Get Your Partner-Paid Expenses Right

If you’re a small business owner, a partner in a partnership, or a member of a multi-member LLC taxed as a partnership, understanding how to handle partner-paid expenses is crucial for maximizing your tax benefits and operating efficiently. When expenses are paid out of pocket, you might wonder how to properly deduct those costs.

Here’s everything you need to know to make the most of partner-paid expense deductions while staying compliant with tax regulations.

Why Partner-Paid Expenses Matter

An LLC or partnership is a separate legal entity with its own bank account to handle business expenses. However, it’s common for members and partners to pay for certain business-related costs themselves, such as travel, meals, continuing education, and home-office expenses.

The question is, how can you deduct those out-of-pocket costs? Essentially, you have two options:

1. Request reimbursement from the LLC or partnership, which deducts the expense itself.
2. Claim the expense on your personal tax return as an Unreimbursed Partnership Expense (UPE).

Option 1: Reimbursement From the LLC or Partnership

Whenever possible, it’s generally best to obtain a reimbursement from your LLC or partnership. Reimbursed expenses are deductible directly by the partnership or LLC and are tax-free for you, provided they meet these requirements:

• The expense is a valid business deduction: It must be necessary and directly related to the business.
• Adequate documentation is available: Detailed records, including receipts, invoices, and reports, must support the expense.
• Timely submission of reimbursement requests: Your request should comply with timeframes set by the partnership or LLC.

Although LLC members or partners are not technically employees, using an “accountable plan” can simplify the reimbursement process and ensure compliance. An accountable plan includes guidelines to prevent inadvertently reimbursing personal expenses. To comply with this plan, you’ll need to:

• Provide proper documentation, such as receipts and detailed expense reports.
• Submit expenses promptly for reimbursement.
• Return any reimbursement amounts that exceed your actual expenditures.

Once reimbursed, the LLC or partnership deducts the expenses as “other deductions” on its tax return (Form 1065).

Option 2: Deducting Expenses on Your Personal Tax Return

If the LLC or partnership doesn’t reimburse certain expenses, you may be eligible to deduct them directly on your personal tax return as unreimbursed partnership expenses (UPE). Here’s how it works:

• Conditions for UPE deductions

You can only claim unreimbursed business expenses if the partnership or LLC explicitly allows this arrangement in one of two ways:

1. The partnership agreement or LLC agreement states that specific expenses will not be reimbursed
2. The partnership or LLC has an established practice of not reimbursing specific costs.

Without written terms or a documented practice, the IRS may disallow your personal tax deduction.

• Practical example

Consider Dr. Magruder, a pathologist and member of a medical partnership. He often bought lunches for hospital medical technologists with whom he worked, paying out of pocket. Since his partnership didn’t have a formal agreement or established practice to justify these as unreimbursed expenses, the IRS disallowed his deduction.

Key Tip

Save yourself time and IRS trouble by formalizing your expense policies within your LLC or partnership agreement. Clearly define reimbursable and non-reimbursable expenses to avoid ambiguity.

• How to Claim UPE on Form 1040

List your unreimbursed expenses on Schedule E, Part II, and mark the “yes” box on Line 27. Identify these deductions separately in Line 28 (Column A) under the label “UPE.” Be sure not to combine these costs with other partnership-related income or expenses.

Keep in mind that deducting UPE will reduce your qualified business income (QBI) for the 20% deduction calculation. However, the immediate tax savings from taking the deduction often outweigh this impact.

Reimbursement vs. Personal Deduction—which is better?

While either approach is valid, obtaining reimbursement from your LLC or partnership typically yields greater tax benefits and avoids complications involving IRS scrutiny.

Example:

Louis, a surgeon and 25% owner of a medical partnership, spent $10,000 on a business trip and had two potential approaches:

1. Personal deduction route

If he deducted the expenses as UPE, he would save $3,200 in taxes (32% tax bracket), leaving his net cost of the trip at $6,800.

2. Reimbursement route

Alternatively, if his partnership reimbursed him in full, he would initially pay nothing out of pocket. Although the taxable income he reports from pass-through partnership income increases by $2,500 (25% share of the reimbursed $10,000 expense), his tax on this additional amount would only be $800. His total net cost? Just $1,700.

Key Takeaway

Reimbursements often minimize out-of-pocket costs, but individual deductions may be preferable for specific scenarios involving uneven expense distribution among partners.

Action Steps for Business Owners and Partners

1. Review Your Partnership or LLC Policies

Ensure that your partnership or operating agreement thoroughly documents whether certain expenses will or won’t be reimbursed. Adjust the agreement if needed to reflect current practices.

2. Maintain Detailed Records

Whether you’re seeking reimbursement or claiming UPE, meticulous documentation is critical. Save receipts, invoices, and any notes that clarify the expense’s business purpose.

3. Update Agreements Before Tax Deadlines

Operating agreements or reimbursement policies can be amended until the due date of the partnership tax return (excluding extensions) and still apply retroactively to that tax year.

By proactively managing your expense reimbursement policies and prioritizing proper documentation, you can ensure compliance, make informed financial decisions, and minimize your tax burden.

Need Help?

Understanding the complexities of partner-paid expenses can feel overwhelming, but you’re not alone. With proper planning and guidance, you can handle expenses efficiently while benefiting your bottom line.

If you’re unsure about structuring expense policies or need personalized advice for your partnership or small business, book a call today.

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