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Absurdities at the IRS

Sunday, April 13, 2014

Under tax law, stolen property, bribes, kickbacks, and income from other illegal activities must be counted as income. Embezzlers, thieves, and bootleggers may also take deductions for costs relating to criminal activity.

As Tax Day approaches and social media goes wild with messages extolling animosity towards the IRS, one would do well to remember the glory days of the IRS as an agent of good.

In 1930s Chicago, American gangster Al “Scarface” Capone led a Prohibition-era crime syndicate dedicated to bootlegging and other illegal activities, including bribery, prostitution, and execution of rival gang members. He made vast sums of money from his business ventures. In 1927, he brought in an estimated $100 million — more than $1 billion in today’s dollars. He was careful about keeping his illegal earnings hidden, and witnesses were unwilling to testify against him. There is no way of knowing how many people died by his hand or his command. But the crime that eventually landed this most notorious American gangster of the 20th century in Alcatraz federal prison was tax evasion. The IRS worked hand-in-glove with the Treasury and the FBI to convict him for not paying taxes on his ill-gotten wealth.

Had the IRS tried to target Al Capone in 1913 for federal tax evasion charges, instead of in 1931 as they eventually did, they may well have missed their mark. The 1913 Income Tax Act defined gross income as including “gains, profits and income derived from … the transaction of any lawful business” (italics added). Therefore, illegally earned income was not technically subject to taxation.

The change towards taxing all income came a few years later. In United States v. Sullivan in 1927, an individual was convicted of fraudulently failing to file an income tax return reporting income from illegal activities. The individual objected that such income should not be considered taxable and that requiring the filing of such income would violate the provisions of the Fifth Amendment against self-incrimination. An appellate court ruled that “it does not satisfy one’s sense of justice to tax persons in legitimate enterprises and allow those who thrive by violation of the law to escape.” In practical terms, this meant that the government could collect taxes on illegal activity if it could prove that the individual had received such income, but it could not charge the individual with a crime, unless the return that he filed was false.

In practical terms, this meant that the government could collect taxes on illegal activity if it could prove that the individual had received such income, but it could not charge the individual with a crime, unless the return that he filed was false.

When Soviet spy Aldrich Ames, who had earned more than $2 million cash for his espionage, was also charged with tax evasion because none of the Soviet money was reported on his tax returns, he attempted to have the tax evasion charge dismissed on the grounds his espionage profits were illegal. But the charges stood.

Under current law, the IRS definition of income includes stolen property. The instructions read, “If you steal property, you must report its fair market value in your income in that year you steal it, unless in the same year, you return it to its rightful owner.” It further includes bribes: “If you receive a bribe, include it in your income.” Illegal Activities: “Income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Form 1040, line 21, or on Schedule C or Schedule C-EZ if from your self-employment activity.” Kickbacks: “You must include kickbacks, side commissions, push money or similar payments you receive in your income on Form 1040, line 21, or on Schedule C or Schedule C-EZ, if from your self-employment activity.”

As if the voluntary disclosure of illegally earned income were not baffling enough, the IRS allows embezzlers, thieves, and bootleggers to 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. The taxpayer subsequently tried to deduct from his gross income the legal fees he spent while defending himself. The U.S. 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.” 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 U.S. Supreme Court in Tellier 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.

Given the jaw-dropping absurdity of these current rules of taxation, it is not surprising that people have tried to claim many other deductions that have turned out to be highly illegal. Rather than continuing to struggle with a floundering business, one man hired an arsonist to burn his store to the ground. In addition to planning on collecting half a million in insurance money, the man also attempted to deduct the $10,000 fee paid to the arsonist. A couple of years later he was audited, and imprisoned for insurance fraud.

In another case, a New Jersey resident who was fed up with poor air quality decided to do something about it by enclosing himself and his family in "a bubble of pure air.” He then attempted to claim it as a medical expense deduction, describing it as a "pure bubble" on his tax returns. He was audited, and the IRS denied the deduction but waived all penalties.

Another often claimed deduction is bad debt from deadbeat offspring. While it’s one thing to claim a loss on money that can be tracked, trying to deduct the $2,000 you loaned to your unreliable son to help start his real estate business isn’t going to fly. Unless you have paperwork to back up the loan and have already attempted to get the money back through the proper legal channels, the IRS doesn’t sympathize with your poor decisions, or those of your children.

Apparently some things are too absurd even for the IRS.

Aparna Mathur is a resident scholar at the American Enterprise Institute.

FURTHER READING: Mathur also writes “A ‘Genius’ Way to Avoid Taxes,” “How Taxing the Rich Harms the Middle Class,” and “Race to the Top of the Laffer Curve.” Alex Brill contributes “One Step Closer to Tax Reform” and “Understanding Tax Fairness (and Why the Buffett Rule Is a Distraction).” Sita Nataraj Slavov adds “The Penalties of Our Tax Code.”

Image by Dianna Ingram / Bergman Group

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