Rankin, the comptroller of Lazy, Inc. has been embezzling funds from his employer for many years, To date, he has taken almost $5,000,000. In view of the fact that Rankin will have to repay this to his employer if he is caught, is this income for Rankin? If so, and he is caught, in what year is it taxable? Explain fully.
Under the terms of Title 26, Section 61, of the United States Code (i.e., the federal law), income from criminal activities is defined as “gross income” for the purposes of computing income taxes owed to the federal government. Specifically, that section of the law states:
“(a) General definition
Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, . . .”
The phrase “from whatever source derived” was intended to include illicitly-attained revenue, and this has been upheld by the United States Supreme Court, specifically in James v. United States, named for the labor union official (Eugene James) convicted of embezzling funds from that union. In its decision, the Court stated the following with respect to lower court rulings on this case and with reference to earlier cases adjudicated by the courts:
“It had been a well-established principle, long before either Rutkin or Wilcox, that unlawful, as well as lawful, gains are comprehended within the term ‘gross income.’ Section II B of the Income Tax Act of 1913 provided that ‘the net income of a taxable person shall include gains, profits, and income . . . from . . . the transaction of any lawful business carried on for gain or profit, or gains or profits and income derived from any source whatever . . . .’ (Emphasis supplied.) 38 Stat. 167. When the statute was amended in 1916, the one word "lawful" was omitted. This revealed, we think, the obvious intent of that Congress to tax income derived from both legal and illegal sources, to remove the incongruity of having the gains of the honest laborer taxed and the gains of the dishonest immune.”
So, it is well-established that embezzled funds are considered taxable income by the federal government. As to the issue of year in which that income is required to be reported to the Internal Revenue Service, taxes are required in the year in which the income is derived. As noted above, for taxation purposes, the IRS treats illicit revenue the same as that derived through legitimate means. As many financial crimes are not detected and prosecuted in the same tax year in which they occur, and many are ongoing or repetitive over multiple years, the tax obligation can accrue just as with un- or underreported income. This is where it gets complicated, however. Tax liabilities accrue over time, and penalties similarly accrue. The illicit income was required to be reported (the amount of money, not the source of the income) on tax forms for the years in which the income was accrued. As with legitimately-attained income, the taxes that weren’t paid on illicit income is considered back-due, and subject to the same penalties as those associated with un- or underreported legitimate income. The interesting component of this discussion has to do with legitimately-reported deductions associated with illicit income and the legal costs associated with one’s defense once the illicit activity is detected. Under the law, expenses associated with defending oneself constitute, under most circumstances, legitimate deductions for income tax purposes, a status upheld in the 1966 Supreme Court decision in Commissioner of the I.R.S. v. Tellier:
“To deny a deduction for expenses incurred in the unsuccessful defense of a criminal prosecution would impose such a burden in a measure dependent not on the seriousness of the offense or the actual sentence imposed by the court, but on the cost of the defense and the defendant's particular tax bracket.”
To reiterate, tax issues associated with illegal activities are not distinguished from taxes associated with legal sources of revenue. The U.S. tax code is kept distinctly separate from the U.S. criminal code, even though the two often overlap in the prosecution of financial crimes.