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Is Income from Illegal Activities Taxable?

December 4, 2018

The U.S. Tax Code is a very curious thing. It contains more words than the Bible, a lot more.  In fact, it has enough rules to make even the sharpest mind a bit puzzled from time to time. When we think of Tax Code violations, we often picture an ambitious employee seeking to maximize a tax refund.  Or maybe a cost-conscious business owner looking to minimize his or her burden. Seldom does a given person think of illegally obtained income and the tax implications of such income. Notwithstanding that fact, there is a well-established body of tax law that pertains to income from criminal activity.  That shouldn’t surprise anyone since money is the proverbial root of all evil. But the issue of what makes illegal activities taxable is usually not something that the typical person tends to ponder.  

The issue of the taxation of illegal source income may seem distant, even obscure.  Yet, it’s still a very important issue.  That’s because illegal source income accounts for a large portion of overall income. In this post, we will cover the basics of how the Tax Code treats income from illegal sources.  We’ll then briefly reference a few prominent cases where the issue has been brought up. 

Illegal Source Income is Still Part of Gross Income 

In the U.S., income from illegal activities, for instance, embezzlement or theft, drug trafficking, etc., is included in a person’s “gross income.” It’s taxed in the same manner as income derived from legitimate means. To many, this fact may come as a surprise; after all, if the federal government collects taxes from such activities, isn’t this a form of approval? Many people would argue that this is the case. If you stop and reflect for a moment, however, this fact really shouldn’t come as much of a shock.  The U.S. government needs funds to operate.  That basic necessity has a funny way of erasing or at least dulling even the most stringent of moral principles. So even though the federal government doesn’t condone illegality, it doesn’t let that stop it from getting its fair share.

U.S. Supreme Court Rules Illegal Activities Taxable

The Supreme Court case which formally established this basic principle is James v. United States (1961). In James, an embezzler argued that he wasn’t required to report his embezzlement  proceeds. Significantly,use of the definition of “income” from the James case became commonplace in subsequent tax cases.

In Commissioner v. Glenshaw Glass, Co. (1955), the court held that “gross income” includes any increase to wealth provided that two conditions are met.  First, that it is clearly realized and, second, that the taxpayer has full control over its disposition. Using this definition, it’s fairly easy to see how illegally derived income would be subject to taxation. Accordingly, if an employee embezzles $200,000 from company profits, that employee is required to report and pay taxes on it. The employee wouldn’t necessarily be required to reveal the exact source of the illegal income, though.  That’s because that would potentially violate the employee’s right against self-incrimination under the 5th Amendment of the U.S. Constitution.  

Well-Known Cases of Taxable Illegal Activities

Perhaps the most well-known case involving income derived from illegal activities is the case of Al Capone. As we discussed in one of our earlier blog posts, Al Capone was a notorious gangster who rose to power and influence in 1930s Chicago. Capone became the head of a vast criminal organization which gained its revenue from a variety of sources; perhaps the largest source was bootlegging alcohol during the years of Prohibition. The authorities were aware of Capone’s criminal activities for many years before his trial.  Nonetheless, they were unable to collect enough evidence to produce a sustainable conviction. Capone ultimately was charged with for tax evasion on his illegally gained income.  That case was successful. Though Capone was guilty of more serious crimes, including murder, the government was only able to obtain sufficient evidence for its tax evasion case.  

Another well-known illegally gained income tax case was the case of Aldrich Ames. Ames acted as a U.S.-based spy for Russia during the Cold War.  In doing so, Ames apparently collected over $2 million from his espionage activities. Ames argued that the funds derived from espionage weren’t subject to tax because of their illegal source,.  Needless to say, he was no more successful with that argument than Capone.  

Illegal Source Income Raises Complicated Issues

The taxation of income from illegal sources is actually a very complex topic. In the future, we will come back and discuss more of the details of this fascinating issue. We’ll dig into issues such as deductions for illegal income, possible criminal prosecution, and others. For now, though, it’s enough to know the basic rule.  Gross income includes that from illegal activity and is, consequently, subject to taxation by the federal government.

Get Professional Tax Attorney Assistance

At Mackay, Caswell & Callahan, P.C., we focus on all aspects of tax law, not just the most common ones. Taxation of illegally gained income certainly isn’t a typical topic for the average person.  Nonetheless, it’s precisely the sort of thing you can expect to see when you tune in to our blog. If you have a tax or business law matter of any kind, don’t hesitate to call one of our top New York tax attorneys and we will open up a file for you right away.   With New York offices in Albany, New York City, Rochester and Syracuse, a New York tax attorney is sure to be near you and able to get started on your issue right away. 

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