This article was updated on August 9, 2021
Generally, a partner may not deduct the expenses of the partnership on his or her individual income tax return, even if the expenses were incurred by the partner in furtherance of partnership business. However, an exception applies when there is an agreement among partners, or a routine practice equal to an agreement, that requires a partner to use his or her own funds to pay a partnership expense.
For partners of service organizations, deducting a qualifying unreimbursed expense may serve not only to reduce federal and state income that is subject to tax at their marginal tax rates, but also to reduce income subject to self-employment tax. A downside to such a deduction is that any reduction in self-employment income is also a reduction in earned income considered in retirement plan contribution calculations, which may reduce retirement funding.
In Peter A. McLaughlan, TC Memo 2011-289, (affirmed upon appeal: 2014-1 U.S.T.C. para 50,203, (Mar. 6, 2014) the taxpayer paid for items such as memberships in professional organizations and continuing legal education in connection with practicing law as a partner in the partnership.
The partnership agreement required partners to pay expenses for what were collectively described as "indirect" expenses, which included business meals, automobiles, travel, entertainment, conventions, continuing legal education and membership fees for professional organizations. Such indirect expenses were reimbursable under the partnership agreement if approved by the managing partner.
In addition to the provisions in the partnership agreement, the partnership had a written reimbursement policy that specifically provided for reimbursement of certain indirect expenses, but denied reimbursement for in-town transportation expenses (i.e., transportation within a 20-mile radius of an attorney's home office) and spousal travel expenses.
As a matter of routine practice, the partnership would reimburse other indirect expenses that were not provided for in the written reimbursement policy, including State Bar membership expenses and professional organization expenses. The partnership did not have a limit on the amount for which a partner could be reimbursed; rather, reasonableness was the overarching standard for approving reimbursement of indirect expenses. The partnership would deem an expense unreasonable if it was personal, excessive or not in the partnership's best interests.
While the taxpayer was reimbursed for over $60,000 of expenses for each of the two years addressed in this case, the taxpayer also claimed more than $100,000 of expenses for which he was not reimbursed.
The Tax Court found that the taxpayer was not required to pay without reimbursement any expenses for continuing legal education, professional organizations or State Bar memberships. However, the taxpayer failed to point to any specific expense for which the partnership denied him reimbursement. Accordingly, the taxpayer's deductions for unreimbursed partnership expenses were denied and additional taxes, interest and penalties were assessed.
The ability for a partner to deduct unreimbursed expenses is not determined in isolation. As long as the expenses are the type the partner is expected to pay without reimbursement under the partnership agreement or other policy, the partner may be able to deduct the expenses. To create a paper trail for deductible expenses, a partner should consider submitting the expenses to the partnership and having the partnership deny the expense reimbursement.
