Is Interest on Penalties Tax Deductible?
The deductibility of interest on a tax penalty depends on the underlying obligation. Discover why this interest often follows the non-deductible rule of the penalty itself.
Many taxpayers face penalties for issues like late filing or underpayment, and these penalties almost always come with accumulating interest. A common point of confusion is whether these additional interest charges can be claimed as a deduction on a tax return. The answer depends heavily on the nature of the underlying tax and the taxpayer’s status. This article will clarify the circumstances under which interest on penalties may or may not be deductible.
Deductibility of the Underlying Penalty
To understand the treatment of interest, one must first understand the tax treatment of the penalty itself. Internal Revenue Code Section 162 states that no deduction is allowed for any fine or similar penalty paid to a government for violating a law. This rule applies to both individuals and businesses because allowing a deduction would undermine the penalty’s purpose of deterring non-compliance.
This prohibition covers common situations, so penalties for failure-to-file or failure-to-pay are not deductible. The principle also extends beyond income taxes to other civil penalties, like traffic tickets or fines for violating local ordinances.
Because these charges are punitive, they are not considered an ordinary or necessary expense, which is a standard for most deductions. This treatment of the penalty determines how the associated interest is handled.
Deductibility of Interest on Penalties
The tax treatment of interest on a penalty directly follows the treatment of the penalty itself. For individual taxpayers, interest paid on an underpayment of personal income tax, or on a penalty related to that tax, is categorized as non-deductible personal interest. This means if an individual owes the IRS for a late payment penalty, the accrued interest cannot be claimed as a deduction on their Form 1040.
For businesses, the situation is more nuanced. Interest paid on a business’s tax deficiency, such as an underpayment of corporate income tax, is considered a deductible business expense. A distinction arises when the interest is charged on a penalty rather than the tax deficiency itself.
The interest charged on a penalty assumes the character of that penalty. Since the penalty is non-deductible, the interest that accrues on it is also non-deductible. For any business, from a sole proprietorship to a large corporation, interest on a penalty for an issue like accuracy-related mistakes cannot be deducted as a business expense. The logic is that allowing a deduction would indirectly subsidize the non-deductible penalty.
State and Local Tax Considerations
The principles for deducting penalties and interest at the federal level also extend to state and local tax matters. When a business incurs interest on an underpayment of a state or local tax, that interest is deductible on the business’s federal tax return. This applies to taxes considered ordinary and necessary business expenses, such as state-level corporate income taxes.
However, the character of the underlying payment remains the determining factor. If a state imposes a penalty for late payment of business taxes, that penalty is not deductible on the federal return. Consequently, any interest charged by the state on that non-deductible penalty is also not deductible for federal tax purposes.
For individuals, the rules are consistent with the federal framework. Interest paid on underpayments of personal state or local taxes is considered non-deductible personal interest on the federal return. This also applies to any interest charged on penalties related to those personal state taxes. This should not be confused with the state and local tax (SALT) deduction, which applies to the taxes themselves, not to penalties or interest.