Are Tax Penalties and Interest Deductible? | What Counts

Tax penalties are usually not deductible, and tax interest is deductible only in limited cases tied to business or investment activity.

If you’ve ever opened a tax notice and seen “tax,” “penalty,” and “interest” stacked together, you’ve probably wondered if any of it lowers your taxable income. The answer depends on what the charge is and what return it relates to. Most of the time, penalties don’t help you at tax time. Interest can, yet only in narrow lanes.

How penalties and interest differ on a tax bill

Penalties and interest are calculated for different reasons, even when they appear on the same notice.

• Penalty: a charge for breaking a filing or payment rule, like filing late, paying late, or underpaying estimated tax.
• Interest: a charge for paying after the due date, calculated over time until the balance is paid.

That split is your first sorting step. If the notice calls it a penalty, treat it as non-deductible until you can point to a primary source that says otherwise. If it calls it interest, you still have to ask what kind of interest it is.

When tax penalties are not deductible

For most filers, IRS penalties don’t belong on a deductions list. Late filing penalties, late payment penalties, accuracy-related penalties, and estimated tax penalties are generally treated as non-deductible costs.

Business owners run into this too. A tax penalty doesn’t turn into a business write-off just because it was triggered by business activity. Penalties are meant to discourage rule-breaking. A deduction would weaken that effect.

Penalty labels you’ll see most often

• Failure-to-file penalty
• Failure-to-pay penalty
• Estimated tax underpayment penalty
• Accuracy-related penalty
• Payroll deposit penalty

If you’re posting these in bookkeeping software, keep penalties in their own account so they don’t get mixed into interest expense by accident.

Why estimated tax charges confuse people

Estimated tax is a common source of confusion because the IRS can charge a penalty even when you pay what you owe by the filing deadline. The reason is timing. The IRS expects tax to be paid through the year, not as one big payment in April.

The estimated tax underpayment amount is usually called a penalty, not interest. It’s computed using a rate that can look like interest, so it feels like interest. Still, its label matters for deductibility and for bookkeeping. Treat it as a penalty unless your notice clearly labels a separate interest charge.

If you’re trying to reduce these charges going forward, two habits pay off:

• Check withholding and estimated payments mid-year, then adjust while you still have time.
• If income jumps late in the year, raise the next estimated payment instead of waiting for the return to be filed.

Those steps don’t change deductibility, yet they can cut down the charges that show up on a notice in the first place.

Are Tax Penalties and Interest Deductible? for business and self-employed returns

The penalty piece stays “no” in most situations. The interest piece can be “maybe,” because interest is handled under the interest deduction rules. The big question becomes: is the interest personal, business, or investment?

Why personal tax interest is usually a dead end

The tax code blocks deductions for “personal interest” for taxpayers other than corporations, with a few carved-out categories that don’t fit IRS bill interest. 26 U.S.C. § 163 (Interest) is the starting point for that rule.

That’s why interest on a balance due from your Form 1040 is commonly treated as non-deductible. The fact that the IRS charges it doesn’t change its character.

Why some tax charges are blocked even before interest rules

Another set of limits comes from rules that deny deductions for certain taxes and related items. 26 U.S.C. § 275 (Certain taxes) is part of the legal backbone that prevents federal income tax from being deducted on a federal return, and it can matter when people try to treat tax charges like regular expenses.

Situations where tax interest may be deductible

Interest can be deductible when it’s tied to income you report as business or investment activity and it isn’t blocked by a separate rule. A clean way to test this is to match the interest to the return or schedule that produced the bill.

Interest tied to a trade or business

If the underlying tax relates to business operations, the interest may be treated as a business interest expense. A common real-life case is interest on late-paid payroll taxes for a business with employees.

Even then, business interest can be limited by other rules. Large businesses can face restrictions, and certain costs have to be capitalized in special cases. Still, this is one of the clearer lanes where tax interest can fall on the deductible side.

Interest tied to investment activity

Investment interest is its own category. It usually refers to interest on money borrowed to buy taxable investments. It can be deductible with limits, often tied to net investment income. People confuse it with IRS underpayment interest because both use the same word.

So when you see “interest” on a notice, slow down and confirm it’s tax bill interest. Don’t post it as investment interest unless you can trace it to an investment loan.

The table below helps you classify common charges quickly. Use it as a labeling aid, not as a substitute for your own facts.

Charge you paid	Deductible?	Common treatment
Failure-to-file penalty on Form 1040 balance due	No	Non-deductible personal cost
Failure-to-pay penalty on Form 1040 balance due	No	Non-deductible personal cost
Accuracy-related penalty (individual or business)	No	Non-deductible penalty
Estimated tax underpayment penalty (individual)	No	Non-deductible personal cost
IRS underpayment interest tied to personal income tax	Usually no	Often treated as personal interest
Interest on late-paid payroll taxes for a trade or business	Often yes	Business interest expense, subject to limits
Interest on business income tax underpayment (corporation)	Often yes	Business interest expense, subject to limits
Interest on an investment loan used to buy taxable securities	Sometimes	Investment interest expense, limited by rules
Payroll deposit penalty	No	Non-deductible penalty

How to read an IRS notice so you don’t mis-label a payment

Most IRS notices list a total due and a breakdown. Your job is to separate three buckets: tax, penalties, and interest. Then you match the interest to the return type that created it.

1. Circle the exact words “penalty” and “interest” on the notice and total them separately.
2. Write down the tax period and the form number, like 1040, 1120, or 941.
3. Match your payment record to the date. Interest keeps accruing until the payment posts.
4. Post three entries in your books if you keep books: tax, penalties, interest.

For the IRS’s own explanation of how notice interest works and how rates are set, see IRS Notice 746. It matches the terminology used on many letters.

Deduction traps that cause avoidable headaches

Blending penalties into interest expense

One sloppy account can create a bad deduction. If your books show one combined “IRS charges” line, you can end up deducting penalties without noticing. Split the accounts and the issue goes away.

Assuming “self-employed” means “business interest”

Self-employed people pay taxes through a personal return, so a tax bill can feel business-related. Still, interest tied to your personal income tax balance is commonly treated as personal interest for an individual. A payroll tax bill tied to a business return is a different matter.

Trying to deduct federal income tax itself

Federal income tax paid is not a deduction on a federal return. If you’re tempted to treat it as a cost of earning income, stop and re-check the rule before you file. Section 275 is one place the tax code draws that line.

Recordkeeping that makes the call defendable

If you claim a deduction for tax-related interest, you want a file that tells a simple story. The table below is a practical checklist.

Document	What to keep	What it proves
IRS or state notice	Tax period, interest amount, penalty amount	Separates interest from penalties
Payment proof	Bank confirmation, check image, EFTPS receipt	Shows payment timing for interest
Ledger detail	Separate accounts for tax, interest, penalties	Prevents blended entries
Return copy	Form type and schedule used	Links the bill to the activity
Short allocation note	Why the interest ties to business or investment	Explains your filing position

Where to check the latest IRS wording

The IRS changed how it packages some business expense guidance after ending Publication 535 with its 2022 revision. If you’re searching for the IRS’s current pointers by topic, IRS Guide to business expense resources is a solid place to start.

What to do next

If you’re filing your own return, treat penalties as non-deductible, then decide whether any interest you paid fits a business or investment category. If your situation involves multiple entity types, multiple notices, or a large interest amount, a credentialed tax pro can help you apply these rules to your facts.