Client is being sued for embezzelment. Should client have reported such embezzeled funds as income? If client didnt report it as income is there a tax fraud issue? Are embezzeled funds income?.......

Good question

The Internal Revenue Code Section 61 states that taxpayers must report income from all sources, even form illegal sources. So, if your client embezzled funds from his/her employer, then such funds should have been reported as income in the year of theft. Your client's exposure is that a second fraud claim, i.e. tax evasion, could be brought against your client. Even if client amends the previosuly filed returns, the crime of tax evasion may have already been committed.