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Privacy of Information Reported on Your Tax Return

February 3rd, 2011 No comments

Fact:  Illegal income is taxable income.  An excerpt from this IRS publication (page 34):

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 (Form 1040) if from your self-employment activity.

**I am NOT encouraging anyone to earn income from “illegal” activities.** But, the fact is that people do, and the Internal Revenue Code addresses it (at least implicitly).  Indeed, there are misunderstandings regarding the ramifications from disclosing potentially incriminating information to the IRS.

A taxpayer who thinks “I am not required to report my income because it is earned from illegal activities,” he/she now knows that is wrong.  Also, if a taxpayer is worried about facing criminal action by reporting illegal income, he/she is very likely wrong again.  BUT, by not reporting and paying tax on illegal income, criminal action may arise.  See Al Capone, and consult a tax professional to discuss options.

Section 6103 of the Internal Revenue Code is appropriately titled “Confidentiality and disclosure of returns and return information.”  The general rule from the statute is that returns and tax return information are confidential and may not be disclosed to federal or state agencies. (Note:  There are some exceptions delineated in the statute.)  The general prohibition on disclosure applies to all officers and employees of the U.S., or any state, or of any local child support enforcement agency.

I mention the local child support enforcement agency because Kelly Phillips Erb, known in the tax blogosphere as “taxgirl,” wrote a story last month that displays the statute’s reach for protecting taxpayer information.  Arguably, it overreaches:

Under current law, the IRS may not share any tax information with any other person, including law enforcement officials. This is true even if the information would help locate a missing child.

In other words, if a child reported as missing turns up as a dependent on an individual’s Form 1040, the IRS cannot turn the taxpayer’s information over the FBI or local law enforcement.  I hope Senator Klobuchar’s (D-MN) quest to change this aspect of taxpayer confidentiality is successful.

Ultimately, a taxpayer concerned with the IRS turning over his/her information regarding income from a source of questionable activity (e.g. winnings from online poker in the state of Washington) shouldn’t be.  As noted above, however, there are some exceptions to the general rule of taxpayer privacy; I’ll delve into those next time, and ponder how online poker activity may, if at all, trigger some of the exceptions.

Again, if you have any concerns regarding how to report income from what you consider questionable activity, be sure to consult a tax professional to explore all of your options.

Confidentiality and disclosure of returns and return information

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