Are California waiting time penalties deductible?

The payment: what a waiting time penalty is

When a California employer willfully fails to pay an employee's final wages on time, the wages of the employee continue as a penalty from the due date at the same rate until paid or until an action is commenced, for no more than thirty days (Labor Code section 203(a)). The exposure accumulates quickly, up to thirty days of the employee's daily wage, counted in calendar days including non-workdays (Labor Code section 203(a); Division of Labor Standards Enforcement, Waiting Time Penalty FAQ), and it is a fixture of California employment litigation and payroll remediation projects, which is how it lands on the tax desk: a provision or a settlement schedule arrives carrying a line called penalties, and someone must decide its tax character. An action for the penalty may be filed within the limitations period for the underlying wages (Labor Code section 203(b)), and that period governs all actions seeking section 203 penalties (Pineda v. Bank of America, N.A. (2010) 50 Cal.4th 1389).

The California Supreme Court has settled the penalty's character. Section 203 "is not designed to compensate employees for work performed"; it is intended "to encourage employers to pay final wages on time, and to punish employers who fail to do so," and for that reason the penalty cannot be recovered as restitution under the Unfair Competition Law (Pineda v. Bank of America, N.A. (2010) 50 Cal.4th 1389). Premium pay for missed meal and rest breaks under Labor Code section 226.7 is different: it is wages for purposes of section 203, and its late payment can itself trigger waiting time penalties (Naranjo v. Spectrum Security Services, Inc. (2022) 13 Cal.5th 93).

The federal characterization follows the same line. The IRS has taken the position that waiting time penalties are not wages for employment tax purposes because the penalty is a separate, statutorily imposed penalty for employer misconduct rather than remuneration for employment (Chief Counsel Advice 201522004, which may not be cited as precedent), and that they are reportable to the employee as other income in box 3 of Form 1099-MISC rather than on Form W-2 (Information Letter 2016-0026). On the California side, the Labor Commissioner states that the waiting time penalty is not wages, so no deductions are taken from the penalty payment (Division of Labor Standards Enforcement, Waiting Time Penalty FAQ). The Employment Development Department has published no specific guidance on section 203 penalties; its regulation defining wages includes additional wages paid pursuant to the Labor Code (Cal. Code Regs., tit. 22, section 926-7(j)), and no published guidance says whether that provision reaches a section 203 penalty.

The disallowance: what Section 162(f) covers

Section 162(f) has two eras. In its pre-2018 form, the statute denied a deduction for any fine or similar penalty paid to a government for the violation of any law, with the regulations confirming that government includes states and their subdivisions. The Tax Cuts and Jobs Act rewrote the provision for amounts paid or incurred on or after December 22, 2017, other than amounts paid under a binding order or agreement entered into before that date; an order that required court approval qualifies for that transition rule only if the approval was obtained before that date (T.D. 9946, preamble). The disallowance now reaches amounts paid or incurred, 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 an investigation into a potential violation, subject to exceptions for amounts the taxpayer establishes, and the agreement or order identifies, as restitution or as paid to come into compliance with law (Section 162(f)(1), (2)), reinforced by the government reporting regime of Section 6050X. The rewrite broadened the net, reaching any amount paid in relation to a violation or an investigation rather than only a fine or similar penalty, and amounts paid at the direction of a government to someone else; the old regulations had already treated a settlement of liability for a government fine or penalty as a fine (former Treas. Reg. section 1.162-21(b)(1)(iii)).

What neither era reaches is a payment made to a private person that no government ordered, received, or directed. A waiting time penalty paid to a departing employee, whether in ordinary payroll remediation or in settlement of the employee's own claim, fails the disallowance's threshold condition under both versions of the statute. Section 162(f)(3) confirms the point for litigated matters: the disallowance does not apply to amounts paid by reason of a court order in a suit in which no government is a party (see also Treas. Reg. section 1.162-21(c)(1)). Who receives the money is not the whole test under the current statute, however. The IRS has disallowed a punitive payment whose ultimate payee was not a government, reasoning that the identity of the payee does not convert "a non-deductible punitive exaction into a deductible expense" (Technical Advice Memorandum 202434011, which may not be cited as precedent, relying on Bailey v. Commissioner, 756 F.2d 44 (6th Cir. 1985)). The Labor Commissioner's three routes to the employee are where that matters.

The first is the citation. Labor Code section 1197.1 allows the Labor Commissioner to cite an employer for minimum wage violations together with any applicable section 203 penalties, which are paid to the affected employee; a payment made under that citation is made at the direction of a government, and because the penalty is punitive rather than compensatory (Pineda), the restitution exception is unlikely to rescue it. The second is the Labor Commissioner's own lawsuit. The Labor Commissioner may prosecute actions for the collection of wages, penalties, and demands of employees (Labor Code section 98.3(a)); a government is a party to those actions, so the private-suit exception of Section 162(f)(3) does not apply. The third is the hearing award. After a hearing on an individual wage claim, the Labor Commissioner issues an order, decision, or award that includes any penalties awarded, and an award that no party appeals becomes enforceable as a judgment (Labor Code section 98.1). The preamble to the final regulations reads "suit, agreement, or otherwise" to include decisions issued by officials, committees, or commissions of a government, and Treasury declined commenters' request to exclude administrative proceedings (T.D. 9946, preamble). No ruling or case addresses whether a section 203 penalty paid under a Labor Commissioner award is paid at the direction of a government, and the question is unresolved.

Outside those routes, the deduction analysis reverts to Section 162(a), where compensation-adjacent payments to employees arising from the conduct of the business are generally deductible, provided they meet the ordinary and necessary standard that section imposes on every deduction.

Timing follows its own rule. For an accrual-method employer, a liability arising out of a violation of law is incurred only as payment is made to the person to which it is owed (Treas. Reg. section 1.461-4(g)(2)), the recurring item exception is unavailable for it (Treas. Reg. section 1.461-5(c)), and a transfer to a qualified settlement fund counts as payment (Treas. Reg. section 1.468B-3(c)(1)). California follows these rules (Revenue and Taxation Code sections 17551(a) and 24681).

The California overlay, and the conformity timeline

California disallows what Section 162(f) disallows, through Section 24343's conformity to Section 162 and, on the personal income tax side, Section 17201. The interesting wrinkle is temporal. California conforms to the Internal Revenue Code as of a specified date, and for years that date was January 1, 2015, which meant California continued to apply the narrow pre-TCJA version of Section 162(f) while federal law applied the broadened one, a federal-state divergence for amounts paid from 2018 forward. SB 711 (Stats. 2025, ch. 231) moved California's specified date to January 1, 2025, for taxable years beginning on or after January 1, 2025 (Revenue and Taxation Code sections 17024.5(a)(1) and 23051.5(a)(1)), which brings the modern Section 162(f), exceptions and all, into the California computation for current years. For the waiting time penalty paid in remediation or private settlement the divergence never mattered, since a payment to an employee that no government directed is outside both versions, but for the government-facing payments discussed next, and for penalties paid through the Labor Commissioner, open back years and current years can take different California answers, and a schedule that survived audit under one era's rule deserves a fresh look under the other's.

The neighbors that are not deductible

The care in this area goes to keeping the waiting time penalty's answer from leaking onto its neighbors. California wage-and-hour exposure often arrives in combination, and the companions have different payees. Civil penalties assessed by the Labor Commissioner are paid to the state and sit inside Section 162(f). Penalties recovered under the Private Attorneys General Act are the treacherous middle case: PAGA penalties are recovered by an employee plaintiff, but for civil actions brought on or after June 19, 2024, other than an action for which the required notice under Labor Code section 2699.3 was filed before that date, the statute directs 65 percent of the civil penalties to the state's Labor and Workforce Development Agency and 35 percent to the aggrieved employees (Labor Code section 2699, subds. (m), (v)). The portion paid to the agency is an amount paid to a government in relation to a violation of law, within the modern disallowance absent an identified restitution or compliance exception, and whether the employee-distributed portion escapes the disallowance is unsettled, because a PAGA plaintiff sues on the state's behalf and the state is the real party in interest (Iskanian v. CLS Transportation Los Angeles, LLC (2014) 59 Cal.4th 348, whose arbitration holding was later limited by Viking River Cruises, Inc. v. Moriana (2022) 596 U.S. 639), which makes the private-suit exception of Treas. Reg. section 1.162-21(c)(1) unlikely to apply, while no regulation or IRS guidance addresses the employee share paid directly to employees. A settlement that resolves waiting time penalties, PAGA claims, statutory penalties, and unpaid wages in one number invites a misallocation in either direction: deducting the government's share, or forfeiting the deduction on the employees' share.

The allocation is therefore the work. Under the current federal regime the settlement agreement itself is a tax document: the restitution and compliance exceptions apply only to amounts identified as such in the agreement or order, and a government that is party to the order or agreement must report the amount required to be paid, and any amount identified as restitution, remediation, or compliance, for orders and agreements binding on or after January 1, 2022 that meet the regulation's $50,000 threshold (Treas. Reg. section 1.6050X-1(b)(1), (f)(6), (g)). An employer negotiating a wage-and-hour resolution has reason to insist that the agreement state the components, because the deduction for each dollar follows the line it sits on.

Practice notes

The deduction analysis for a wage-and-hour resolution is an allocation schedule with authorities attached. The first step is to classify every component by payee and character before the provision is booked: unpaid wages and section 226.7 premium pay (deductible compensation, and payroll-taxable, the premium pay being wages under Naranjo), waiting time and similar employee-paid penalties paid in remediation or private settlement (generally deductible, and reportable to the employee as other income in box 3 of Form 1099-MISC when the year's payments reach the reporting threshold, which is $2,000 for tax years beginning after 2025 under the IRS Instructions for Forms 1099-MISC and 1099-NEC), waiting time penalties paid under a Labor Commissioner citation (paid at the direction of a government, and within the post-2017 disallowance) or recovered in a Labor Commissioner action (outside the private-suit exception), penalties paid under a Labor Commissioner hearing award (unresolved, and a position to document), agency-assessed civil penalties and the government's share of any PAGA recovery (nondeductible absent an identified exception), and interest (its own analysis). The second is a settlement agreement that does the identifying: amounts intended as back pay or restitution belong labeled in the document, since the post-TCJA exceptions are unavailable without identification, and silence defaults to disallowance for the government-facing dollars. The third is the conformity years and the claim periods on both sides. For taxable years before 2025 California tested these payments under the old, narrower statute, and open-year amended returns or audits should apply each year's own version rather than whichever one the workpaper was built on. A California refund claim is timely only if filed within the later of four years from the date the return was filed (if filed by the extended due date), four years from the original due date, or one year from the date of overpayment (Revenue and Taxation Code section 19306(a)); a federal claim is due within three years from the time the return was filed or two years from payment, whichever is later (IRC section 6511(a)). The fourth is coordination of the information reporting with the deduction position: for employees whose payments reach the reporting threshold, the employee-paid penalty deducted as a business expense should reconcile to the amount reported, because a schedule that deducts one number and reports another is a discrepancy an examiner can readily find. G&G State Tax Group provides federal and California income tax analysis of wage-and-hour settlements and penalty payments alongside its state and local tax practice.