The Chronicles Of Grant County

Income Taxes On Illegal Activities

IRS Broken Eggs June 14 2019 65(This photograph was provided courtesy of the U S IRS, June 14, 2019.)

During the last week of December, the U S Internal Revenue Service (IRS) sent out a news statement highlighting an aspect of tax code not top-of-mind for many residents of Grant County – Federal income taxes are due on illegal activities. A number of news organizations then published or broadcast news stories detailing this aspect of the tax code.

Headlines warned criminals that sell drugs that they need to report their income to the IRS. In addition, news organization informed criminals who steal items that they need to report the fair-market value of the stolen products and then pay Federal income taxes on that amount. There was one "loophole" noted in a number of those news articles: If you steal a product, but return it to its rightful owner within the same year, then you don't have to report those stolen goods as income.

No indication if criminals will now steal cars, for example, in the first week of January and then return the stolen vehicles to their rightful owners in mid-December to avoid having to pay Federal income taxes. (Afterall, thoughtful felons won't want to wait until the last week of December to return stolen vehicles, for example, just in case the rightful owners might be on vacation.) Also, no details were provided on how criminals need to prove that stolen items were actually returned to their rightful owners. (Do you need signed statements from crime victims that they received their stolen items prior to year-end? Do the statements need to be notarized? Do you have to declare the value of using the stolen vehicle for each month it's in your possession? Inquiring car thieves may want to know such details.)

Few, if any, of those news articles detailed that many wholesome-type activities are also affected by these same IRS regulations. People who are paid cash – paid "under-the-table" – and "forget" to declare that income on their Federal tax returns may number far more than the number of gang members selling drugs.

When the modern Federal income tax was implemented in 1913, the U S Congress required people to declare all income from "lawful" sources. Three years later, The Revenue Act of 1916 passed by the U S Congress included wording that stated that the "...entire net income received in the preceding calendar year from all sources by every individual..." was subject to income tax.

It took the Federal government several years to obtain firm guidance that the legislation mandating the reporting of all income was constitutional. On May 16, 1927, the U S Supreme Court issued its unanimous ruling in which it stated that "We see no reason to doubt the interpretation of the Act [dealing with the Federal income tax], or any reason why the fact that a business is unlawful should exempt it from paying the taxes that if lawful it would have to pay."

Students of the history of the United States may recall that certain illegal activities were quite prevalent at that time. Specifically, the sale of liquor. In 1920, Prohibition had been implemented nationwide with the passage of the 18th Amendment in 1919. (New Mexico was among the last of the 46 states that passed the 18th Amendment.) Some Americans came up with the idea that supplying the demand for alcoholic beverages – legal or not – was a lucrative business opportunity.

As such, bootleggers – while seemingly free to sell their wares, bribe corrupt officials, threaten those that got in their way, and even kill competitors – could be prosecuted – and jailed – for non-reporting of income and non-payment of taxes.

But the rules were written to apply to all Americans – not just those that lived beyond their means in obvious fashion while selling booze to the masses.

Being paid "under-the-table" and not reporting that income to the IRS is illegal.

That should be obvious, but rationalization among Americans has never been a difficult concept.

It's easy to imagine a fine, upstanding drug runner being pursued by the IRS, but it's more difficult to acknowledge that "regular" folks – your neighbors or even you – may be engaged in the same type of tax cheating as auto thieves.

People who work on a construction site and get paid in cash, but "forget" to note that income on their Federal income tax return; individuals who work in a bar or restaurant and have amnesia when it comes to reporting tip income; persons who sell home-made products and decline to make note of that income on their Federal tax returns are, in essence, no different from the "escorts" who ply their trade, but "forget" to include that income on their Federal tax return; the executives who steal from the corporate coffers and have forgetfulness when it comes to reporting the proceeds of their sticky fingers; the governmental officials that receive bribes to "look the other way," yet dismiss the need to acknowledge that income on their Federal income tax forms; and the "entrepreneurs" who offer pharmaceuticals without prescriptions to addicts and decline to detail that income on their Federal tax returns.

All are engaged in activities that produce income that should be declared on their Federal income tax returns.

"It's more common than many may think," stated Mike Morones, CPA and Managing Member of Mike Morones & Associates. The accounting firm is based in Silver City. "A number of individuals engaged in wholesome activities may not be declaring all of their income to the IRS."

Mr. Morones noted that people should follow all of the tax laws. All income should be declared.

"There is a strong reason to declare all income," explained Mr. Morones. "It makes a person more bankable when all income is declared. Without declared income, you cannot easily buy a home, for example."

He also noted that not declaring all income and, thus, not paying all self-employment taxes due also hurts people in the long-run: "If you don't declare all income, you aren't paying your self-employment taxes – taxes for Social Security and Medicare – in the proper amounts. If you don't pay those taxes or don't pay all of the taxes you truly owe, you cannot claim those benefits or your benefits may be reduced when you retire."

In the case of income from illegal activities, if you're self-employed, you may want to list that income on Schedule C of the IRS Form 1040 and use "999999" as the principal business or professional activity code for "Unclassified establishments (unable to classify)." That code is listed as an option to use on the last page of the instructions issued by the IRS for Americans to complete the IRS Form 1040 Schedule C.

While self-employed individuals are able to typically deduct their business-related expenses incurred to engage in their business activities, Mr. Morones noted that expenses incurred to engage in illegal activities are not deductible: "Self-employed individuals are able to generally deduct the cost-of-goods from their income, but they cannot deduct the actual business-related expenses that they might have while engaged in illegal activities."

So, for example, the drug dealer may be able to deduct the actual cost of the drugs they sell, but they cannot deduct other business-related expenses – bribes paid to officials, packaging for the drugs, storage fees, cell phone monthly bills, and other such costs.

Bottom Line: Individuals engaged in illicit activities should contact legal professionals for advice on how to handle their tax responsibilities.

Even better, don't engage in illegal activities.

IRS Building 1111 Constitution Avenue NW Washington DC Library of CongressThe headquarters of the U S Internal Revenue Service is located at 1111 Constitution Avenue NW in Washington, District of Columbia. (The photograph was provided courtesy of the Library of Congress.)

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© 2022 Richard McDonough

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