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.