New Column: Wait, What? Law Students on What Surprises Them

March 26, 2013

In this new series, our law student contributors share unexpected lessons from law school. 

My tax class (the official name is Federal Income Taxation, but everyone just calls it “Tax”) is a pretty reliable source of surprising facts. Granted, that’s partly because I couldn’t have been more of a tax ignoramus heading into it, but sometimes we learn things that would make even a financial literate adult raise an eyebrow. Here’s one: did you know that expenses associated with illegal businesses, including those arising from criminal prosecution, are generally tax deductible?

I know, weird, right? Would you expect an IRS agent, of all people, to let you claim deductions for expenses you’ve incurred in order to commit crimes?

But of course, that’s why you and I don’t work for the IRS. (That and the fact that you have to pay taxes on game-show prizes; no one sees that coming.) The federal income tax is designed to tax net income, not gross receipts. That’s why if you spend $100 on lemons and sugar and sell $110 worth of lemonade, your taxable income is $10, not $110. The tax statute codifies this rule by providing that, in general, taxpayers can deduct from income “all the ordinary necessary expenses” arising in a given year from “carrying on any trade or business” or any private income-generating activity.  This rule is meant to be broad; courts have interpreted “necessary” to mean simply “appropriate and helpful,” while the term “ordinary” just serves to exclude capital expenditures (the lemonade stand), which aren’t deductible immediately.

Now, you might think that we should punish criminals by refusing to extend the logic of the income tax to them. But the courts have consistently held that punishing wrongdoing is the job of criminal law, not the tax code. (It probably goes without saying that this issue only comes up once people get caught and are forced to pay taxes on their illegal businesses.) In the 1966 case Commissioner v. Tellier, for example, the Supreme Court considered the case of Walter F. Tellier, a stockbroker and big-time con artist who had been convicted of wire fraud, securities fraud, and conspiracy to commit those frauds. Mr. Tellier had deducted about $23,000 in legal fees incurred during his unsuccessful defense, but the Commissioner (as in, Commissioner of Internal Revenue, the head of the IRS and the synecdoche by which the agency is referred to in these kinds of cases, hence the cool case name) disallowed the deduction on the basis that it would violate public policy.

In an opinion by Justice Potter Stewart, the Court disagreed with the Commissioner, maintaining that because “the federal income tax is a tax on net income, not a sanction on wrongdoing,” the tax code “does not concern itself with the lawfulness of the income that it taxes.” Justice Stewart also referenced an earlier case, Commissioner v. Sullivan, which affirmed that operating expenses from an illegal gambling operation were deductible, and in which the Court observed, “Were we to enforce as federal policy the rule [that illegal business expenses are non-deductible], we would come close to making this type of business taxable on the basis of its gross receipts, while all other business would be taxable on the basis of net income. If that choice is to be made, Congress should do it.”

Congress has generally declined to make that choice. In fact, as the Tellier opinion points out, during the original debates over the statute establishing a federal income tax way back in 1913, Senator John Sharp Williams explained, “The law does not care where [income comes] from, so far as the tax is concerned, although the law may very properly care in another way.” In other words, keep the income tax away from criminal law’s turf.

There’s plenty of sense to this. Imagine Lucy gets busted for running an illegal blackjack game out of her house. She has documented expenses of $100,000 against $100,000 in revenue, just breaking even. (She goes through a lot of felt.) If we suppose her average tax rate on the $100,000 is 35%, denying her the deduction would be equivalent to hitting her with a $35,000 fine on top of her criminal penalties. Moreover, the extent of that extra punishment would depend not on Lucy’s crime, but on her tax bracket, which is not generally how we go about punishing wrongdoing. (That is, we don’t tend to punish higher-income people more than lower-income people for the same crime, to put it gently.)

Now, you might say that since people like Lucy are ordinarily evading the income tax, they should be denied deductions to try to balance things out. But it must be the case that in practice, criminals aren’t getting the same level of deductions as law-abiding citizens because they’re much less likely to be able to prove their expenses. (Example: mob hit men probably don’t keep receipts for all the cement they go through.)

Despite all of this, Congress has established some exceptions in the tax code to the general rule. Although you can deduct legal fees incurred in defending business-related criminal charges, you can’t deduct fines or penalties for wrongdoing–the logic being that it would dull the impact of the fines. You also can’t deduct illegal bribes or kickbacks. I suspect that here, the spirit of the exclusion is that it’s the payment itself that constitutes the criminal and immoral act; the expense is the crime, in other words. Perhaps Congress is turned off by the idea of a tax-deductible crime.

But surely the most curious exception is the one for drug dealers: business expenses arising from illegal traffic of Category 1 or 2 controlled substances are not deductible–you can’t deduct the gas you use to transport your cocaine. However, the costs of buying the drugs themselves are deductible. So if Lucy decides to switch from running a card game to dealing coke, she will be able to deduct the money she spends on the cocaine, but not the cost of her flights to Colombia.

Are you confused? Don’t worry, so is Congress. The legislative history on the 1983 law justifies the exception by pointing out that “there is a strong public policy against the sale of narcotics.” True enough, but you might wonder whether there isn’t strong public policy against prostitution, racketeering, securities fraud, and so on. Why are only drug dealers denied the neutral protection of tax logic? I don’t know, but don’t bother saving the receipts from your heat lamps.