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July 23, 2013 The Tax Lawyer

Reconsidering the Classification of Illegal Income

Vol. 66, No. 3 - Spring 2013

Donald DePass


    Theft, larceny, embezzlement, and comparable crimes plague our society. These criminal acts impose hardships on victims who no longer have access to the funds stolen. When detected, these crimes are addressed by the criminal justice system and by civil actions in which victims seek to recover what has been taken by the acquirer of the funds (acquirer). These crimes also present unique and interesting income tax issues, as we must consider the victim’s loss and the acquirer’s gain. These tax issues take on unique complexity in light of what happens when the criminal act is detected and the criminal is obligated to repay the stolen funds.

    Courts classify illegal income as gross income. They interpret section 61(a)’s sweeping definition of gross income, which includes “all income from whatever source derived,” to encompass even illegally obtained income.1 Thus, stolen funds are considered part of the acquirer’s gross income and must be declared in the year in which the funds are taken. This presents something of a catch-22 for acquirers. If the tax-conscious criminal declares the income, the discrepancy between his legal income and the amount of income he is declaring may tip off law enforcement about possible illegal gains. Conversely, opting not to declare the illegal gain risks a tax penalty. Thus, a criminal declining to declare his illegal income may face a tax penalty in addition to any imprisonment, fines, and civil liability imposed for his crime.

    The Tax Court in Wood v. Commissioner stayed true to precedent in finding embezzled funds taxable to the defendant. It is well settled that income gained from embezzlement and other illegal activities is taxable to those who obtain such illegal funds. Despite the fact that Wood, the acquirer, funneled some of the embezzled funds into his corporation rather than using them for personal expenses, his initial dominion over the funds established his personal tax liability. Although the court reached the appropriate decision, the outcome of Wood highlights an unsettling practice whereby illegal income is taxed, acquirers are effectively assessed an additional penalty, and the victims’ hope of recovering stolen funds is diminished.

    This Note argues that the current policy of classifying unlawfully obtained funds as gross income challenges fundamental notions of fairness and justice. Taxing illegal income as gross income functions as a penalty against acquirers. This unwarranted sanction is fundamentally unfair and serves no justifiable purpose. Moreover, because a victim’s claim for recovery of stolen funds is often subordinated to the Service’s tax claim against the acquirer, taxing illegal income jeopardizes victims’ chances at recovering taken funds. Given these undesirable consequences, the federal government should consider eliminating the punitive use of the taxing power and, at a minimum, subordinating the government’s claim to that of the victim.

    Part II of this Note provides an overview of the historical evolution of gross income tax jurisprudence. Part III explores the gross income tax classification of embezzled income and other types of illegal income. Part IV provides an explanation of the Wood decision and places the case into context by analyzing it against the backdrop of two fairly recent Second Circuit decisions. Part V.A discusses how the taxing power functions as a punitive mechanism when used to tax illegal income as gross income. It elucidates issues of fairness and injustice that arise from such a penal use of the taxing power. Part V.B argues that taxing illegal income is also inequitable because it impairs a crime victim’s ability to recover stolen money. Finally, Part V.C suggests an alternative approach to the taxation of illegally acquired income that would subordinate the government’s tax claim to the victim’s claim of recovery. Alternatively, and more ambitiously, it suggests eliminating illegal income from the tax base.

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