I remember back in the '30s, some mobsters that could not be pinned for anything else, were convicted of income tax evasion, and sent to the bighouse (that term dates me).
So, if you found a big package of money, probably from some drug deal gone bad, and reported it, what would the IRS do? Or if you reported some huge sum from illegal activity?:
I understood that years ago, no such reporting could not be divulged to authorities. Still the case?
I believe the answer is: quickly open up a laundromat. Or, if you wanted to “do the do” a barbershop also works. 
Only somewhat related to your question, but Texas requires all drug-dealers to purchase a State Drug Tax Stamp before illegally selling their blow and weed.
Many people have bought the Stamps, usually as curiosities. As I understand it, the officials who sell them never even bat an eye.
On a more serious note, a quick google search reinforces my recollection that any found property (including wads of cash) has to first be reported to a local government agency, generally law enforcement. If the property is considered to have played a part in illegal activity, it will be forfeited and no longer your concern; if not, there will be several weeks of notices and a waiting period to allow the rightful owner to make a claim and then the money is yours. I imagine it is then reported to the IRS just like any other windfall.
The specific laws regarding the handling of found property vary by jurisdiction.
Drat! Missed the edit window. ETA: Evidently, several states use these. Pictures
You’re not going to put “Prostitute” or “Drug Dealer” at the top of your Sch C if you want to report illegal income. You’re going to put a NAICS code for “Personal Services” or “Non-store retailer.” After that, illegal income looks just like legal income to the tax man. You haven’t even lied.
If you’re a mobster with a ton of money, you have to be a little more sophisticated, but laundromats and other cash-heavy businesses are popular. After all, if you take $100,000 in racketeering income and pretend it came from a profitable laundromat, you’re not really going to raise any eyebrows. In this case, you have lied, but it’ll take a criminal investigation to prove it.
From a real experience, I turned down a client who was probably involved in real estate scams (collusion between the seller, the real estate agent, the mortgage broker, an appraiser and a patsy buyer to get a home financed for far more than its worth; everyone gets their cut and they let the thing foreclose). Had I accepted the tax return, though, it would have been reported like any other home flip. The red flags that made me worried would not have been on the tax return itself.
Damn! There goes that $20 million I just found.
Lot of interesting posts, but until an accountant and/or an IRS employee shows up, got to wait for an answer about whether IRS notifies any law enforcement about what is reported.
I have a related question now… let’s say you rob a bank, but you pay taxes on your “income”. If you get caught next year, is the IRS (or CRA or whatever) going to give that money back to the bank?
If they don’t… can you write off your “losses” on your next tax return? (It seems only fair).
That’s similar to the recent case of Madoff. There was a question of what would happen if the government “clawed-back” money from the early investors who took out more money than they put in. They did pay capital gains tax on it, so what would happen to that part of the money?
This was just speculation though, I never saw an answer.
No, the IRS does not notify law enforcement about tax return contents.
Here’s a perfect example: illegal immigrant works under a false social security number. They file a tax return with the IRS, which says “Oops, that’s not your SSN. You need an ITIN.” They file the return again with the ITIN. The IRS sends them their refund. At no point is any branch of law enforcement notified that there are illegal workers or companies employing them. There are millions of tax returns filed like this every year. I’ve done about a dozen of them myself.
(I am a CPA, by the way).
What’s the penalty for this kind of lying (not the drug selling itself.) On one hand you’ve reported all your income, and so owe the IRS nothing, on the other you misreport its source.
There are a lot of options for how this might get prosecuted. As I tell my clients, my focus is to do it all right the first time, so I don’t worry too much about the details. But, some speculation:
You might be denied some or all of your deductions. Illegal activities are not deductible. In a more real-world example, that means you can’t deduct a speeding or parking ticket, even if you got it while on business. In a case like a mobster, I’m sure you’d have bribes to officials and pay to lackeys that would be nondeductible. The IRS might even rule that your other businesses were not actually businesses (i.e. not engaged in for profit, but only held to disguise income) which could give them grounds to deny other deductions. Taken far enough, there could be criminal penalties for this, but the IRS is almost always more interested in collecting cash than pursuing criminal proceedings.
Criminal prosecution would much more likely come from some other branch of government.
I think medical marijuana growers run into some of these issues. It’s legal to grow, provide medicine to legal patients, and be remunerated for your expenses, i.e. get paid. If you report this to the IRS I don’t believe they have an issue with it even though pot is illegal at the federal level. The question is whether they let you claim any business expense deductions, since what you’re doing is “illegal.”
If you don’t report this as income to the IRS, they look at frequent cash deposits as evidence of unreported income.