Blunt Truth: Paying Taxes on Illegal Income

When a taxpayer makes money from something like selling marijuana, they still owe taxes on that income. The law requires the marijuana profits to be reported for income tax purposes.

This type of income is usually only reported and tax collected if the IRS catches wind of the illegal activities. This is often limited to situations in which the taxpayer is prosecuted and/or tried for the illegal activity.

Some criminal cases at the federal level may result in a restitution order to pay the IRS for unpaid taxes on illegal income. This is usually limited to cases involving financial crimes. State-level crimes and non-financial crimes usually do not result in a restitution order for unpaid taxes. The IRS does assess tax on income from these crimes.

Absent a restitution order, several questions come up about how the amount of income tax is to be determined. There are often no records of the illegal activity that gave rise to the income that the IRS can use for this purpose. So how does the IRS determine how much tax is due?

The court addresses these questions in Attisha v. Commissioner, T.C. Memo 2023-150. The Attisha case involves a taxpayer who had income from manufacturing and selling marijuana.

Facts & Procedural History

The case involves a taxpayer who was an entrepreneur. He operated several businesses, including credit card sales, ATM sales, a partnership venture, and some donut shops. He also manufactured and sold marijuana.

The Drug Enforcement Administration (“DEA”) began investigating the taxpayer in 2017 for the manufacture and sale of marijuana. The DEA executed search warrants at the taxpayer’s home and other locations, seizing evidence of marijuana sales such as cash, drugs, ledgers, and text messages.

The taxpayer was indicted in 2018 on several charges related to conspiracy to manufacture, possess and distribute marijuana. He ultimately pled guilty to one count of conspiracy to manufacture, possess and distribute marijuana. As part of the plea agreement, the taxpayer agreed to forfeit over $500,000 in assets that had been seized.

The taxpayer did not report any income from selling marijuana on his 2017 tax return. The criminal case was referred to the IRS Exam function for audit. After reviewing the criminal case information, the IRS assessed more than $250,000 in taxes and penalties for 2017. The taxpayer challenged the IRS assessment in the U.S. Tax Court.

About Unreported Income

Section 61 of the tax code defines gross income broadly as “all income from whatever source derived.” This includes both legal and illegal sources of income.

This even includes illegal income that the taxpayer is ordered to repay. This was the situation in James v. United States, 366 U.S. 213 (1961). James was a union official who had embezzled money from the union and did not report the amounts on his tax return. He was criminally tried for tax evasion. He argued in his defense that embezzled funds were not taxable income because, like a loan, he had an obligation to repay the money to its rightful owner. He pointed to an earlier Supreme Court case that had made such a determination. The Court held that the receipt of embezzled funds was included in the wrongdoer’s gross income and was taxable even though the funds had to be returned. However, the taxpayer may be entitled to a claim of right deduction in the year that the income is repaid.

As a result of these court cases, taxpayers must report all income on their tax return, including income from illegal activities, like the income from selling marijuana. Willfully failing to report income can lead to civil fraud penalties and criminal prosecution for unreported income for tax purposes.

Burden of Proof for Income

In civil tax disputes, the IRS typically bears the initial burden of proof to show that a taxpayer received unreported income. This requires the IRS to establish that the taxpayer was linked to an income-producing activity.

For income earned from illegal activities, courts have adopted a more relaxed evidentiary standard for the IRS. Rather than having to provide definitive proof, the IRS only needs to show a “minimal factual nexus” between the taxpayer and the unlawful income-generating activity. This means introducing evidence demonstrating a connection between the taxpayer and the alleged illegal activity is sufficient.

That is what the IRS did in this case. In this case, the tax court found that the IRS met its burden by introducing evidence directly tying the taxpayer to marijuana manufacturing and sales in 2017. This included drugs, cash, records, text messages, and admissions in the taxpayer’s later guilty plea.

Since the tax court held that the IRS met its initial burden of proof to consider the forfeited assets as unreported income, the taxpayer then had the burden to show the IRS calculations were erroneous or excessive.

Uncovering Unreported Income

The IRS manual provides examiners with various methods to uncover unreported income during audits. These tools can reveal income that taxpayers attempted to hide through inadequately kept books or commingling funds.

One approach is a full bank account analysis checking for cash deposits, suspicious transactions, and income that exceeds reported amounts. Examiners can tally deposits and withdrawals across personal and business accounts to estimate total income. This assumes that the funds from illegal activities ended up in the taxpayer’s bank or other financial accounts.

For funds that are not in the financial accounts, the net worth method is often used. The net worth method looks at changes in a taxpayer’s net worth between years to identify income that improved their financial position more than reported income support. This can help identify income from illegal activities that did not make it into a bank or other financial account.

For income from illegal activities that are coming up with legitimate business activities or laundered from others, the IRS may employ various financial analyses and ratios. This may include comparing key financial ratios for a business, like gross profit percentage, to norms for that industry. Significant deviations can indicate underreporting of gross receipts or overstatement of expenses–including those from illegal activities.

In addition, checking for fluctuations in ratios and income data year-over-year may identify business changes not visible by analyzing just a single return. For example, if sales increased 30% but expenses jumped 40%, it warrants scrutiny to see if income corresponded to the expense pattern.

Reconstruction of Income

This brings us to the method the IRS used to reconstruct the income it determined that the taxpayer received.

When a taxpayer fails to keep adequate records, the IRS can determine income “under such method as, in the opinion of the Secretary, does clearly reflect income.” As noted above, the IRS has several methods available to reconstruct a taxpayer’s income, such as the net worth method, bank deposits analysis, or source and application of funds method.

In this case, the IRS identified more than $500,000 of unreported income based on assets the taxpayer forfeited that he admitted were connected to his marijuana business. The IRS just picked up the amount from the criminal court proceedings.

It does not appear that the taxpayer was given credit for any tax deductions to offset this income. The limitation for tax deductions for those in the marijuana business may be a reason for this, in part. Section 280E was enacted by Congress in the 1980s after a court allowed a drug trafficker to deduct rent, packaging, telephone, auto, and other standard business expenses against illegal drug income. This limitation does not apply to the costs of goods sold, however. Costs of goods sold is not a tax deduction; it is a reduction in gross receipts. Given these rules, only costs of goods sold like invoices for products, packaging, testing, etc. can be deducted by marijuana businesses. Common expenses like marketing, franchise fees, or banking charges are not deductible.

It would seem that the IRS would have to estimate the taxpayer’s costs of goods sold in determining the income that the taxpayer received. It does not seem that the IRS did this. It is not clear whether the taxpayer raised this issue in court. It is also not clear which party would bear the burden on this issue–presumably it would be the taxpayer.

The court held the IRS’s approach reflected the taxpayer’s income. It did so even though the IRS did not use its more common indirect methods, such as the bank deposit method or net worth method.

The Takeaway

This case shows how liberal the courts are when it comes to allowing the IRS to assess income on illegal activities. Those who have income from illegal sources should consider reporting the income, even with minimal details, and letting the statute of limitations expire for the IRS to challenge it. This can prevent a situation like in this court case where income from years past gets disputed because it was never reported at all.