Do I need to report earnings from illegal activities or just list as self-employment income?

The IRS is primarily concerned with collecting taxes, not enforcing other laws. That said, there's important context here. Legally speaking, all income is taxable regardless of source - this has been established through Supreme Court cases like James v. United States. The IRS created the "illegal activities" category to comply with these rulings and ensure they can collect taxes on all income. While the IRS generally doesn't actively report tax information to law enforcement due to taxpayer confidentiality laws, this protection isn't absolute. If there's an active criminal investigation and proper legal channels are followed, your tax information can be accessed. The bigger risk is explaining unexplained wealth. If you're audited and claim self-employment income but can't document a legitimate business generating that revenue, that itself creates problems. Inconsistencies between reported income and lifestyle/assets often trigger audits.

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Something nobody's mentioned yet - there's actually a line on Schedule C (line I) where you're supposed to indicate the principal business code. If you're reporting income from illegal activities as self-employment, you'd technically be lying about the business code too. Dishonesty on tax forms can be considered fraud even if you're paying the right amount of tax. It's not just about paying the correct amount, but also truthfully reporting the source.

I actually know someone who got caught for tax evasion on illegal income. The issue wasn't just not reporting it, but the lifestyle mismatch. They had a minimum wage job but drove an expensive car and bought a house. IRS flagged it, started investigating, and that led to the criminal charges for the original illegal activity. So yeah, damned if you do (admit to illegal activity) and damned if you don't (get caught for tax evasion AND the original crime).

This is a fascinating legal paradox that highlights the complexity of tax law. The Fifth Amendment protects against self-incrimination, but the Supreme Court ruled in United States v. Sullivan (1927) that this doesn't exempt illegal income from taxation. The practical reality is that the IRS operates under strict confidentiality rules (IRC Section 6103), so they generally can't share your tax information with law enforcement without proper legal process. However, unexplained wealth discrepancies are what typically trigger investigations in the first place. If someone hypothetically had $135k in unreported income, the bigger risk isn't necessarily how you categorize it, but whether your reported lifestyle matches your claimed income sources. The IRS has become very sophisticated at detecting these mismatches through data analytics. The "illegal activities" checkbox exists primarily for legal compliance with Supreme Court rulings, not as a trap. But you're right that it creates an impossible situation - report honestly and potentially incriminate yourself, or misrepresent and risk fraud charges if discovered later. For anyone in genuinely complex income reporting situations, consulting a tax attorney who can provide privileged advice is usually the safest approach.