In the United States, the Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
(IRC) was enacted by the U.S. Congress in part for the purpose of taxing net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
. The Code is not a mechanism for enforcing other codes of law, for example, criminal law
Criminal law, is the body of law that relates to crime. It might be defined as the body of rules that defines conduct that is not allowed because it is held to threaten, harm or endanger the safety and welfare of people, and that sets out the punishment to be imposed on people who do not obey...
. A person’s taxable income
Taxable income refers to the base upon which an income tax system imposes tax. Generally, it includes some or all items of income and is reduced by expenses and other deductions. The amounts included as income, expenses, and other deductions vary by country or system. Many systems provide that...
will generally be subject to the same Federal income tax
In the United States, a tax is imposed on income by the Federal, most states, and many local governments. The income tax is determined by applying a tax rate, which may increase as income increases, to taxable income as defined. Individuals and corporations are directly taxable, and estates and...
rules, regardless of whether the income was obtained legally or illegally.
In James v. United States
, 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 v. Glenshaw Glass Co., , was an important income tax case before the United States Supreme Court. The Court held as follows:...
, 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". 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. 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
Congress enacted the Securities Act of 1933 , in the aftermath of the stock market crash of 1929 and during the ensuing Great Depression...
. The taxpayer subsequently tried to deduct from his gross income the legal fees he spent while defending himself. 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)., 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.” 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. 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. The Court suggested that if this was not the case, Congress would change the tax code to include special tax rules for illegal conduct.
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.
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. 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." 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." 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." 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.