Penalty Deductions

[Corduroy Frog]

The IRS is adamant that no tax penalty be deductible.

Shifty-Eyed Sam, a sole proprietor, prepared a return for one of his clients. Some time later, this client was audited and was smacked with a "substantial understatement" penalty of $1200. Sam was determined to be grossly negligent, and was assessed a penalty of $250 as well.

Client was a longtime customer, a friend, and Sam decided to reimburse his client for the $1200 penalty, and of course had to cough up $250 for his own penalty.

Are ALL of the following true? If not, which are not?

1) Client cannot deduct his $1200 penalty.
2) Sam cannot deduct his $250 penalty.
3) Sam CAN deduct his $1200 reimbursement to client, as a sales allowance to customer on his Sch C.
4) Client must treat Sam's $1200 reimbursement as income (or reduction in expense).

[New York Enrolled Agent]

The IRS is adamant that no tax penalty be deductible.

Actually, the IRS is simply acting in response to §162(f):
(f) Fines and penalties.
No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

Reg §1.162-21(b)(1)(ii) says that civil penalties and additions to tax assessable under Chapter 68 of the IRC are penalties for the purpose of §162(f). The penalties described in your post fall under Chapter 68.

Thus, IMO #1 is true, #2 is true and #3 is false. Paying the penalty of another would not change the character of the penalty. As an example see Patton 71 TC 389 (a trust fund penalty) and the included cites in that decision.

I think #4 involves an opinion that MIGHT differ based on all the facts of the case. For example, did the taxpayer fail to give documents to the preparer resulting in the §6662 penalty or did the preparer have all the documents and simply screw up?