Income earned from illegal acts is nevertheless taxable income. Although a taxpayer may hesitate to report such income in fear of revealing illegal acts, yesterday’s Tax Court case of William and Sharon Norris is a perfect example demonstrating when a taxpayer obtains a more favorable result via disclosure.

In 1994, Mr. Norris purchased the “Little Barn Market,” a convenience store and gas station in Nashville, Tennessee. In the back of this little market, Mr. Norris installed and operated poker machines for patrons to gamble. That’s against the law in Tennessee. In 1996, the Nashville police learned of the machines and seized them. Norris pleaded guilty to a misdemeanor gambling offense.

I suspect Norris was earning some nice profits from the machines, because within months after the seizure he purchased and installed new machines. Yes, the police were onto him again and once again seized the machines in 1997.

The story becomes laughable at this point. After pleading guilty to a misdemeanor gambling offense for a second time in as many years, Norris yet again purchased and installed poker machines. So what happened? You guessed it, the police seized poker machines from the Little Barn Market for a third time in 1998.

In 2005, Mr. Norris was indicted on two counts of criminal tax evasion, one for 1996 and one for 1998. He pleaded guilty to the 1998 count, the Department of Justice dismissed the 1996 count, and in 2006 Norris was sentenced to 15 months in prison. Read the court’s decision to learn of the acts giving rise to the tax evasion in 1998, as I’m focusing on the 1996 tax year.

On October 22, 2008, the IRS issued a notice of deficiency to Norris and his wife for their 1996 and 1998 tax years. For the 1996 tax year, the IRS asserted that the taxpayers owed $83,907 more in tax plus interest, and $62,930 in penalties.

Remember, in general, the IRS has three years from the due date of the return or the date the return is filed, whichever is later, to make an assessment. In this case, the parties stipulated that the IRS did not timely do so. Instead, to make its assessment, the IRS needed to rely on section 6501(c)(1) of the Internal Revenue Code, which extends the statute of limitations for assessment to forever “in the case of a false or fraudulent return with the intent to evade tax.”

Because Norris didn’t plead guilty to criminal tax evasion for the 1996 tax year, the IRS had to prove fraud by clear and convincing evidence in order to extend the statute of limitations. To prove fraud under the Internal Revenue Code, the IRS must show (1) an underpayment in tax and (2) the taxpayers “intended to evade taxes known to be owing by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes.”

On his 1996 tax return, Norris reported $22,380 of “poker machine income.” He failed to report, among other items, an additional $43,120 of legal gambling income, $35,800 of which was attributable to a 1957 Corvette that he won at the Mirage Casino in a slot machine tournament. Apparently, the casino issued to Norris a Form 1099-MISC reflecting the income, but mailed it to the wrong address. It was clear the IRS established element (1). Failure to receive a 1099-MISC does not relieve a taxpayer’s obligation to report the associated income.

To evaluate whether a taxpayer exhibits fraudulent intent to evade taxes, courts have developed a list of “badges of fraud.” In this case, the court examined eleven badges of fraud. For the 1996 tax year, the court concluded the IRS failed to meet its burden of demonstrating fraud, as the taxpayer’s behavior showed four of the badges in support of fraud, five factors against, and two factors neutral.

One of the factors the court held as against a showing of fraud was “concealment of income or assets.” Although it was unclear to the court whether “poker machine income” was income attributable to Norris’ illegal poker machine business, the IRS failed to provide any evidence that Norris attempted to conceal, so the factor went against a finding of fraudulent intent. If, however, Norris did not report any “poker machine income” on his 1996 tax return, and the IRS later discovered that Norris earned such sums from his illegal poker business, the court may very well could have came out differently on this factor.

Had the court found that the factor went in favor of fraudulent intent, then there would have been five factors in support of fraud, four against, and two neutral. Such difference could have rendered a finding of fraud, resulting in an indefinite period for auditing the 1996 tax return. Instead, without the fraud, the IRS is barred from pursuing Norris for over the alleged $140,000 in tax, interest, and penalties from the 1996 tax year. All because in part, he reported his illegal income earned from the back of his convenience store.

It’s possible we’ll see this issue come up again in connection with the recent lawsuit brought against Tobey Macguire and others to recover sums gambled away by jailed Ponzi schemer Brad Ruderman in an invitation-only underground poker game. The court documents purport the games took place for three years starting sometime in 2006.

If, and I stress if, a participant failed to report gambling winnings from these games, the IRS may have an opening to examine the player’s tax returns beyond the past three years, if it’s shown the winners sought to conceal their income from these games. Of course, this is simply speculation. But, it’s a significant consideration for taxpayers to always keep in mind, as opening these years could lead to additional tax, interest, and penalties, as well as possible jail time for criminal tax fraud.

Case: Norris v. Commissioner, T.C. Memo 2011-161.