Using a pretext, a fraudster deceived me and caused me to receive funds from illicit activities. Was my receipt of these funds gross income to me?
It depends. If not, you may still have some explaining ahead of you.
As a preliminary note, income from “unlawful gains” is generally taxable. Most people already understand this. In 1952, the U.S. Supreme Court expressed the standard as follows:
An unlawful gain . . . constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it. That occurs when cash, as here, is delivered by its owner to the taxpayer in a manner which allows the recipient freedom to dispose of it at will, even though it may have been obtained by fraud and his freedom to use it may be assailable by someone with a better title to it.
Rutkin v. United States, 343 U.S. 130, 137 (1952) (citations omitted) (boldface added); see also James v. United States, 366 U.S. 213 (1961) (extending reasoning of Rutkin to weaken the “embezzler exemption”).
Such “control” may seem a far cry from your experience, particularly if you were a victim of social engineering. Indeed, if the fraudsters' tactics were sophisticated, or if you were exploited based on a specific profile, you may feel that the bad actors wielded control over you. Often, though, fraud schemes relying on these tactics are designed so that the recruited participant, even if acting fully or partially in the dark, is the most visible and identifiable person to hold the bag, if necessary. Schemes call for deceived recruits to create any number of future messes for themselves: form business entities, obtain EINs, open bank accounts, set up crypto wallets, receive questionable payments, etc.
Maybe you were just an unwitting mule. In that case, you might assume that the bad actors who “earned” the unlawful income, through their personal services, are the appropriate taxpayers, if any, to recognize the gains. If the facts bear out, you may be correct.(1) However, if the trail of transactions is convoluted, and the extent of your activity significant, you should prepare for some difficult questions.
Assume you're under audit for the relevant taxable year. (2) Further assume that, based on its “minimum income” probe, the IRS determines an in-depth examination of income is required. See IRM 4.10.4.4. Unfortunately, you have little documentation, in tangible or electronic form, regarding the persons who designed and initiated the scheme. (This may have been by their design.) You're largely confined to transaction-source documents, bank statements, and your oral account. Is that enough to satisfy the IRS regarding the source of receipts and the roles of others?
The Service may consider your oral testimony reliable under the circumstances. See IRM 4.10.7.3.2. Then again, other facts may render it unreliable. Say your account, in effect, is that you inadvertently assisted fraudsters in their laundering operation, attributable to their fraudulently sourced income. You maintain that you received no compensation. This explanation seems straightforward. However, if upon completion of the operation, you retained part of the proceeds, the Service may question whether this was intended as a fee, commission, or other benefit for your assistance and services. If you commingled fraudulently obtained funds with your own, things could get blurrier, especially if the activities you performed were extensive. What if you used a single business entity or operating account to both (i) knowingly conduct lawful business activities and (ii) unknowingly facilitate unlawful gains? In such a situation, if the Service were to ultimately determine a deficiency, you would likely bear the burden of proof to show the determination was erroneous if you petitioned the Tax Court.(3)
Again, justifying tax consequences in these situations can be a headache. This says nothing of the information-reporting requirements that may apply, depending on the activities you undertook. Trying to pigeonhole these circumstances into a single template or playbook is counterproductive.
On the other end of the spectrum, maybe you were manipulated into fully “going into business” with the fraudster, for lack of a better description. You may have committed significant time and effort to the endeavor, perhaps even believing that many of your actions, as you understood their purpose, were substantially compliant with applicable laws. Depending on your role, contributions, and knowledge, as well as any benefits you received, the Service may have grounds to assert you were effectively in a partnership with the other actors. See, e.g., Delyra v. C. I. R., 33 T.C.M. (CCH) 660 (T.C. 1974), acq. recommended by In Re: John Delyra, 1974 WL 36351 (IRS AOD Dec. 18, 1974); Baughn v. C.I.R., 28 T.C.M. (CCH) 1447 (T.C. 1969), acq. recommended by In Re: Hubert F. Baughn, et al., 1970 WL 22839 (IRS AOD May 28, 1970).(4)
Again, there's no one-size-fits-all solution. To illustrate, in the simplest of cases, if you directly received proceeds from a fraudster's victim, you might argue that you acted as a conduit of funds received for the benefit of another. (Asserting the existence of an agency, on the other hand, may present unique challenges.) In other circumstances, this argument might be unnecessary. And yet in others, frivolous.
These matters require delicacy. You may need assistance on compliance, representation in examinations, or both. If the firm is engaged, after the fact, on tax and/or reporting matters affected by fraud, it will perform a rigorous factual inquiry and develop a tailored strategy. Hopefully, you'll eventually be able to move on with your with life and untangle the lingering messes from the unpleasant experience. But this won't happen overnight.
(1) Even then, there may be civil, regulatory, or criminal consequences, depending on the structure and extent of transactions, along with other facts. See, e.g., United States v. Bivins, 104 Fed. Appx. 892, 897 (4th Cir. 2004) (observing, with respect to conspiracy to commit money laundering, that “willful blindness serves as a proxy for knowledge, [and] there is nothing inconsistent in saying that a defendant knowingly joined a conspiracy because he was willfully blind to the conspiracy's existence and purpose.”). Obviously, ignoring warnings from law enforcement or other sources would not help your cause. You should consult a criminal defense attorney regarding any circumstance that may expose you to criminal liability. This firm does not provide criminal defense representation.
(2) Depending on the facts, the IRS's Special Enforcement Program (SEP) may become involved. See IRM Chapter 4.16.
(3) See Welch v. Helvering, 290 U.S. 111, 115 (1933); Tax Ct. R. 142(a)(1); I.R.C § 7491. In these situations, it's possible the Service would employ a “formal indirect method” to determine the actual unreported income, particularly if insufficient clarification was obtained through the “in-depth examination.” See IRM 4.10.4.5.4; I.R.C § 7602(e) (restricted indirect methods to determine unreported income authorized if “reasonable indication that there is a likelihood of such unreported income”). However, even then, it's unlikely the IRS would reconstruct income “solely through the use of statistical information on unrelated taxpayers,” under I.R.C § 7491(b), so as to assign the burden of proof to the Service.
(4) To be sure, these are memorandum opinions that predate current Treas. Reg. §§ 301.7701–1, –2, and –3. However, the Tax Court's analyses raised many of the same factors relevant to a determination, today, of whether joint undertakings result in entities for federal tax purposes.
Content posted July 9, 2023.
