The US tax code does not allow taxpayers to deduct penalties assessed by the Internal Revenue Service (IRS). IRS penalties are typically assessed for violation of tax laws, such as misreporting income or claiming false deductions or tax credits. The IRS typically assesses penalties along with interest on the balance owed by a taxpayer, and this interest is not tax-deductible.

Key Takeaways

  • Taxpayers cannot deduct IRS penalties on their tax return.
  • Penalties are commonly assessed for a failure to file or pay and for dishonored checks.
  • Penalties vary according to the type of violation and may accrue until the account is fully paid or until the taxpayer enters into an approved payment plan.
  • Taxpayers can deduct legal fees and expenses associated with resolving IRS tax issues, such as an audit.

IRS Penalties

Fines and penalties a person owes to the government for violating local, state, and federal laws are never deductible. According to the IRS, the goal of its penalties are to discourage illegal activity related to federal taxes. Penalties also discourage people from neglecting their obligations to file and/or pay. The IRS typically sends a notice to a person after a tax audit and assesses both penalties and interest on underpaid amounts.

Most often, penalties are assessed for dishonored checks and when taxpayers fail to file their tax return by the required due date, pay the full amount of taxes owed by the due date, and pay the proper amount of estimated taxes. Penalties vary according to the type of violation. For example, a penalty of 5% of the tax required is assessed when the taxpayer fails to file on time, and it is charged each month that the return is late, up to five months. The IRS assesses a 0.5% penalty on taxes not paid by the tax filing due date, which is generally April 15. Although taxpayers are not allowed to deduct penalties, they may qualify for relief for extenuating circumstances. If approved by the IRS, all or a portion of the penalty may be relieved. However, interest still accrues until amounts owed are fully paid.

Failure-to-pay penalties are assessed monthly until the taxpayer's account is resolved. The IRS allows installment agreements to pay off the outstanding balance and to stop the assessment of failure-to-pay penalties.

Legal Fees Deductibility

IRS Publication 535 states that a taxpayer is eligible to deduct various legal fees and expenses associated with resolving the tax problem for which the IRS assessed penalties. Court fees can also be deducted on a tax return, subject to the 2% limit promulgated by the IRS. According to IRS Publication 529, the 2% limit states that legal fees for tax advice can be deducted if a taxpayer itemizes his deductions, but these legal fees fall under the 2% limitation on miscellaneous itemized deductions.

Other Penalties

While IRS penalties cannot be deducted, other penalties related to business activities can be deducted by companies on a tax return. For instance, penalties paid by a manufacturing company due to nonperformance on a construction contract are typically deductible as a business expense.