Does the IRS really expect taxpayers who have illegal income to report it on their tax returns? The answer may appear preposterous. But it is still yes.
In fact, it's right there in the instructions that go with the 1040 form. "Income from illegal activities such as money from dealing illegal drugs," the official instructions say, must be counted when calculating your income.
Does anyone actually do this? Again, the answer is rather surprising. Most taxpayers do not - but some do.
The motivation for including illegal income may come from an anticipation of being caught anyway. No one wants to be punished twice: once for the underlying and again for not paying taxes on the illicit gains from it.
After all, it was for the later offense that federal authorities famously brought down the notorious mobster Al Capone. They got him not for racketeering or orchestrating violent crimes, but for tax evasion.
Among taxpayers who choose to self-report illegal income, the desire to avoid embezzlement charges is frequently a key driver in decision. Accountants, in particular, often are well aware that illegal income is taxable. With this knowledge comes the awareness that the consequences of getting caught embezzling money would only grow worse if a tax crime were included in the charges.
The IRS declines to say how many people actually report illegal income. But for those who are hesitating about whether to do so, it is worth noting what the law specifies. When a taxpayer reports illegal income, the IRS is not supposed to share that information with other agencies, unless it relates to terrorism investigations.
Source: "The IRS wants to tax your illegal income," CNN Money, Steve Hargreaves, 3-7-13
Our firm handles situations similar to those discussed in this post in California. To learn more about our practice, please visit our page on criminal tax defense.