Business Tax Preparation · Business expenses, deductions and credits

Taxes, assessments and penalties

Verification 2026 Verified
tax year · reviewed 2026-08-21 · Draft for I. Ohu review

Three provisions decide whether a tax or a penalty is deductible, and they operate in a fixed order. IRC § 164 allows; IRC § 275 forbids; IRC § 162(f) disallows what is paid to a government over a violation of law. A business question is usually testing which of the three applies.

The rule

Taxes allowed by name. state and local and foreign real property taxes, state and local personal property taxes, state and local and foreign income, war profits and excess profits taxes, and the generation-skipping transfer tax imposed on income distributions^TY2026 (IRC § 164(a)(1)–(4)). And beyond the list, in addition, state and local and foreign taxes not on that list are deductible if paid or accrued within the taxable year in carrying on a trade or business or an IRC § 212 activity^TY2026 (IRC § 164(a), flush text) — a catch-all confined to business and income-producing activity.

But not where the tax buys something. a tax outside the four listed categories that is paid or accrued in connection with an acquisition of property is treated as part of the cost of the property, and one paid on a disposition reduces the amount realised^TY2026 (IRC § 164(a), closing sentence).

The cap that does not reach a business. the cap does not apply to foreign income, war profits and excess profits taxes, nor to real property or personal property taxes paid or accrued in carrying on a trade or business or an IRC § 212 activity^TY2026 (IRC § 164(b)(6), flush text). For an individual’s own taxes the cap is $40,400 for taxable years beginning in calendar year 2026 (half that on a married filing separate return), rising 1 percent a year through 2029 and reverting to $10,000 for years beginning after 2029^TY2026 (IRC § 164(b)(6)(B), (b)(7)), and note the heading of IRC § 164(b)(6) still reads "for taxable years 2018 through 2025" although Pub. L. 119-21 § 70120(a)(1) struck the words "and before January 1, 2026" from the operative text, and § 70120(a)(2) replaced the fixed figure with the applicable limitation amount defined in the new IRC § 164(b)(7)^TY2026.

Taxes never deductible. federal income taxes including the employee share of FICA and tax withheld at source on wages, federal war profits and excess profits taxes, estate, inheritance, legacy, succession and gift taxes, foreign income taxes where the taxpayer takes the IRC § 901 credit, and real property taxes treated by IRC § 164(d) as imposed on another taxpayer^TY2026 (IRC § 275(a)).

Penalties. no deduction is allowed for any amount paid, whether by suit, agreement or otherwise, to or at the direction of a government or governmental entity in relation to the violation of any law or the investigation of a potential violation^TY2026 (IRC § 162(f)(1)), subject to the disallowance does not reach an amount the taxpayer establishes is restitution, including remediation of property, or is paid to come into compliance with the law violated — but only where the court order or settlement agreement identifies it as such, and identification alone is not enough^TY2026 (IRC § 162(f)(2)(A)) — but the restitution exception never reaches an amount paid as reimbursement to the government for the costs of an investigation or litigation^TY2026 (IRC § 162(f)(2)(B)) — and the disallowance does not apply to an amount paid by reason of an order of a court in a suit in which no government or governmental entity is a party^TY2026 (IRC § 162(f)(3)).

Current figures

Item	Rule	Authority
Taxes allowed by name	state and local and foreign real property taxes, state and local personal property taxes, state and local and foreign income, war profits and excess profits taxes, and the generation-skipping transfer tax imposed on income distributions^TY2026	IRC § 164(a)(1)–(4)
Business catch-all	in addition, state and local and foreign taxes not on that list are deductible if paid or accrued within the taxable year in carrying on a trade or business or an IRC § 212 activity^TY2026	IRC § 164(a), flush text
Taxes on an acquisition	a tax outside the four listed categories that is paid or accrued in connection with an acquisition of property is treated as part of the cost of the property, and one paid on a disposition reduces the amount realised^TY2026	IRC § 164(a)
Business exception to the cap	the cap does not apply to foreign income, war profits and excess profits taxes, nor to real property or personal property taxes paid or accrued in carrying on a trade or business or an IRC § 212 activity^TY2026	IRC § 164(b)(6)
The individual cap, 2026	$40,400 for taxable years beginning in calendar year 2026 (half that on a married filing separate return), rising 1 percent a year through 2029 and reverting to $10,000 for years beginning after 2029^TY2026	IRC § 164(b)(6)(B), (b)(7)
Where the phase-down starts	$505,000 of modified adjusted gross income for 2026 (half that on a married filing separate return), above which the cap falls by 30 cents on the dollar but never below $10,000^TY2026	IRC § 164(b)(7)
A stale heading	the heading of IRC § 164(b)(6) still reads "for taxable years 2018 through 2025" although Pub. L. 119-21 § 70120(a)(1) struck the words "and before January 1, 2026" from the operative text, and § 70120(a)(2) replaced the fixed figure with the applicable limitation amount defined in the new IRC § 164(b)(7)^TY2026	IRC § 164(b)(6)
Never deductible	federal income taxes including the employee share of FICA and tax withheld at source on wages, federal war profits and excess profits taxes, estate, inheritance, legacy, succession and gift taxes, foreign income taxes where the taxpayer takes the IRC § 901 credit, and real property taxes treated by IRC § 164(d) as imposed on another taxpayer^TY2026	IRC § 275(a)
Government penalties	no deduction is allowed for any amount paid, whether by suit, agreement or otherwise, to or at the direction of a government or governmental entity in relation to the violation of any law or the investigation of a potential violation^TY2026	IRC § 162(f)(1)
Restitution and compliance	the disallowance does not reach an amount the taxpayer establishes is restitution, including remediation of property, or is paid to come into compliance with the law violated — but only where the court order or settlement agreement identifies it as such, and identification alone is not enough^TY2026	IRC § 162(f)(2)(A)
Investigation costs	the restitution exception never reaches an amount paid as reimbursement to the government for the costs of an investigation or litigation^TY2026	IRC § 162(f)(2)(B)
Private litigation	the disallowance does not apply to an amount paid by reason of an order of a court in a suit in which no government or governmental entity is a party^TY2026	IRC § 162(f)(3)

How it works in practice

The business catch-all does most of the work. in addition, state and local and foreign taxes not on that list are deductible if paid or accrued within the taxable year in carrying on a trade or business or an IRC § 212 activity^TY2026 (IRC § 164(a), flush text). Sales tax on business purchases, excise taxes, licence and franchise taxes, gross receipts taxes and local business taxes are not on the list of four, and they are deductible because of this sentence. Note its two conditions: the tax must be state, local or foreign, and it must be paid in carrying on a trade or business or an IRC § 212 activity.

But a tax that goes into an asset is capitalised, not deducted. a tax outside the four listed categories that is paid or accrued in connection with an acquisition of property is treated as part of the cost of the property, and one paid on a disposition reduces the amount realised^TY2026 (IRC § 164(a), closing sentence). Sales tax on a machine is part of the machine’s cost and is recovered through depreciation; sales tax on stationery is deducted. The same tax, at the same rate, in two places. And where IRC § 263A applies, a tax allocable to property produced or acquired for resale is capitalised into inventory under IRC § 263A(a)(2)(B), which expressly names taxes among the indirect costs.

The state and local tax cap is an individual provision and says so. the cap does not apply to foreign income, war profits and excess profits taxes, nor to real property or personal property taxes paid or accrued in carrying on a trade or business or an IRC § 212 activity^TY2026 (IRC § 164(b)(6), flush text). The flush sentence takes out foreign income taxes and any real or personal property tax paid in carrying on a trade or business or an IRC § 212 activity. So the cap that limits an individual’s deduction for the property tax on their home does not touch the property tax on their factory.

Where a business is a pass-through, the cap can still bite in the middle. The exception is for taxes paid in carrying on a trade or business, so a partnership’s or S corporation’s state income tax measured on the entity is a different question from a partner’s own state income tax on their distributive share. Many states now impose an elective entity-level tax precisely so that the liability is the entity’s and the exception applies to it.

IRC § 275 is a flat prohibition and needs no analysis. federal income taxes including the employee share of FICA and tax withheld at source on wages, federal war profits and excess profits taxes, estate, inheritance, legacy, succession and gift taxes, foreign income taxes where the taxpayer takes the IRC § 901 credit, and real property taxes treated by IRC § 164(d) as imposed on another taxpayer^TY2026 (IRC § 275(a)). Federal income tax is the obvious one; the employee’s share of FICA and the tax withheld from wages are the two most often missed, because a business writes a single cheque covering both its own deductible employer share and the employee’s non-deductible share. Only the employer’s share is deductible, and it is deductible under IRC § 164(a)‘s flush text rather than under any of the four listed categories.

A penalty paid to a government is disallowed, and the exception is procedural. no deduction is allowed for any amount paid, whether by suit, agreement or otherwise, to or at the direction of a government or governmental entity in relation to the violation of any law or the investigation of a potential violation^TY2026 (IRC § 162(f)(1)) is written broadly: “whether by suit, agreement, or otherwise,” and it reaches amounts paid over an investigation as well as a proven violation. the disallowance does not reach an amount the taxpayer establishes is restitution, including remediation of property, or is paid to come into compliance with the law violated — but only where the court order or settlement agreement identifies it as such, and identification alone is not enough^TY2026 (IRC § 162(f)(2)(A)) is the way out, and it has three conditions, of which the second is a drafting requirement — the court order or settlement agreement must identify the amount as restitution or as a compliance payment. The statute then adds that identification alone is not sufficient, so the taxpayer must satisfy both the substance and the form.

Two things the exception never reaches. the restitution exception never reaches an amount paid as reimbursement to the government for the costs of an investigation or litigation^TY2026 (IRC § 162(f)(2)(B)), and — the other way round — the disallowance does not apply to an amount paid by reason of an order of a court in a suit in which no government or governmental entity is a party^TY2026 (IRC § 162(f)(3)) means a payment under a court order in purely private litigation is outside IRC § 162(f)(1) altogether and needs no exception.

One sales tax, three answers

A retailer in a state with sales tax makes three purchases in the same month: $900 of shop stationery, a $40,000 delivery van, and $60,000 of goods for resale. Sales tax at the local rate is charged on each.

The tax on the stationery is deducted as a business expense. in addition, state and local and foreign taxes not on that list are deductible if paid or accrued within the taxable year in carrying on a trade or business or an IRC § 212 activity^TY2026 (IRC § 164(a), flush text) — a state or local tax not on the list of four, paid in carrying on a trade or business.

The tax on the van is not deducted. a tax outside the four listed categories that is paid or accrued in connection with an acquisition of property is treated as part of the cost of the property, and one paid on a disposition reduces the amount realised^TY2026 (IRC § 164(a), closing sentence) makes it part of the cost of the van, recovered through depreciation over the van’s recovery period.

The tax on the goods for resale is capitalised into inventory. IRC § 263A(a)(2)(B) names taxes among the indirect costs allocable to property acquired for resale, so it enters cost of goods sold when the goods are sold — unless the retailer meets the IRC § 448(c) gross receipts test and is exempt from IRC § 263A under IRC § 263A(i), in which case it follows its own inventory method.

Same tax, same rate, same month, three different timings.

The settlement with three components

A manufacturer settles an environmental enforcement action with a state agency for $4,000,000. The settlement agreement, as signed, describes the whole sum as “a civil penalty in resolution of the matter.”

None of it is deductible. no deduction is allowed for any amount paid, whether by suit, agreement or otherwise, to or at the direction of a government or governmental entity in relation to the violation of any law or the investigation of a potential violation^TY2026 (IRC § 162(f)(1)) — it is paid to a governmental entity in relation to the violation of a law.

Now suppose the agreement had instead identified $1,200,000 as a civil penalty, $2,300,000 as restitution for remediating the contaminated site, and $500,000 as reimbursement of the agency’s investigation costs.

The $1,200,000 remains disallowed. The $2,300,000 may be deductible, because the disallowance does not reach an amount the taxpayer establishes is restitution, including remediation of property, or is paid to come into compliance with the law violated — but only where the court order or settlement agreement identifies it as such, and identification alone is not enough^TY2026 (IRC § 162(f)(2)(A)) — the agreement identifies it as restitution, and the company can establish that it is remediation of property damaged by the violation. Both conditions must hold: the statute says identification alone is not sufficient. The $500,000 is disallowed whatever the agreement says, because the restitution exception never reaches an amount paid as reimbursement to the government for the costs of an investigation or litigation^TY2026 (IRC § 162(f)(2)(B)).

The difference between the two versions is $2,300,000, and it turns entirely on how the agreement was drafted at the time it was signed. There is no way to allocate it afterwards.

The payroll cheque with two halves

An employer remits $186,000 to the Treasury for a quarter. Of that, $62,000 is federal income tax withheld from employees’ wages, $62,000 is the employees’ share of FICA withheld, and $62,000 is the employer’s own share of FICA.

The employer deducts $62,000 — its own share. That is a tax paid in carrying on a trade or business within in addition, state and local and foreign taxes not on that list are deductible if paid or accrued within the taxable year in carrying on a trade or business or an IRC § 212 activity^TY2026, though not one of the four categories in IRC § 164(a)(1) to (4).

The other $124,000 is not the employer’s tax at all. It is the employees’ money, withheld and remitted on their behalf, and federal income taxes including the employee share of FICA and tax withheld at source on wages, federal war profits and excess profits taxes, estate, inheritance, legacy, succession and gift taxes, foreign income taxes where the taxpayer takes the IRC § 901 credit, and real property taxes treated by IRC § 164(d) as imposed on another taxpayer^TY2026 (IRC § 275(a)(1)(A) and (C)) names both the employee FICA tax and tax withheld at source expressly.

The employer does of course deduct the gross wages of $500,000 out of which the $124,000 was withheld, so nothing is lost. But the deduction is a wages deduction under IRC § 162(a)(1), not a taxes deduction, and a question that asks for “deductible taxes” is testing exactly this separation.

Traps.

A tax on an acquisition is capitalised. {fig:tax.acquisition_capitalized} (IRC § 164(a)). Sales tax on a capital asset is part of its cost, not a deduction.

The state and local tax cap does not reach business taxes. {fig:tax.salt_business_exception} (IRC § 164(b)(6), flush text). Nor does it reach foreign income taxes.

Only the employer's share of employment tax is deductible. {fig:tax.never_deductible} (IRC § 275(a)(1)). The withheld employee share is the employee's tax and is covered by the wages deduction instead.

A foreign income tax is deductible or creditable, not both. IRC § 275(a)(4) denies the deduction where the taxpayer chooses the IRC § 901 credit "to any extent."

IRC § 162(f)(1) reaches investigations, not only violations. The words are "the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law."

The restitution exception has a drafting condition. {fig:tax.restitution_exception} (IRC § 162(f)(2)(A)) requires identification in the order or agreement, and adds that identification alone is not sufficient. Both limbs are needed and neither can be supplied after the event.

How this has changed

The state and local tax cap became permanent in 2025, and the heading of the paragraph has not caught up. the heading of IRC § 164(b)(6) still reads "for taxable years 2018 through 2025" although Pub. L. 119-21 § 70120(a)(1) struck the words "and before January 1, 2026" from the operative text, and § 70120(a)(2) replaced the fixed figure with the applicable limitation amount defined in the new IRC § 164(b)(7)^TY2026. IRC § 164(b)(6) is headed “Limitation on individual deductions for taxable years 2018 through 2025,” but Pub. L. 119-21 § 70120(a)(1) struck the words “and before January 1, 2026” from the operative text, so the limitation no longer expires. In the same section, § 70120(a)(2) replaced the fixed dollar figure in IRC § 164(b)(6)(B) with “the applicable limitation amount,” and § 70120(b) added a new IRC § 164(b)(7) defining that amount and providing for it to be reduced for higher-income taxpayers.

This is the same pattern the loss limitations topic records for the excess business loss rule: the rendered text carries an artefact of the pre-amendment version while the operative words have changed. Here it is the heading rather than the body, and the LII page marks it with a footnote. The body governs; the heading is not law.

For 2026 the figures on the individual side are $40,400 for taxable years beginning in calendar year 2026 (half that on a married filing separate return), rising 1 percent a year through 2029 and reverting to $10,000 for years beginning after 2029^TY2026, with the reduction beginning at $505,000 of modified adjusted gross income for 2026 (half that on a married filing separate return), above which the cap falls by 30 cents on the dollar but never below $10,000^TY2026. Neither reaches a business, for the reason in the cap does not apply to foreign income, war profits and excess profits taxes, nor to real property or personal property taxes paid or accrued in carrying on a trade or business or an IRC § 212 activity^TY2026.

IRC § 162(f) was rewritten in 2017 and the exception is now conditional on drafting. Pub. L. 115-97 § 13306(a) replaced a provision that had simply disallowed “any fine or similar penalty paid to a government for the violation of any law” with the present structure: a wider disallowance reaching investigations and inquiries, and a restitution exception that requires identification in the court order or settlement agreement. The practical effect is that the tax treatment of a settlement is now fixed when the agreement is signed, and material written before 2018 describes a regime in which it could be argued afterwards.

Exam focus

Ask first which of the three provisions is in play. IRC § 164 allows, IRC § 275 forbids outright, and IRC § 162(f) disallows what is paid to a government over a violation. Almost every question is testing the boundary between two of them.

For a tax, ask what it was paid on. A tax on an acquisition is capitalised; a tax on operations is deducted; a tax allocable to inventory is capitalised into it.

Know that the state and local tax cap is an individual provision with an express business exception, and be ready to reject an answer that applies it to a business.

For a penalty, know that the disallowance is broad and the exception is narrow and procedural, and that reimbursement of investigation costs is never deductible.

Check yourself

1. A business pays $2,400 of sales tax on office supplies and $9,000 of sales tax on a new machine. What may it deduct this year?

Answer: $2,400. in addition, state and local and foreign taxes not on that list are deductible if paid or accrued within the taxable year in carrying on a trade or business or an IRC § 212 activity^TY2026 allows the tax on the supplies as a business expense. a tax outside the four listed categories that is paid or accrued in connection with an acquisition of property is treated as part of the cost of the property, and one paid on a disposition reduces the amount realised^TY2026 (IRC § 164(a)) makes the $9,000 part of the machine’s cost, and it is recovered through depreciation.

2. A sole proprietor pays $14,000 of property tax on her home and $31,000 on her warehouse. How much is subject to the state and local tax cap?

Answer: Only the $14,000 on the home. the cap does not apply to foreign income, war profits and excess profits taxes, nor to real property or personal property taxes paid or accrued in carrying on a trade or business or an IRC § 212 activity^TY2026 (IRC § 164(b)(6), flush text) excepts real property taxes paid in carrying on a trade or business, so the warehouse tax is deducted in full on Schedule C.

3. An employer remits withheld employee income tax of $40,000 for the quarter. Is it deductible as a tax?

Answer: No. federal income taxes including the employee share of FICA and tax withheld at source on wages, federal war profits and excess profits taxes, estate, inheritance, legacy, succession and gift taxes, foreign income taxes where the taxpayer takes the IRC § 901 credit, and real property taxes treated by IRC § 164(d) as imposed on another taxpayer^TY2026 (IRC § 275(a)(1)(C)) names tax withheld at source on wages under IRC § 3402. It is the employees’ tax, and the employer’s deduction for the same money is the wages deduction under IRC § 162(a)(1).

4. A company settles a federal enforcement action, and the agreement identifies $800,000 as restitution but the company cannot show that any of it remediates harm caused by the violation. Is it deductible?

Answer: No. the disallowance does not reach an amount the taxpayer establishes is restitution, including remediation of property, or is paid to come into compliance with the law violated — but only where the court order or settlement agreement identifies it as such, and identification alone is not enough^TY2026 (IRC § 162(f)(2)(A)) requires both that the taxpayer establish the amount constitutes restitution and that the order or agreement identify it as such, and the statute adds in terms that identification alone is not sufficient.

5. A business pays $250,000 under a court order in a suit brought by a competitor, with no government a party. Does IRC § 162(f)(1) disallow it?

Answer: No. the disallowance does not apply to an amount paid by reason of an order of a court in a suit in which no government or governmental entity is a party^TY2026 (IRC § 162(f)(3)) takes an amount paid by reason of a court order in a suit in which no governmental entity is a party outside the disallowance entirely, so its deductibility is decided by IRC § 162(a) on ordinary principles.

Change log

2026-08-21Initial draft. Sets out the four categories of IRC § 164(a), the catch-all for other state, local and foreign taxes paid in carrying on a trade or business, and the rule capitalising a tax paid on an acquisition. Records that the IRC § 164(b)(6) cap excepts business property taxes and foreign income taxes by its own flush text, that its heading still says 2018 through 2025 although Pub. L. 119-21 § 70120(a)(1) struck the end date, the IRC § 275(a) list of taxes never deductible, and the IRC § 162(f) disallowance of government penalties with its three exceptions.