In the crime of embezzlement, there are tax implications for both the embezzler and the embezzled.
Embezzled income is taxable to the person who does the embezzling (revenue ruling 61-185, 1961-2 CB 9; revenue ruling 65-254, 1965-2 CB 50; James v. United States, 366 US 213 (1961), Ct. D. 1863). The embezzled amount should be included in the embezzler's gross income in the year of the embezzlement. In addition, the embezzler/employee may be subject to self-employment taxes on the embezzled amount.
Since the embezzlement constitutes income to the embezzler, the entity that has suffered the loss should report it to the IRS.
Proper reporting of the embezzled income to the IRS will provide the employer with documentation for deducting its loss and also meet the filing requirements of section 6721 and section 6722. It will, in addition, alert the IRS to possible unreported income by the employee.
The employer should report the embezzled income on form 1099-MISC as non-employee-compensation. The employer must prepare a form 1099-MISC for each tax year the employee embezzled funds.
Restoration of embezzled funds does not affect the reporting requirement. Income is recognized at the time the embezzler takes control of the funds ( Ernestine K. Alcorn, TC Memo 1969-751), and, is, therefore, not affected by subsequent restitution. Thus the embezzler would be required to report the restitution as a miscellaneous itemized deduction subject to the two-percent adjusted gross income exclusion in the year of the restitution.
The following example shows how embezzled income should be reported for tax purposes.
An organization's bookkeeper embezzled funds for three calendar years beginning in 1996. The company dismissed the employee in 1998 when it discovered his theft. At that time, the organization decided to prosecute, and the employee made a $5,000 payment in restitution. The amounts embezzled were $5,000 in 1996, $30,000 in 1997, and $10,000 in 1998.
The company must file 1099-MISC forms with the IRS for the tax years 1996 through 1998.
In 1998, the embezzler would have an additional $10,000 in gross income but could include the $5,000 restitution payment as a miscellaneous itemized deduction. As the $10,000 may be subject to self-employment taxes as well as income taxes, the $5,000 payment would be the only reduction of the embezzler's increased taxable income.
The embezzler would also be subject to penalties if the additional income for the 1996 and 1997 tax years was not reported. The embezzler would have to file amended returns for those two years, and the income might be subject to self-employment taxes.
The IRS offers the embezzler two options for reporting the increased income. If the embezzled funds are from self-employment activity, schedule C or schedule C-EZ should be used and the amount is subject to self-employment taxes. If not, the embezzled funds can be reported on line 21 of form 1040 and are not subject to self-employment taxes.
Observation: Taxpayers who embezzle funds over several tax periods are subject to a variety of income taxes and penalties. Companies that have been embezzled are subject to additional reporting requirements.
If the amounts embezzled cannot be absolutely determined, it is the responsibility of the embezzler to prove to the IRS that the amounts reported by his or her employer to the IRS are not correct. Such evidence could benefit an employer during legal proceedings against the embezzler.
—P. Michael McLain, CPA, DBA, associate professor of accounting, and Marc I. Lebow, CPA, PhD, associate professor of accounting, Hampton University, Hampton, Virginia.