Is Interest on IRS Penalties Tax Deductible?

Interest on IRS penalties is not tax deductible for individual taxpayers. Federal law treats it as personal interest and disallows the deduction entirely, no matter whether the underlying tax came from wages, self-employment, or investments. C corporations are the significant exception: they can generally deduct interest on their own federal tax deficiencies because the personal interest rule does not reach corporations.¹

Why Individuals Can’t Deduct It

The statute that closes the door is IRC Section 163(h). For any taxpayer other than a corporation, it disallows the deduction of personal interest, and it defines personal interest as everything that doesn’t fall into a short list of carve-outs: trade or business debt, investment interest, passive activity interest, qualified mortgage interest, certain estate tax interest, and student loan interest.¹

Interest the IRS charges on a penalty fits none of those categories. It isn’t a business loan, a mortgage, or an investment cost. It’s a charge for money you owed the government and didn’t pay on time, so it defaults to personal interest. You cannot claim it on Schedule A, offset it against business income on Schedule C, or deduct it anywhere else on Form 1040.

This is the point that trips people up: the classification follows the taxpayer, not where the income came from. A freelancer who underpaid estimated taxes on Schedule C business income has the same non-deductible interest as someone who simply forgot to file. The character of the underlying income does not convert the interest into a business expense.

The C Corporation Exception

Section 163(h) applies to “a taxpayer other than a corporation.” That single phrase creates an entirely different outcome for C corporations. Because the personal interest disallowance does not reach them, interest on a federal income tax deficiency stays deductible under the general rule that allows interest deductions.¹

A C corporation that owes interest on underpaid federal income tax can treat that interest as a deductible expense on Form 1120, reducing taxable income dollar for dollar. The penalty itself remains non-deductible under Section 162(f), but the interest component is treated as an ordinary cost of doing business.²

The result is a real structural difference. The same dollar of interest that is a dead cost to an individual becomes a tax-reducing expense inside a C corporation.

What About S Corporations and Partnerships

Pass-through entities do not pay federal income tax at the entity level. Income flows through to the owners’ individual returns on Schedule K-1, and any federal income tax liability lands on those owners personally. Interest on a federal income tax deficiency tied to that pass-through income becomes personal interest once it hits the owner’s Form 1040, and Section 163(h) disallows the deduction.¹

There’s one narrow situation where the entity itself is on the hook: taxes imposed directly on the entity rather than on its owners. Some states impose entity-level franchise or income taxes on S corporations, and the federal government imposes excise taxes on certain business activities. Interest on those entity-level obligations may be deductible as a business expense at the entity level. The controlling question is who the tax was imposed on.

When Interest Tied to a Tax Can Be Deducted

Section 163(h) is aimed at interest connected to income tax. Interest tied to some other federal tax categories sits in a different bucket.

Estate Tax

Section 163(h) explicitly excludes interest on unpaid estate tax during an approved extension under Section 6163 from the definition of personal interest, so that interest can be deducted.¹ More broadly, interest accrued on estate tax obligations can be deductible as an administrative expense of the estate on Form 706, since settling the estate’s tax affairs is a legitimate cost of administration.³

Federal Excise Tax

Interest a business incurs on a federal excise tax penalty is deductible as an ordinary business expense. Excise taxes are imposed on specific activities and products rather than on income, so the personal interest disallowance does not apply. The interest is a cost of the business that produced the excise tax liability.

The Better Move: Ask for Penalty Abatement

Since the deduction is unavailable, the practical way to shrink an IRS interest bill is to get some of the underlying penalty removed. The IRS will automatically reduce or remove related interest whenever a penalty is abated.⁴ Less penalty means less interest accruing on it, so a successful abatement saves you twice.

Two main routes are available:

First-time abatement. If you have a clean compliance history for the three prior tax years — filed on time, paid on time, no penalties — you can request a one-time waiver of failure-to-file or failure-to-pay penalties. It’s administrative relief that doesn’t require proving hardship, just a clean record.
Reasonable cause. If you can show you exercised ordinary care and prudence but still couldn’t comply because of a natural disaster, serious illness, reliance on a competent tax advisor who gave bad guidance, or similar circumstances, the IRS may waive penalties on that basis.

You can request relief by calling the number on your IRS notice. Some abatements are approved on the phone. If the representative can’t approve it during the call, you can submit a written request using Form 843, Claim for Refund and Request for Abatement.⁴

Paying the balance down quickly matters too. IRS interest compounds daily on any unpaid amount, and entering an installment agreement does not stop it from accruing.⁵⁶ A payment plan spreads the pain, but the total cost keeps climbing until you pay in full.

What Happens If You Deduct It Anyway

Some taxpayers try to slip this interest onto a business return, particularly when the underlying income came from self-employment. It doesn’t work, and the IRS can impose an accuracy-related penalty of 20% on any resulting underpayment when the deduction is disallowed. The penalty applies when a taxpayer claims deductions for which they don’t qualify, and the IRS treats this as negligence.⁷

For individuals, that penalty kicks in when the understatement exceeds the greater of 10% of the tax that should have been reported or $5,000. If you also claim the qualified business income deduction under Section 199A, the threshold drops to 5%.⁸ Claiming the deduction improperly doesn’t just fail to save money. It builds a new penalty on top of the one you already owe.

1
Office of the Law Revision Counsel. 26 USC 163 – Interest
2
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
3
GovInfo. 26 CFR 20.2053-6 – Deduction for Taxes
4
Internal Revenue Service. Penalty Relief
5
Internal Revenue Service. Interest
6
Internal Revenue Service. Payment Plans; Installment Agreements
7
Internal Revenue Service. Accuracy-Related Penalty
8
Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments