Taxation of illegal income in the United States

In the United States, the Internal Revenue Code (IRC) was enacted by the U.S. Congress in part for the purpose of taxing net income. ["Commissioner v. Tellier", 383 U.S. 687, 691, 86 S. Ct. 1118, 66-1 U.S. Tax Cas. (CCH) paragr. 9319 (1966).] The Code is not a mechanism for enforcing other codes of law, for example, criminal law. [See Id.] A person’s taxable income will generally be subject to the same Federal income tax rules, regardless of whether the income was obtained legally or illegally.

Income

In "James v. United States", ["James v. United States", 366 U.S. 213 (1961), "overruling" "Commissioner v. Wilcox", 327 U.S. 404 (1946).] the Supreme Court held that an embezzler was required to include his ill-gotten gains in his "gross income" for Federal income tax purposes. In reaching this decision, the Court looked to the seminal case setting forth the tax code’s definition of gross income, "Commissioner of Internal Revenue v. Glenshaw Glass Co." ["Commissioner of Internal Revenue v. Glenshaw Glass Co.", 348 U.S. 426 (1955).] , in which the Supreme Court held that a taxpayer has gross income when he has "an accession to wealth, clearly realized, and over which the taxpayers have complete dominion". ["James v. United States", 366 U.S. at 219 (quoting "Commissioner v. Glenshaw Glass", 348 U.S. 426, 431).] At the time the embezzler acquired the funds, he did not have a consensual obligation to repay, or any restriction as to his disposition of the funds. [366 U.S. at 219.] If he had acquired the funds under the same circumstances legally, there would have been no question as to whether he should have gross income. Therefore, the embezzler had gross income under the tax code, even though the application of another body of law would later force him to return the money.

Deductible expenses in illegal activity - the general rule

While embezzlers, thieves, and the like are forced to report their ill-gotten gains as income for tax purposes, they may also take deductions for costs relating to criminal activity. For example, in "Commissioner v. Tellier", a taxpayer was found guilty of engaging in business activities that violated the Securities Act of 1933. [383 U.S. at 688.] The taxpayer subsequently tried to deduct from his gross income the legal fees he spent while defending himself. [Id.] The Supreme Court held that the taxpayer was allowed to deduct the legal fees from his gross income because they meet the requirements of §162(a). [383 U.S. at 690.] , which allows the taxpayer to deduct all the “ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business.” [See usc|26|162(a).] The Court reasoned (and the Internal Revenue Service did not contest the point) that it was ordinary and necessary for a person engaged in a business to expect to have legal fees associated with that business, even though such things may only happen once in a lifetime. [383 U.S. at 690] Therefore, the taxpayer in Tellier was allowed to deduct his legal fees from his gross income, even though he incurred the fees because of his crime. The Tellier court reiterated that the purpose of the tax code was to tax net income, not punish unlawful behavior. [383 U.S. at 691.] The Court suggested that if this was not the case, Congress would change the tax code to include special tax rules for illegal conduct. [383 U.S. at 692.]

Expenses that are not deductible

Deductions relating to unlawful conduct may be disallowed when to allow them would sharply frustrate a national or state policy prohibiting such conduct. [Id. at 694.]

Congress may impose specific provisions that prohibit deductions in connection with illegal activity or other violations of law. No deduction is allowed for fines or similar penalties paid to a government for the violation of any law. [See usc|26|162(f).] Internal Revenue Code section 280E specifically denies a deduction or credit for any expense in a business consisting of trafficking in illegal drugs "prohibited by Federal law or the law of any State in which such trade or business is conducted." [See usc|26|280E.] Similarly, no business deduction is allowed "for any payment made, directly or indirectly, to an official or employee 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." [See usc|26|162(c)(1).] Similarly, tax deductions and credits are denied where for illegal bribes, illegal kickbacks, or other illegal payments under any Federal law, or under a State if such State law is generally enforced, if the law "subjects the payor to a criminal penalty or the loss of license or privilege to engage in a trade or business." [See usc|26|162(c)(2).] No deduction is allowed for kickbacks, rebates, or bribes made by those who furnish items or services for which payment may be made under the Social Security Act. [See usc|26|162(c)(3).]

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