Business activities should be kept separate from personal activities. It is preferable to have the entity pay for all of its business expenses form the entity’s checking account and to have one credit card that is used solely for business expenses.
It is not uncommon that the partners/members need to pay for business expenses out of their own pocket. According to the Tax Court, unless an agreement between a partnership and a partner states otherwise, a partner cannot deduct expenses on his or her personal tax return if they were incurred on the partnership’s behalf, because it is not “necessary” that a partner pay for them with his own funds. This also holds true regarding LLC members of an LLC taxed as a partnership.
“Accountable” Reimbursement Plan
One method is for an “expense report” with attached invoices to be submitted to the entity for reimbursement payments. There should be an agreement, an understanding, about just how to handle these payments. Each partner shall be entitled to reimbursement for the reasonable and necessary expenses incurred by the Partner on behalf of the Partnership. In order to receive reimbursement, a Partner must submit a written itemized report of all expenses for which reimbursement is sought, and partnership enters the expense report with the Partnership books and records. It may be easier for the partners to turn in a periodic expense report and get reimbursed by the partnership. This way, you will have the receipts turned in for documentation by partnership. However, if the partner has the right to be reimbursed, but fails to obtain reimbursement, the partner is not entitled to a deduction for the expenses.
Unreimbursed Partnership Expenses (UPE)
Another method is for the partnership to require the partners to pay for business expenses without getting reimbursed. The Partnership’s Partnership Agreement or the LLC’s Operating Agreement might contain a clause saying that each partner shall be required to incur those reasonable and necessary expenses as determined appropriate for the effective operation of the partnership, and such expenses will be made without reimbursement by the Partnership.
If the partnership’s agreement or practice requires a partner to pay certain partnership expenses from his own funds, with no right to reimbursement from the partnership, the partner is entitled to deduct these as trade or business expenses on his personal return. Those expenses are not subject to the 2% miscellaneous itemized deduction threshold. A partner’s out-of-pocket expenses are deducted on Schedule E (Form 1040), Part II, column (i) as Unreimbursed Partnership Expenses (UPE). These expenses also reduce self-employment income on Schedule SE.
While the “requirement” that the partner incur the expense without right of reimbursement need not be in writing, it is a question of fact, and may be the subject of IRS dispute. As a consequence, the partners will benefit by making this requirement explicit, either as a provision of their partnership agreement or through a written policy of the partnership.
No Deduction on Schedule C
Limited partners, and non-management owners are not be allowed to deduct “ordinary and necessary” expenses on schedule C for eligible “trade or business”. They may be allowed to take these as itemized deductions as Code §162 “ordinary and necessary” or Code §212 “expenses for production of income” investment related expenses on their personal form 1040, Schedule A, line 23, when appropriate.
Any unreimbursed expense that is not deductible by the partner can be treated as a contribution to capital, pursuant to TAM 8442001. Each partner who pays a liability of the partnership upon submission of proof of such payments, will have made an indirect contribution to such partner’s capital account.
