Ok, so I know someone who is working from home doing something that isn't exactly legal in their state. Nothing crazy, but you aren't allowed to sell food products out of your home in this state, and this person is selling cakes and cupcakes.

My question is related to taxes. We were talking and they expect to make 2-3k this first year (it's a stay at home mom doing it very part-time). I wouldn't be so much worried about getting caught by the health department, but I would be deathly afraid to be caught not reporting the income to the IRS. What would you do in this situation? Do you report the income? If so, how do you do it?

It would need to be reported on schedule C, since it would be self employed income.

Yes, schedule C.

Obviously the person SHOULD pay taxes on the money. Lots of people with incomes that small don't (I know a few).

Could paying taxes on the income raise a red flag somehow with the health department?

I doubt the health department is reviewing everyone's tax returns to see if anyone is reporting income from selling food without a license.

Though your "friend" should be very concerned about potential liability. Insurance isn't going to cover anything resulting from illegal activities.

Your friend should report the income, on a schedule C as has been mentioned. She can deduct all her costs as well.

Generally speaking, you do have to report income from illegal activities. And up until a few years ago your tax return could not be used as evidence against you for prosecution of that other illegal activity. But I think the Patriot Act might have changed that. I actually was a friend of a friend of a guy who was selling pot to support an extravagant lifestyle. He dutifully reported his business activity to the IRS. When he got caught he was prosecuted for the drug dealing, and got probation for a few years. The state also reported him to the IRS because of the activity and the cash he had in his house. He was audited but nothing came of it because he had been honest. This guy was actually a very smart engineer who knew that the punishment for the drug dealing would not be too bad but tax evasion could get him in serious trouble!

I had another friend who was doing something very similar - she was making and selling muffins. All she had to do to be legal was to pay for use of a commercial kitchen for a couple of hours a week and get herself a health certificate which took about a 2 hour class. The commercial kitchen did not cost that much either. There are places you can rent in most places.

Seems like your friend should look into making her business legal. If she is making $3000 a year selling cupcakes she could probably easily double or triple that just by coming out in the open and doing a little marketing.

Thanks everyone for the replies. Sounds like it is unanimous.

Doinghomework: That is actually the goal. I believe there is a cottage food law that may get passed that would make it legal in this state to sell food from a home kitchen. I will also mention the possibility of renting a commercial kitchen.