On page 32 of IRS publication 525 we are instructed:
Stolen property. If you steal property, you must report its fair market value in your income in the year you steal it unless in the same year, you return it to its rightful owner.
So, presumably the IRS won't turn you over to the cops if you declare income from theft?
Probably not. Most states have similar rules in their tax code, including for drugs. IIRC, Kentucky says they won't report you to the police, they just want to make sure they get their tax money from any pot or whhtaever you sell.
I'm not sure you have to report the fact that you stole it, merely that you acquired it as income. If the IRS won't report anyone who is dumb enough to admit to stealing, they're pretty dumb themselves.
According to Alan Dershowitz's book "The Best Defense," there are drug dealers who annually file Form 1040, with a check for their federal taxes. Yes, they admit to being drug dealers on the form. They merely leave out their names and other identifying information.
You can't make this stuff up.
After Capone, what's a drug dealer to do?
It sounds weird, I know. But if you didn't tax illegal income, then the tax system would favor breaking the law.
Take it another step: What deductions should the IRS allow a drug dealer? Can he deduct bribes and legal fees spent defending criminal charges?
This is fascinating...time to weigh in.
Either one of these two COULD be true:
A) The IRS was instructed to write this in to possibly assist in locating and catching stupid criminals.
B) This is not to catch criminals, but to profit from their criminal behaviour; thus, the government officially sanctions this type of activity as long as they get their cut.
I realize my point B directly conflicts with your assesment, Ben, but I disagree with you, partially. I think whether they taxed illegal behaviour or not, they're still favoring it.
On the one hand, by not taxing it, they favor it by making that behaviour MORE profitable to the criminal.
But by taxing it, they favor it by seeming to legitimize it. As in, "that's illegal, but if you do it we'll still take a cut of your blood money."
I've read that part of why the IRS started to go after unreported tip income so aggressively in the mid-1970s is that there was a court ruling that said the IRS could not turn over evidence of drug trafficking from tax returns to the DEA (maybe it was still the BNDD back then).
Some years ago, I noticed that IRS and the California Franchise Tax Board had different rules about illegal businesses. IRS allowed you to deduct business expenses for illegal businesses; California did not. In both cases, your illegal income was taxable, but California wouldn't let you deduct the expenses.