Business Tax Preparation · Business expenses, deductions and credits

Taxes, assessments and penalties

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^TY2026Verified 2026-08-21IRC § 164(a)(1)-(4), opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-21IRC § 164(a), flush text, opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-21IRC § 164(a), closing sentence, opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-21IRC § 164(b)(6), flush text, opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-19IRC § 164(b)(7)(A)(ii), (iv) — https://www.law.cornell.edu/uscode/text/26/164 (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)^TY2026Verified 2026-08-21IRC § 164(b)(6) and its amendment notes, opened at law.cornell.edu/uscode/text/26/164.

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^TY2026Verified 2026-08-21IRC § 275(a), opened at law.cornell.edu/uscode/text/26/275 (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^TY2026Verified 2026-08-21IRC § 162(f)(1), opened at law.cornell.edu/uscode/text/26/162 (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^TY2026Verified 2026-08-21IRC § 162(f)(2)(A), opened at law.cornell.edu/uscode/text/26/162 (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^TY2026Verified 2026-08-21IRC § 162(f)(2)(B), opened at law.cornell.edu/uscode/text/26/162 (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^TY2026Verified 2026-08-21IRC § 162(f)(3), opened at law.cornell.edu/uscode/text/26/162 (IRC § 162(f)(3)).

Current figures

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^TY2026Verified 2026-08-21IRC § 164(a), flush text, opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-21IRC § 164(a), closing sentence, opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-21IRC § 164(b)(6), flush text, opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-21IRC § 275(a), opened at law.cornell.edu/uscode/text/26/275 (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^TY2026Verified 2026-08-21IRC § 162(f)(1), opened at law.cornell.edu/uscode/text/26/162 (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^TY2026Verified 2026-08-21IRC § 162(f)(2)(A), opened at law.cornell.edu/uscode/text/26/162 (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^TY2026Verified 2026-08-21IRC § 162(f)(2)(B), opened at law.cornell.edu/uscode/text/26/162 (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^TY2026Verified 2026-08-21IRC § 162(f)(3), opened at law.cornell.edu/uscode/text/26/162 (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.

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)^TY2026Verified 2026-08-21IRC § 164(b)(6) and its amendment notes, opened at law.cornell.edu/uscode/text/26/164. 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^TY2026Verified 2026-08-19IRC § 164(b)(7)(A)(ii), (iv) — https://www.law.cornell.edu/uscode/text/26/164, 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^TY2026Verified 2026-08-19IRC § 164(b)(7)(B)(i)-(iii) — https://www.law.cornell.edu/uscode/text/26/164. 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^TY2026Verified 2026-08-21IRC § 164(b)(6), flush text, opened at law.cornell.edu/uscode/text/26/164.

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^TY2026Verified 2026-08-21IRC § 164(a), flush text, opened at law.cornell.edu/uscode/text/26/164 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^TY2026Verified 2026-08-21IRC § 164(a), closing sentence, opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-21IRC § 164(b)(6), flush text, opened at law.cornell.edu/uscode/text/26/164 (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^TY2026Verified 2026-08-21IRC § 275(a), opened at law.cornell.edu/uscode/text/26/275 (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^TY2026Verified 2026-08-21IRC § 162(f)(2)(A), opened at law.cornell.edu/uscode/text/26/162 (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^TY2026Verified 2026-08-21IRC § 162(f)(3), opened at law.cornell.edu/uscode/text/26/162 (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.