Could an S corporation deduct IRS payroll-tax penalties when computing former Texas earned surplus?

Plain-English summary

IRS payroll-tax penalties could not be deducted from the S corporation's taxable earned surplus.

The S corporation had paid IRS penalties for late payroll-tax deposits and payments and reported them on Schedule K of its 1994 and 1995 federal returns.

Section 171.110(d) used the S corporation's income reported to the IRS as taxable to shareholders. Rule 3.556 treated allocated income and deductions as if the S corporation were federally taxed as a C corporation.

Because the Comptroller understood Section 162 to disallow deductions for U.S. government fines and penalties, the penalties did not reduce former Texas taxable earned surplus.

What this means for you

S corporations reviewing historical penalties

Passing the penalty through on Schedule K did not turn it into a deductible earned-surplus item.

Tax professionals

Check federal deductibility before carrying an S-corporation deduction into the former Texas earned-surplus base.

Common questions

Q: Were the IRS penalties deductible?
A: No.

Q: What type of penalties were involved?
A: Late payroll-tax deposit and payment penalties.

Q: Which Texas rule governed S-corporation items?
A: Rule 3.556.

Citations and references

• Texas Tax Code Sec. 171.110(d)
• 34 Tex. Admin. Code Sec. 3.556
• I.R.C. Sec. 162, as discussed in the letter

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=FIT
• Opinion: https://star.comptroller.texas.gov/view/9611095L

Original ruling text

November 14, 1996

Dear**:

Thank you for your letter concerning the deductibility of Federal tax penalties
paid by an S corporation.

You stated in your letter that your client was assessed tax penalties by the
IRS for late deposit and payment of payroll taxes. The penalties were reported
on line 10 of Schedule K of your client's 1994 and 1995 Forms 1120S.

Section 171.110(d) of the Texas Tax Code states that "an S corporation's
reportable federal taxable income is the amount of income reportable to the
Internal Revenue Service as taxable to the corporation's shareholders."
Franchise Tax Rule 3.556, Earned Surplus: S Corporations (copy enclosed),
states "where and to the extent an S corporation allocates income and
deductions to shareholders, such items will be treated as income and deductions
of the S corporation as though the corporation were taxed as a C corporation
for federal income tax purposes."

Based on my understanding of Internal Revenue Code Sec. 162, no deduction for
any fine or penalty assessed by the government of the United States may be
deducted from federal taxable income. Therefore, the penalties may not be
deducted in computing taxable earned surplus for franchise tax reporting
purposes.

This response is based on the facts presented. If there are different or
additional facts, the response may change.

If you have any questions about this or any other franchise tax matter, please
call me at
1-800-531-5441, extension 34612. My direct number is (512) 463-4612. You may
write me at Tax Policy Division, Comptroller of Public Accounts, Austin, Texas
78774.

Sincerely,
Janet Spies
Tax Policy Division