According to the Internal Revenue Code, the IRS has the power to tax all gross income, even if some of it was obtained illegally. As such, taxpayers are required to report illegal income when filing tax returns otherwise they put themselves at risk for tax evasion charges. Illegal income can come from any number of criminal ventures including embezzlement, drug sale and trafficking, theft and gambling.
The federal government can use this law to prosecute criminals for illegal activities in which there is insufficient evidence against the violator. By implementing the illegal income law, government agencies can convict criminals on charges of tax evasion and filing of false returns. It is often the case that those that face unrelated criminal charges have also failed to report his or her illegal profits.
The notorious Al Capone, a renowned smuggler of illegal liquor, netted huge profits from this criminal enterprise but was never convicted for these activities. In 1931, Capone was found guilty of failing to report his illegal income as well as on charges of tax evasion. He was sentenced to 11 years in federal prison, the longest sentence imposed for the crime of tax evasion.
Illegal Income and the Law
Interestingly, taxpayers who have a criminal history may be entitled to deductions from their illegal income. The Supreme Court has held that these taxpayers can deduct legal fees from their tax returns since such fees are expected when operating a criminal enterprise. Still, the government has severely limited the extent of deductions relating to illegal activities. No deductions are allowed for fines paid to the government for illegal activities. Similarly, illegal bribes and kickbacks are also excluded from tax deductions.
Another fascinating aspect of illegal income in the context of tax laws is its relation to the Fifth Amendment. The Fifth Amendment protects an individual from bearing witness against oneself.
In a courtroom, this means that the defendant cannot be forced to testify— they can “plead the fifth.” In a broader sense the Fifth Amendment protects against self-incrimination. As a result, the Supreme Court has held that the IRS can require the disclosure of illegal income, but no other information regarding the source of the income.
Even though the taxpayer is not forced to explicitly state the source of illegal income, the IRS can report illegal income to the appropriate authorities and even use the report of illegal income as evidence against the taxpayer in criminal court. Since reporting illegal income is required under tax law, and this report can be used as evidence against the taxpayer, some have questioned whether the requirement to report illegal income is in violation of the Fifth Amendment.
Read More about Tax Evasion Charges for Illegally Obtained Income