The Tax Loophole You Never Thought Of

When someone in the local area makes the news for embezzlement it is not a matter of if they will show up at my office, it is a matter of when they show up. The same scenario plays out every time. Someone gets caught with her fingers in the cookie jar (usually for gambling) and charges are filed. The district attorney prosecutes the case. (Embezzlement cases make the news and the district attorney is a politician who can’t help getting on her knees to earn some votes.)

Most embezzlement cases end with a conviction, or more often, a plea agreement. The accused is eager to make a deal that keeps her out of prison. The DA and judge soil themselves with the familiar sentencing template. The defense attorney has no choice but to recommend her client goes along with the deal to stay out of jail.

I see the same agreements again and again. The prosecutor demands a brutal repayment plan to the victim, the judge rubber stamps the deals and the accused jumps up screaming, “I’ll take it!”

Then the IRS letter arrives three weeks later and the house of cards is ready to fall. Ill gotten gains, you see, are still required to be reported as income and the IRS watches these financial crimes cases very closely. When the defendant loses or takes a knee the IRS swoops in for their share of the pickings. All that unreported income is now taxed with penalty and interest added. And no money to pay for it.

The court ordered payments are mandatory for the accused to stay out of jail. The IRS doesn’t care. They have a spotless record of killing the goose that lays the golden egg. First the IRS demands payment, a payment which can’t be made because all income is diverted to the court to reimburse the victim. But don’t count the IRS out so fast. They have more power than any rinky-dink state court. The IRS is part of the Treasury Department which is part of the federal bureaucracy. Now they have power.

The defendant has no power! She has to pay the court ordered payments or go straight to jail, do not pass go, do not collect $200 (and if you have $200, please send it to . . .) Then the IRS gets sick of waiting for their money so they levy bank accounts (which are empty) and garnish the paycheck. Now the defendant has no money to pay the court ordered restitution.

This is where I pick up a new client because no other firm in town wants them. Oh, and they have so much money to pay my fee.

They Took Down Al Capone

But this isn’t a story about embezzlement and the consequences; it is about getting caught. Al Capone had a criminal organization to die for. Many did. Al knew how to get the job done. He embezzled, of course, and murdered, bootlegged, racketeered (I love that word. It would be awesome to go through life telling people I was convicted of racketeering. Nobody knows what it really is, but it sure as hell sounds cool), and bought off the police (not a hard thing to do).

The law couldn’t get a charge to stick until they called in Elliot Ness. Now Ness was with the Treasury Department, you know, the feds. Now those boys know how to get shit done. The reason is simple. The government doesn’t really care if you get murdered or beat up. That’s your problem. They only care if it feathers their cap or gives them political capital. But if you take a penny from the government you better bring the jar of Vaseline with you; you’re going to need it.

What is due to the state pay as quickly as you can, and you will never be asked for that which is not due.

—Epictetus, Enchiridion

Al Capone committed crime after crime and got away with it. His one mistake was not reporting the illegal income on his tax return, yet another crime. Capone paid Alcatraz a visit due to a tax evasion conviction. The government put in half efforts when it came to bootlegging and murder, but when the government was due some coin they pursued poor old Al relentlessly. And he could have avoided the whole unpleasant issue if he would have just reported his income from criminal activity.

Tax Planning Tip and Financial Planning Opportunity

It gets interesting here so follow me. You report illegal activity income on the front page of Form 1040, other income, Line 21 on your 2016 tax return. Listen close now. You only pay income tax on the illegal gains. There is no payroll tax or self-employment tax! This means you can bump off the local First National Bank and pay less tax on the haul than if you ran a legal enterprise! Talk about a fucked up system.

Let me remind you how crime works again. If you bump off the bank you are stealing ***FEDERAL RESERVE NOTES***. Eventually this comes out the government’s pockets and once again you have serious problems. Elliot Ness, or some similar character, will turn you into a project. Now if you kill somebody you will be fine, but where is the profit in that (unless you are a gun for hire).

Capone was on the right track: bootlegging. Ya gotta sell something illegal for this thing to work smooth. Drugs or stolen goods will work fine. To keep the government only working half-heartedly to disrupt your criminal enterprise you will need to report the income from said enterprise. If the government gets their cut they are implicit in your crime and deep down not bothered by your behavior. Cut them out of the loop and you would be better off stiffing the mob.

Here is the best part. You will only pay income tax. If you were an upstanding citizen (like a dumbass) you would pay self-employment tax on top of the income tax. But not you. You know how to run a business: either illegal or stay home. Who can afford to pay another 15% on top of the income tax? Honest people (in a sarcastic voice), that’s who.

Think Fast and Plan Ahead

We are not out of the woods yet. If I were an IRS auditor I would challenge a tax return claiming illegal income on the front page of 1040, especially if you have been doing it for a number of years. Here would be my angle as an IRS auditor. I would argue you started your illegal activity as a hobby. If you make a profit 3 out of 5 years the IRS automatically considers you a business whether you are doing it as a hobby or not. They do that to collect more self-employment tax. You’re starting to catch on, aren’t you?

I have a few solutions to pre-plan any IRS BS argument in an audit. First, we have a new President coming into office promising to lower taxes on businesses to no more than 15%. Corporations don’t pay self-employment tax either. So, we can sit back and hope Trump sends us a massive gift, in which case we are more than happy to be called a business, or . . .

. . .  we can do what any hard working business person would do: take a multiyear vacation periodically. Consider it a form of early retirement or a side hustle. Well, hustle might be too strong of a word.

I know, I know. I can hear you through the internet already. You claim to be an honest man. Fuck honest! Honest hits you with bonus taxes criminals are not required to pay! If the government wanted you to conduct legal activities they would not reward you criminal behavior and punish the dip shits working those legal businesses. Everybody, especially the government, knows the real work gets done by the underground economy.

Think of it this way. Pretend you need to get some illegal shit across the border. You have to come up with some very creative ways to get the job done. The government appreciates the mindset because it is identical to the way government officials think when they are spying on another country. Get it?

There is no reason you can’t put the kids through college and retire early by using your head. A simple $100,000 profit in a criminal enterprise is taxed $15,000 less than a so-called honest business all due to the self-employment tax. There are other tax saving strategies if you start thinking about it, too. In 30 years you would save $450,000 in taxes. Invested in a broad-based index fund you would be well north of a million bucks. And what criminal stops at $100,000? You’re a smart guy. I bet you could do triple that a year.

A Few Caveats

Now is where I need to point out a few caveats so you don’t piss off the IRS. The marijuana industry is finding out the hard way how this works. Just because weed is legal in your state doesn’t change the fact it is illegal under federal law. If the activity is illegal under federal law you need to follow a few additional tax laws. The IRS has spent plenty of time thinking this through. They don’t care if you put bread on the table by breaking the law as long as they get their cut. So follow the rules. They are there for a reason. To keep you out of prison, unlike our buddy Al.

You are an industrious goodfella. You work hard and keep good records so you pay the appropriate cut to your Uncle, you know, the boss. The government does not allow most deductions in your type of business. Now before we start, these special laws only apply to drug dealers. If you are a contract killer or a prostitute you can write off all those “regular and necessary” expenses of your, ehem, business. Since we are treating this like a hobby by reporting the income on the front page of 1040, the deductions are reported on Schedule A, subject to 2% (look it up). You can’t show a loss, so be sure to only deduct expenses up to the level of reported income. Also be careful not to miss deductions. For example, if you decide to knock over the First National Bank against my advice, be sure to keep track of your mileage. It really adds up after a few bank jobs. Masks are another often missed legal deduction. And if you travel out of town to hit a bank and need to stay overnight (perhaps a short stint in the county jail) make sure you keep a record of the number of overnights. You do get a per diem deduction for meals and incidentals.

You are a smart businessperson and took the advice of a crazy, sorry, nationally renowned accountant from Wisconsin and built a drug business from the ground up with your own two hands. (You built that.) A law was passed back in the 1970s disallowing deductions to drug dealers against their illegal gains. (IRC Section 280E. And you thought I was making this shit up.) You still need good records because you CAN deduct your costs of goods sold since these expenses are not technically deductions; they are a subtraction from gross receipts used to derive gross income. (See, it pays to listen to your accountant. You can learn, and save, a lot.)

But there is a way around this dilemma for drug dealers. If you think about it there are two things going on in a drug dealing business similar to a pharmacy. One business is selling drugs and the other is providing advice and consulting. I recommend you keep excellent records while conducting business for both enterprises (drugs and the advice/consulting business) under one roof. The consulting business CAN deduct all those pesky rent, wage and utility expenses while the drug dealing operation gets the cost of goods sold allowance. (Californians Helping to Alleviate Med. Problems, Inc. v. Comm’r (CHAMP), 128 T.C. 173 (2007). Thought I was bullshitting you again, didn’t you?)

One More Thing

I gave you a lot to munch on. You learned running a legal business gets you fucked by the tax code and criminals get an awesome tax deal if they have good lawyers.  You also know I was pumping you full of it so don’t get any stupid idea. (Yes, I see you in the back row taking notes.)

This post is for the New Year’s holiday weekend. Go out and have fun. Don’t drink too much. Be safe. Most of all have fun. And laugh.

See you next year.

Persons attempting to find a motive in this narrative will be prosecuted; persons attempting to find a moral in it will be banished; persons attempting to find a plot in it will be shot.

—Mark Twain

 

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