Penalties paid to the Internal Revenue Service are never deductible. The same holds true for interest paid to the IRS related to those penalties or simply because you didn't pay your taxes on time. Some other expenses related to resolving tax issues, even if the IRS finally rules against you and imposes a penalty, may be deductible under specific conditions.
IRS Publication 535
IRS Publication 535, "Business Expenses," covers many different aspects of tax deductions. Chapter 11 of that publication, "Other Expenses," deals with the deductibility of various kinds of penalties. The language of the code with respect to deductibility of IRS tax penalties is clear and unambiguous: "Penalties or fines paid to any government agency or instrumentality because of a violation of any law are not deductible." The code is similarly clear about interest paid to the IRS on those penalties: You cannot deduct it.
Expenses Related to Penalties
IRS publication 535, however, states that you may deduct legal fees and any expenses related to those fees, including travel expenses, if they are directly related to your tax problem. Travel expenses include transportation, food and lodging. Similarly, any expenses you may have that relate to an IRS prosecution or civil action against you, whether or not this eventually results in the imposition of a penalty, are generally deductible. You can also deduct court costs, such as stenographic fees and printing charges. All of these deductions, however, are subject to the IRS 2 percent rule.
The 2 Percent Rule
IRS publication 529 discusses the 2 percent rule for certain expenses, which requires that before you can deduct expenses appearing on lines 21 to 23 on your 1040 return from your taxable income, you must deduct 2 percent of your gross income from the total. Tax preparation expenses, including money spent on legal or accounting work in response to an IRS penalty, are among those expenses subject to the rule. Apply the 2 percent limit after any other deduction limit. For example, if you have business and entertainment expenses of $2,000 subject to the 80 percent limit, subtract $400 from $2,000, then add the allowable 80 percent -- in this instance, $1,600 -- to any other miscellaneous expenses. Enter the total of these on line 23, then total lines 21, 22 and 23. Subtract from this amount 2 percent of your gross income. The result is the total of allowable deductions.
Regarding a Misunderstanding
Taxpayers sometimes assume that IRS tax penalties, although not deductible in the current tax year, represent a loss that can be carried forward to future tax years. This is not true. The purpose of the penalty, as the IRS often states, is not the collection of revenue but the discouragement of illegal tax avoidance. If the IRS has assessed the appropriate penalty in one tax year -- the amount it has judged appropriate for the offense -- it would have no reason to reverse that decision by discounting the penalty in some future tax year, which is what allowing the deduction of the tax penalty would amount to. Just as IRS taxes cannot be deducted from income in some future tax year, neither can the penalties and interest on those taxes.