The short answer is no. Penalties and interests paid to the Internal Revenue Service (IRS) are not deductible on your next tax return.
Read further to learn more about the penalties and interests in question and what expenses are actually tax-deductible.
Identifying Penalties and Interests
The Internal Revenue Code outlines the rules and corresponding penalties regarding taxation on the official IRS website. If you violate any of the laws described in the tax code, the Internal Revenue Service can slap tax penalties for your violation. This is on top of the taxes you did not pay on time. Furthermore, failure to pay penalties could result in heavier sanctions.
Some violations that come with a penalty include the following:
1. Failure to File
Failure to file means the concerned taxpayers did not make the proper tax payment before the tax filing deadline. The penalty is proportionate to the federal taxes that were not filed on time. In this scenario, the IRS will be sending a notice for Failure to File Penalty, including the tax owed and the IRS penalties imposed.
For Failure to File, the penalty is computed based on the amount of unpaid tax and the period elapsed from the deadline. This means that the longer you fail to settle your outstanding balance the greater penalty you face from the revenue service. Key details to remember include:
- The penalty starts with five percent of the unpaid taxes for every month or a partial month. It is capped at 25 percent of the unpaid taxes.
- If a taxpayer is slapped with a Failure to File notice and Failure to Pay penalty simultaneously, the penalty for Failure to Pay is deducted from the penalty for Failure to File. The IRS then computes based on their combined penalty.
- If the violation remains unsettled after five months, Failure to File maxes out and would no longer increase. On the other hand, Failure to Pay continues until the tax is settled or up to a maximum of 25 percent of the unpaid taxes.
Additionally, the IRS can also charge interest on your outstanding penalty. It varies depending on the gravity of the situation and continues to take effect until the entire balance is paid.
2. Inaccurate Filing of Taxes
There are different kinds of accuracy-related violations, each being subject to a certain penalty. For example, underpayment may occur if the taxpayer doesn’t report all income or claims tax deductions or tax credits when you’re not actually qualified.
Another form is negligence, which occurs when the IRS establishes that taxpayers fail to exercise due diligence or make a reasonable attempt to comply with existing tax laws. This may include not keeping tax records when the IRS requests for them, not including an income reported in an information return in the tax return filed, or failing to verify the accuracy of tax credits or deductions claimed.
In most cases, accuracy-related penalties start at 20 percent of the underpaid tax caused by negligence. The same applies to a case of a substantial understatement—or those who understate 10 percent of the correct tax amount. Additionally, if you can prove that you acted in good faith and can provide reasonable cause for the inaccuracy, the IRS can remove or reduce your penalties and interest. Also, if you can show that you were not able to meet your duties due to extenuating circumstances, the IRS can also extend consideration.
Otherwise, you can file for a dispute if the tax you paid and the tax required from you are different, and you believe that there must be some mistake.
3. Tax Fraud
Considered the most serious of tax code violations, tax fraud refers to conscious attempts by an individual or entity to falsify information in order to mislead or defraud the government. It generally carries higher penalties or worse, criminal charges. There is also no statute of limitations for this kind of violation. Meaning, the IRS can still come after you even years after you’ve committed tax fraud.
According to the IRC section 6663, if an underpayment of tax has been found to be from fraudulent efforts, 75 percent of the underpaid tax attributable to fraud shall determine penalties and interest. Additionally, section 7201 explains that an entity that willfully tries to defraud the government can be charged with a felony. This can lead to penalties of up to $100,000 in fines or penalties for individuals and $500,000 for corporations. Furthermore, it could land the guilty party for up to five years in prison plus the costs of prosecution involved.
Are Interests and Penalties Deductible?
The general idea is that fines, penalties, and interests stemming from the violation of any law, including those of the tax code, are not deductible. This includes the compensation following settlement agreements of a potential or actual liability for a fine or penalty—both civil and criminal cases. Aside from tax return violations, the exemption also covers parking tickets, and penalties paid to any governmental entity, such as teachers’ paychecks after a non-sanctioned strike.
For interest paid to the IRS, these are no longer deductible since the implementation of IRS Notice 746. Since 1991, interests from tax violations can no longer be itemized as a tax deduction on the Income Tax Return Filing.
The rationale behind the non-deduction of interests, fines, and penalties comes from the government’s effort to further discourage negligence and attempts to defraud the government. If these are deductible, then it somehow defeats the purpose of the federal government imposing these penalties and interests in the first place.
Removal of Interests and Penalties
The law offers taxpayers an opportunity to remove or at least reduce the fines and penalties imposed upon them. If the taxpayer believes that there is a reasonable cause behind the tax violation they are charged with, they can always lodge a formal request with the IRS.
Another scenario that warrants the removal or reduction of penalties and interests is when the IRS issues erroneous written advice. If a taxpayer writes to the IRS for advice and the resulting advice from the IRS leads to the taxpayer being penalized, then it is considered erroneous.
Also, the IRS systematically provides penalty relief for first-time violators. If the violation was committed on the first tax filing season, meaning that there was no return filed for the past three years, then a relief might be offered. The same applies to those who already filed the required returns or filed a valid extension.
