly illegal themselves and could therefore be counted as acceptable. One thing about the tax code in the United States is that it is designed to treat any and all income as fair, taxable, game. The general rule for what cannot be deducted has been decided in some of these cases, and in today's terms is seen as anything that "frustrates public policy" on a particular issue.
The CFO has started to hire lawyers for his impending embezzlement case. Their costs can be deducted from his tax burden for the illegal income.
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Many people do not report their illegal income on their taxes for the obvious reason of not being caught committing the crime that gave them income. This is a major misstep though as the IRS will punish people not reporting all of their income on their taxes. Reporting illegal income is more advisable for those who committed a crime because they are protected by the Fifth Amendment, which gives people the right to not self-incriminate. This isn't an air-tight situation though as the tax code is very complex and does have loopholes that allow the IRS to tip off relevant agencies about potential criminal activity. They can't hand over tax returns or any evidence of the crime that may have been committed, but they can still make reference and give probable cause that would allow another agency to start looking.
An often cited example of this type of situation is the downfall of Al Capone. The government didn't have the case they needed to prosecute him on all the various crimes and criminal enterprises that he had a hand in publicly. He however did not file his taxes in an effort to obscure where his money came from, and that was all the government needed to prosecute and jail him. Even if the income earned is illegal, it is far easier for the IRS to prosecute for tax evasion because they have all their evidence in front of them. The IRS also knows that thieves and criminals are not going to make the most honest taxpayers in the country, so this has become an easy way to nab someone without being able to directly implicate them in a crime.
In a final look at the CFO's embezzling money, he decides to declare the $100,000 he embezzled on his tax return after learning that the case against him was being built. His logic is that he can fight the charge of embezzlement in court before a judge and jury, but the IRS will certainly nail him for tax evasion if they discover unreported income. His actions are wrong, but as far as the tax collectors are concerned it is not their business to directly handle. In a court system that establishes innocence until proven guilty, it is better to pay taxes and stay in good standing with the IRS.
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Illegal Income and property gained from Illegal activities are still subject to income tax on a 1040 form. It may be tempting to not declare these types of income for fear of being prosecuted, but the IRS will pursue criminal prosecution and jail time for tax evasion. An example of illegal income that needs to be declared would be hush money received, or a drug dealer making a sale. Even if a business owner is embezzling from their business it is still best to declare that income for fear of facing federal tax charges. Deductions of illegal activities are not allowed, however. If a medical expense is incurred while buying drugs overseas, that deduction cannot be used.
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Additional Info
Taxation of Illegal Income
Have you received any bribes lately? Embezzled from your company? Maybe you bribed a few officials to ensure the trampoline park would get built.
The IRS would like to know.
The US Tax Code states that income from illegal activities is to be declared on form 1040, or on Schedule C if it's from your business. This includes sales from dealing drugs, embezzling, etc. It's not surprising that criminals decline to fill out these amounts on their taxes.
What's Deductible?
Although the IRS requires that income from illegal sources be declared, the same rule doesn't apply to deductions.
Under current tax law, you are not able to deduct any business expenses that would violate federal or state laws. The types of deductions would include the following:
- Losses incurred from unlawful business activity
- Bribes paid
- Kickbacks and rebates used to defraud Medicare or Medicaid
For example, you can't deduct supplies purchased for the sale of drugs. If you are running a legitimate business that also conducts illegal activity, the LEGAL business expenses ARE deductible. Take a small business that sells shoes in front and drugs out the back door: the expenses related to shoe selling are completely valid. Expenses related to the sale of drugs are not deductible.
Consequences
You would think that declaring illegal income would be an immediate tip-off to law enforcement. However, you are somewhat protected by the Fifth Amendment: you are not allowed to incriminate yourself. In theory, the IRS would honor the situation and not immediately report to law enforcement.
Because the tax law is so complex and convoluted, there are loopholes that the IRS could exploit to notify other agencies of the illegal activity. Even though the IRS can't share your tax return, it can give out other information.
Let's say you were audited and they interviewed witnesses: information from these sources can be used to investigate the activity.
Although the IRS might not directly prosecute you for claiming embezzling funds, criminals don't trust the system and do not file. For them, however, the burden is only delayed until they are caught. At that point the penalties are much higher.
Remember, Al Capone was put away for tax evasion, not his gangster activities. Some individuals do log their income from embezzlement on their taxes, especially if they think they feel they are going to get caught anyway. Even though the income was obtained illegally, it may be better to be honest on the tax return than face jail time in the future.
In order to avoid any of these tax problems, taxpayers are encouraged to avoid illegal activity. Still, it is a fact that individuals engage in illicit actions and earn income though these illegal operations. According to US tax law, this income is to be claimed on the 1040.
Lesson Summary
You are required to declare illegal income on your federal taxes on form 1040. Most criminals choose not to file this income, but some do. They figure it's better to claim the illegal activity now than to be caught and face federal tax charges (as Al Capone found out).
However, even though illegal income is to be claimed, you cannot claim deductions/expenses as part of your illegal activity. Bribes paid, kickbacks as part of fraud, etc., cannot be used as valid business deductions.
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