Does income from illegal activity need to be reported?
Yes. Failure to report income is what eventually landed Al Capone in jail.
IRS Publication 17 states: Income from illegal activities, such as money from dealing illegal drugs, must be included in your income on Form 1040, line 21, or on Schedule C or Schedule C-EZ (Form 1040) if from your self-employment activity.
Illegal activites include but are not limited to bribery and kickbacks, embezzlement, extortion, fraud (including tax fraud), selling illegal drugs or other restricted/banned items (antiquities, ivory, wildlife, moonshine, etc.), prostitution, smuggling, burglary, robbery, and theft.
IRS Publication 17 also states: If you steal property, you must report its fair market value in your income in the year you steal it unless in the same year, you return it to its rightful owner.
On the flip side, expenses incurred while engaging in illegal money-making activities usually cannot be deducted.