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Keep up to date with the latest tax changes!

Taxation of Income from Sex Work and Other Illegal Activity

Christopher Kirk

For people who are engaged in a business that is illegal under state or federal law, a natural inclination might be simply to leave that income off of the tax return, thinking that omitting the income decreases the likelihood of getting caught. Unfortunately, following that inclination can have dire results. 

If you have income, you are required to report it on your tax return. That includes tips earned as an exotic dancer, being paid under the table for sensual massage work, and “gifts” from clients in exchange for being an escort. If you fail to report income, you could face penalties for filing an inaccurate return (20% of the tax owed), substantial understatement of income (25%), or civil fraud (75%). In particularly egregious cases, you could be found guilty of tax evasion, a felony that carries a sentence of up to five years in prison. Remember, Al Capone went to prison, not for bootlegging, extortion, or murder, but for lying on his tax returns.

Fortunately, even most illegal business operations can take deductions connected to their illegal activities. While some may find this surprising, it makes sense when considering the fact that “the federal income tax is a tax on net income, not a sanction against wrongdoing.” Thus, if the expense is one that would normally be incurred in the course of the business in question (such as condoms for sex workers), it can be deducted, even if the business itself is illegal. An important exception to this is trafficking in controlled substances prohibited by federal law or the law of any state. Due to federal law, expenses incurred in connection with the sale of marijuana, including rent, power, security, and the like, cannot be deducted on a federal tax return, even where the business operates in states like Washington and Colorado, where recreational marijuana use is legal under state law.

Additionally, tax authorities are not allowed to provide information to law enforcement agencies absent a court order to do so. This means that the police can’t obtain a tax return as evidence of criminal activity, unless the court orders it. Be aware, however, that IRS officials can disclose supplemental information obtained from outside sources, such as witnesses interviewed in the course of an audit investigation.

The takeaway from this is that you will be reasonably safe disclosing income from illegal activity, while not doing so gives rise to serious risks. Good tax return preparers can work with you to find deductions you might not have thought available, and help minimize your tax burden.

Congress Doubles Time for IRS to Audit Certain Returns

Christopher Kirk

Taxpayers be aware: if you overstate your basis in property when reporting a sale, the IRS may have six years, instead of the usual three, to audit you.

The default rule for audits is that the IRS has three years from the date the return is due or filed, whichever is later, to assess additional tax. An important exception to this is that, if a taxpayer omits an item of income from their return, amounting to 25% or more of the gross income stated on the return, the statute of limitations on assessment is six years, not three. Generally, this was understood to apply only to complete omissions, not misstatements - if you included an item of income, but misstated the amount, it was not considered omitted from the return.  If you bought a painting at a garage sale for $10, and it was sold for $100,000 after discovering it was an undiscovered work by Jasper Johns, only the three-year statute of limitations applied if you reported the sale but claimed your basis was $90,000.

For many years, the IRS argued against this understanding, and brought assessments against taxpayers after the three-year period had run, claiming that an overstatement of basis constituted an omission of income and thus brought the case within the ambit of the exception. For many years, the IRS lost the argument. In 2012, the Supreme Court finally weighed in on the matter, affirming its earlier decision that an overstatement of basis did not constitute an omission of an item of income, and throwing out IRS regulations interpreting the statute of limitations the other way. The Court found that the language of the statute had not changed since its earlier decision, so there was no reason to change how it should be applied.

What the IRS could not win through litigation, it has won through legislation. On July 31, 2015, President Obama signed into law the Surface Transportation and Veterans Health Care Choice Improvement Act. Attached to that act was a provision that included an overstatement of basis as an omission of an item of income. 

The takeaway from this is that even if the IRS loses the battle, it may end up winning the war.

Annual Tax Changes, 2015 Edition

Christopher Kirk

As usual, Congress enacted year-end changes to the Internal Revenue Code in order to extend tax breaks, delay the effective date of new taxes, close certain loopholes, and take general steps to meet taxpayer concerns.  Adopted on December 17, 2015, and signed into law by President Obama on December 18, the Protecting Americans from Tax Hikes Act of 2015 included the following provisions:


·         Enhancements to the child tax credit, earned income tax credit, and American opportunity tax credit were made permanent

·         The deduction for elementary and secondary school teachers purchasing schoolroom supplies was made permanent, indexed for inflation, and extended to purchases of materials used for professional development

·         The exclusion from income of distributions from individual retirement accounts directly to charitable organizations was made permanent

·         The exclusion of gain on qualified small business stock was made permanent

·         The recognition period for built-in gains for existing corporations electing S corporation status was permanently reduced to five years

·         The limitation on expensing of certain equipment was permanently increased to $500,000

·         Bonus depreciation under Section 168(k) was extended through 2019

·         The new markets tax credit and work opportunity tax credit were extended through 2019

·         The exclusion from taxable income of cancellation-of-indebtedness income resulting from foreclosures and short sales of personal residences, which had expired at the end of 2014, was reauthorized and extended through 2016

·         Treatment of mortgage insurance premiums as mortgage interest was reauthorized and extended through 2016

·         Tax credits for various alternative energy, energy-efficiency and other energy conservation programs were extended through 2016

·         The start date for the medical device excise tax, which was included in the Affordable Care Act as a means to help pay for insurance under that law, was delayed until 2018

·         Use of 529 Plan funds was expanded to include the purchase of computers and related equipment

·         Use of personal email accounts by IRS employees to conduct official business was prohibited

·         Taking official actions by IRS employees for political purposes was made a terminable offens

Tax reporting for hobbies is evolving!

Christopher Kirk

The New York Times reports on a recent court case that may change the game for hobby-loss rules. See how this accomplished painter proved her expertise and demanded the same tax treatment as a professional, not some one who is just pursuing an expensive hobby. 

Artist Wins!