Protecting your Partnership Expense Deduction (article)
It is common in partnerships for a partner to incur related business expenses for which the partnership does not reimburse him, especially in professional service partnerships. Many partners seek to deduct these expenses on their personal income tax returns "above the line," i.e., as a deduction from adjusted gross income (usually on Schedule E). For those expenses to be deductible, several elements must be present. A recent case from the Tax Court, McLauchlan v. Commissioner (TC Memo 2011-289, Dec. 19, 2011), is a good reminder of those elements and some things to avoid.
Partners in service partnerships, such as accounting or law firms, often incur meals and entertainment expenses in developing new client relationships, automobile expenses going to and from client meetings, professional dues and publications, continuing education, home office expenses and other business related expenses. Assuming the partnership would have been able to deduct these expenses as ordinary and necessary business expenses had it paid them directly, the partner generally should be able to deduct any unreimbursed expenses on Schedule E of his Form 1040, but only if the partnership requires him to pay such expenses personally. The IRS and the courts also have consistently ruled that if a partner has a right to be reimbursed for expenses by the partnership under the partnership agreement or established practice, but does not elect to seek such reimbursement, the partner is not entitled to the deduction on his personal tax return.
In McLauchlan, the taxpayer was a partner in a professional service partnership and personally paid various business expenses, including advertising, cell phone, home office, automobile, meals and entertainment, travel, continuing education and professional organization expenses. The law partnership reimbursed the taxpayer for over $60,000 of business expenses, and the taxpayer deducted on his personal tax return over $40,000 of additional expenses that were not reimbursed by the partnership..
The partnership agreement provided that each partner was required to incur and pay for certain indirect partnership expenses. The law firm had a written reimbursement policy that specifically provided for reimbursement of certain of those indirect expenses, such as reasonable travel expenses for client development, interoffice travel, business meals and entertainment (if approved) and continuing education (if approved). The reimbursement policy also specifically provided that certain expenses, such as local travel and spousal travel expenses were not reimbursable.
While not stipulated in the reimbursement policy, the partnership also reimbursed certain other indirect expenses as a matter of routine practice, such as state bar membership expenses and professional organization expenses. The partnership did not have a limit on how much a partner could be reimbursed, instead applying a reasonableness standard. The partnership would deem unreasonable any expenses that were personal, excessive or not in the partnership's best interests.
The Tax Court applied three different tests in disallowing some of the expenses that the partner sought to deduct personally:
- Some expenses were disallowed because the partnership agreement did not stipulate that the partners were required to pay those expenses personally. As mentioned above, a partner can personally deduct partnership expenses only if the partnership requires him to pay such expenses personally.
- Other expenses were disallowed because they were eligible for reimbursement, either via the written reimbursement policy or routine practices. The partnership would only deny reimbursement of eligible expenses if they were deemed to be unreasonable, i.e., personal, excessive or not in the partnership's best interests.
- Finally, the deduction for certain automobile expenses that the partnership required to be paid personally, but that were not eligible for reimbursement, were denied because the expenses were not properly substantiated. The partner failed to maintain records that indicated the amount, dates and purposes of any business use.
To help protect both the partnership and the partners who desire to deduct expenses incurred on behalf of the partnership without reimbursement, it is important that:
- The partnership agreement specifically requires the partner to incur such expenses and pay for them personally,
- The partnership, in fact, does not reimburse any partners for such expenses, and
- The partners properly substantiate the expenses.
This case should also be of concern to partners who fail to seek reimbursement from the partnership for expenses incurred when available, as they would not be entitled to deduct such expenses on their personal income tax returns. McLauchlan is a timely reminder for partnerships who intend to allow partners to deduct on their personal returns indirect partnership expenses to establish and follow a consistent reimbursement policy. To determine whether your partnership's policies and practices facilitate the partners' ability to deduct unreimbursed expenses, when appropriate, contact your local CBIZ MHM tax advisor.
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