What Penalties Are Disallowed as Income Tax Deductions?

Federal tax law does not let you deduct fines, civil penalties, forfeitures, or most settlement payments made to a government because you broke the law or were investigated for possibly breaking one. Section 162(f) of the Internal Revenue Code sets out the penalties disallowed as income tax deductions, and it reaches payments to federal, state, local, tribal, and foreign governments alike. A handful of exceptions preserve deductions for restitution, remediation, compliance spending, private-party judgments, and taxes actually due, but every one of them turns on how the underlying agreement is written and documented.¹

What Section 162(f) Blocks

The statute denies a deduction for any amount paid by suit, settlement, or otherwise to a government or governmental entity in relation to the violation of any law or the investigation of a potential violation. You do not need to be convicted, or even charged. Paying money to close out an inquiry is enough to trigger the bar.¹

“Government” is read broadly. Federal agencies, state governments, municipalities, tribal governments, U.S. territories, and foreign countries all count. A fine paid to a European data-privacy regulator is treated the same as a domestic EPA penalty. Certain self-regulatory organizations, including FINRA, are treated as governmental entities when they impose sanctions in connection with a qualified board or exchange.²

The label on the payment does not decide anything. Fine, civil penalty, forfeiture, disgorgement, settlement payment — if the money moves to a government entity because of a law violation, the deduction is off the table. A $5,000 OSHA citation and a $50 million fraud settlement receive the same tax treatment.

Exceptions That Keep a Deduction Available

The statute preserves four categories of payment. Each has its own logic, and each has to be identified in the agreement itself.

Restitution and Remediation

Amounts that compensate victims or repair the harm caused by the violation can still be deducted. A court order requiring reimbursement of overcharged customers, or cleanup of contaminated property, fits here. The reasoning is that restoring someone to their pre-violation position is compensatory rather than punitive.¹

One narrow limit: if the restitution is for a tax you failed to pay, it is deductible only if the underlying tax would itself have been deductible. This blocks a backdoor deduction for taxes that were never deductible to begin with.

Coming Into Compliance

Spending required by a court order or settlement to bring operations into compliance with the law is generally deductible. Emissions upgrades, new safety systems, compliance hires mandated by a consent decree — these look forward, not backward, and function like ordinary business costs.¹

Private-Party Lawsuits

Section 162(f)(3) says the disallowance does not apply to amounts paid under a court order in a suit where no government is a party. A breach-of-contract settlement with another company, or damages ordered in a private negligence case, is not blocked by 162(f). Whether the payment is actually deductible still depends on ordinary business-expense rules, but the government-penalty bar is not in the way.¹

Taxes Due

Section 162(f)(4) exempts amounts paid as taxes due. Back taxes owed under a settlement are not disallowed as penalties; their deductibility is then governed by the normal rules for tax deductions, such as Section 164.¹

Payments That Stay Non-Deductible Inside an Otherwise Qualifying Settlement

Even when a settlement contains deductible restitution or compliance spending, some line items remain permanently non-deductible:

Reimbursement of the government’s investigation or litigation costs, even if the rest of the settlement is restitution.
Amounts paid in lieu of a fine or penalty, which take on the character of the fine they replace.
Amounts directed into a government’s general enforcement fund or discretionary accounts, which are treated as penalties rather than restitution.¹

This is where negotiated agreements often go wrong. Separating deductible and non-deductible amounts in the settlement text can matter on the return, but only if the allocation matches economic reality. A “restitution” label pinned to what is functionally a fine will not survive IRS review.

Sexual Harassment Settlements With Nondisclosure Agreements

A separate rule, Section 162(q), disallows deductions for any settlement or payment related to sexual harassment or sexual abuse if the payment is subject to a nondisclosure agreement. Attorney’s fees connected to such a settlement are also non-deductible. The trigger is the confidentiality clause, not the payee: this rule applies whether or not any government is involved, so a fully private settlement can lose its deduction the moment an NDA attaches.¹

What the Agreement Has to Say, and What You Have to Prove

Claiming the restitution or compliance exception requires clearing two hurdles. Miss either one and the payment is treated as a non-deductible penalty in full.

Identification in the Agreement

The court order or settlement must specifically identify the payment as restitution, remediation, or an amount paid to come into compliance with the law. A lump-sum settlement that never breaks the payment into categories does not qualify. If the exact statutory terms are not used, the agreement needs enough detail about the harm being remedied or the corrective action required for the allocation to be clear on its face.³

This has to happen during negotiation. Relabeling payments after signing is not a workable fix, and lawyers drafting settlement terms should be thinking about the tax consequences before the ink dries.

Independent Proof

The statute says the identification alone is not sufficient. You still have to establish that the payment truly constitutes restitution, remediation, or compliance spending. That means keeping records of the legal obligation, the amount, the payment date, and evidence tying the money to actual harm or actual corrective work. If a settlement requires $400,000 in new filtration equipment, you need vendor invoices, proof of installation, and documentation linking the spend to the settlement terms, all in your files before you file the return. When these records are missing on audit, the IRS has grounds to reclassify the whole amount as a non-deductible penalty.¹

Reporting the Payment on Your Return

Form 1098-F From the Government

Government entities that receive payments of $50,000 or more in connection with a law violation must file IRS Form 1098-F. The form reports the total paid, any amount identified as restitution or remediation, and any amount designated for compliance. This applies to suits, orders, or agreements that became binding on or after January 1, 2022, and the government must furnish a copy to the taxpayer who paid.⁴

If a 1098-F arrives, your return needs to line up with it. A mismatch between what the government reported and what you claimed is one of the quickest ways to attract IRS attention.⁵

Book-Tax Reconciliation for Corporations

Non-deductible fines create a gap between financial-statement income and taxable income. Corporations reconcile that gap on Schedule M-1, or Schedule M-3 for companies with total assets of $10 million or more. A penalty expensed on the books but disallowed for tax purposes gets added back, raising taxable income above book income. A company that booked $200,000 in regulatory fines adds that $200,000 back on Schedule M-1 to reach the correct taxable figure.⁶

What Happens If You Deduct One You Shouldn’t

An improperly claimed deduction for a fine or penalty exposes you to the accuracy-related penalty of 20% on the portion of the underpayment attributable to the deduction. For individuals, the penalty applies when the understatement exceeds the greater of 10% of the correct tax or $5,000. For corporations other than S corporations, the threshold is the lesser of 10% of the required tax (or $10,000 if greater) and $10,000,000.⁷

Reasonable cause and good faith can defeat the penalty. The IRS weighs the complexity of the issue, the effort made to report correctly, and reliance on qualified professional advice given full and accurate information. Written documentation of that advice matters; a verbal recollection generally will not carry the day.⁸

Interest also runs on any underpayment from the original due date of the return. When a large deduction is disallowed years after the fact, the combined cost of the reclaimed tax, the 20% penalty, and accumulated interest can dwarf the tax benefit the taxpayer thought they had captured.

1
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
2
eCFR. 26 CFR 1.162-21 – Denial of Deduction for Certain Fines, Penalties, and Other Amounts
3
Internal Revenue Service. Notice 2018-23 – Transitional Guidance Under Sections 162(f) and 6050X
4
Internal Revenue Service. Instructions for Form 1098-F
5
Internal Revenue Service. Questions and Answers About the Reporting Requirement Under Section 6050X
6
Internal Revenue Service. Schedules M-1 and M-2 (Form 1120-F)
7
Internal Revenue Service. Accuracy-Related Penalty
8
Internal Revenue Service. Penalty Relief for Reasonable Cause