The passage of the Tax Cuts and Jobs Act of 2017 has increased the planning importance associated with the “unreimbursed partnership expense” income tax deduction exception for owners of partnerships and LLCs treated as partnerships. Before the Act took effect, about 30% of taxpayers itemized deductions on Schedule A, instead of taking the standard deduction associated with their filing status. However, the Act has had a substantial impact on these types of itemized deductions, as several have been eliminated or modified. For example, the deductions for unreimbursed employee business expenses, tax preparation fees, and investment advisory fees have been eliminated through 2025. These itemized deductions had been relied on by many taxpayers who incurred significant expenses relating to the production or collection of income, tax preparation or the trade or business of being an employee.
However, the Act did not affect the above-the-line deductibility of “unreimbursed partnership expenses” under a comparatively less used alternative available to owners of partnerships and LLCs treated as partnerships in certain circumstances. Generally, a partner (or member of an LLC treated as a partnership) may not directly deduct the expenses of the partnership on his or her individual federal income tax return, even if the expenses were incurred by the partner or member in furtherance of the organization’s business. However, the IRS has ruled that if, under the partnership agreement of the partnership, a partner must pay certain partnership expenses out of his or her own funds, then he or she can deduct such expenses on his or her individual tax return. When deductible, these expenses are claimed on Schedule E as an offset against partnership income. The instructions for Form 1040, Schedule E, state that unreimbursed ordinary and necessary partnership expenses paid on behalf of the partnership may be deducted on Schedule E if a partner was “required to pay these expenses under the partnership agreement.” So then, for a partner to be permitted to deduct unreimbursed partnership expenses on his or her personal return both of the following elements of this exception must be met: (1) the partnership agreement must require the partner to pay such expenses without having a right to be reimbursed; and (2) the claimed expenses must be able to be substantiated in the case of an audit by the Internal Revenue Service.
Careful planning is required to take advantage of this exception, including amending the language of any existing partnership or operating agreement to provide that each partner or member is required to pay for automobile, continuing education, communication, client entertainment, professional association or such other partnership expenses without reimbursement. Additionally, adequate records must be kept substantiating the expenses consistent with the documentation requirements of the tax code (e.g., the heightened requirements for substantiation of automobile travel costs). Please note, however, that this exception is not available for shareholders of S corporations. Unreimbursed corporate expenses paid for by shareholders, are treated as unreimbursed “employee” business expenses. As noted above, unreimbursed “employee” business expense deductions are no longer permitted under the Act.
If your partners previously took advantage of Schedule A deductions, but can no longer do so, modifying your governing documents to allow them to take advantage of this exception may be advantageous for your business as well as said partners. Frier Levitt, working in conjunction with your accountants, can evaluate whether or not your business can take advantage of this exception. Frier Levitt can also assist in amending your governing documents to meet the applicable requirements. If you are interested in taking advantage of this exception, please contact Frier Levitt today to speak to an attorney.
