Periodically every accountant gets The Question: “Do I have to pay taxes on the money I earn running guns, peddling influence, selling drugs, bookmaking, poaching exotic wildlife? How is the IRS going to know? What happens if I don’t tell anyone?”
It’s all taxable…
The short answer is Yes. Money you earn in most any illegal activity is fully taxable as though it was wages paid from your job, profit from your sales on eBay, or interest you get on your 0.000004% account at the bank. It’s all taxable, and the IRS may strongly suggest that you file a tax return once your name hits the newspaper when you get popped.
Why would anyone know this stuff?
There’s no reason for most people to know this stuff, but different illegal activities can be treated differently on your tax return. For example, if you steal a few thousand dollars that you find unattended at work, and only do it once, you report the gain on Line 21 under miscellaneous income. You’d pay your marginal tax rate on the few thousand dollars as though stealing was just a hobby. But let’s say you set up a scheme at work where you regularly steal a few thousand dollars and devote time and energy to managing the fraud. The IRS might say you’re “engaged in the trade or business” of regularly stealing money, and hit you with the additional Self Employment Tax. That’ll add 13.8% to the tax on the illegal money. Ouch.
Wait, there’s more!
Using the example of embezzling from work, the two types of stealing will be treated differently later on when you’re ordered to pay back the money, too. It’s tax deductible, but paying back the one-or-two time embezzled funds won’t get you much of a deduction. Your restitution payments will be included with your Miscellaneous Itemized Deductions, subject to the 2% of Adjusted Gross Income limit. So if you don’t itemize or you didn’t pay much back over the course of the year, your payments won’t help you out. However… if you’d been hit with the “trade or business” determination and had been subject to the Self Employment Tax, then you’d be able to take a business loss deduction for the restitution payments without having to itemize deductions. It would really be a case of paying refunds to your “customers.”
You mean I can deduct that?
Now, there’s another factor to consider before you start your life of tax-compliant crime. If you’re in pretty much any business but the drug business, keep good records, because your expenses are deductible. You bought a van to smuggle migrant workers over the border? You can take the standard mileage deduction or actual expenses on the van (Sorry, not both. Let’s not be greedy.). You bought a computer system to manage your sports betting business? You can depreciate it. You hired 10 telemarketers to get on the phone when people press ‘1’ to talk with Rachel at Card Services? Their wages are deductible (be sure you pay their employment taxes, of course!).
BUT.. if you’re in the drug business, none of that applies. You really don’t need to keep any records. The reason is that since the Drug War started ramping up in 1982, expenses involved in the sale of illegal drugs haven’t been deductible. You’re allowed an adjustment for the cost of the drugs you buy for resale plus packaging and adulterants, but nothing else. Gas for the truck you use to smuggle the product? Not deductible. Wages for your bodyguards? Nope. That warehouse you rented to store your inventory? Sorry. Drug traffickers get hit hard by the tax law, and there really isn’t much of an appeal process involved. The statute (it’s Section 280E of the Internal Revenue Code) says you get hit, so you get hit.
Legal drugs can be illegal too…
But today we have a new issue: Not only have several states legalized therapeutic marijuana use, but some have legalized recreational marijuana use. And in places where it’s legal, that means someone has to be in the perfectly legal business of selling it, right?
The IRS doesn’t see it that way. Irrespective of the states’ legalization of the drug, the federal government hasn’t legalized it. That means that the marijuana dispensaries that operate legally under state law are still selling illegal drugs for federal purposes. And the IRS is a federal agency, so…
Yes, the dispensaries are getting hit hard until the law is changed, which could be some time. The rent they pay for storefronts – not deductible. Wages paid to their staff – not deductible. Light bill – nope. Insurance if they can get it – nope. For many people in the legal marijuana business, that means a federal tax rate of 40, 50, 60% or more on their legal income because most of the their business deductions are disallowed.
What goes to the IRS, stays with the IRS…
One last thing: Is it true that the IRS won’t call your local police if you file a return saying that you stole money? Yes, it’s true. The IRS is prohibited from using your tax return information for any purpose but assessing or collecting your tax. Their interest is always, ever and only about collecting the money – so they’ll take that prohibition seriously.
On the other hand, of course, the IRS is also statutorily prohibited from using its law enforcement power to intimidate, harass or bully tax payers who the Administration sees as their political enemies, and we saw how that worked out starting in 2012. But the conservative-organization-targeting effort involved corruption at the highest levels of the IRS. The Revenue Agents and Revenue Officers on the front line, the legions of office workers who process and examine returns, really don’t have a political focus to their jobs like senior management does. For the most part, if you tell them a secret, it’ll stay a secret.
Just say No. Really, just say No.
Bottom line: On balance, engaging in illegal activity will likely get you in trouble with the law. And if you get in trouble, you could very well end up in tax trouble as well – especially if you make some affirmatively false statement to the IRS to hide that illegal income. So, all things considered, it’s ultimately easier (and more profitable) to just not do it in the first place.
Tom Hughes, Speaker and Writer 