Unreimbursed Partnership Expenses Operating Agreement
If one is self-employed in a partnership, the partnership may require you to pay for some expenses out of your own pocket. When one is preparing for personal tax returns, one might be able to use these unreimbursed partner expenses to lower your income and self-employment tax bill. Hence the need for unreimbursed partnership expenses operating agreement.
Using an unreimbursed partnership expenses operating agreement can aid in deducting unreimbursed partnership expenses (UPE) if one was required to pay partnership expenses personally under the partnership agreement. One should not include any expenses that can be deducted as an itemized deduction. Further, one should not combine these expenses with — or net them against — any other amounts from the partnership. You can’t deduct unreimbursed expenses if you weren’t required to pay them under the partnership agreement.
Moreover, an unreimbursed partnership expenses operating agreement aids in the reduction of the self-employment income. In deducting the unreimbursed partnership expense:
- Add another K-1, enter “UPE” as the Partnership name, and enter the total expense as a negative in both Boxes 1 and 14.
- Answer all other questions the same as on your original K-1, but don’t enter the income amounts again.
Deductible unreimbursed partner’s expenses
Since the Tax Cuts and Job Act of 2017 (TCJA) was passed, a little-known deduction for unreimbursed partner’s expenses (UPE) has taken on more significance. Partners in a partnership and members of an LLC often incur significant out of pocket expenses for travel to conduct business with clients. Other aspects include professional education, seminars, professional dues, client entertainment, and expenses for maintaining a home office that are all captured in the unreimbursed partnership expenses operating agreement. This is assuming that the expense meets the definition of a deductible trade or business expense. Often, the partnership will reimburse the partner or member for these expenses, and the partnership will claim this reimbursement as expense on their own tax return. All this is included in the unreimbursed partnership expenses operating agreement.
In other cases, pursuant to the unreimbursed partnership expenses operating agreement, or policy of the firm, partners and members are expected to pay these expenses from their own funds. Prior to the TCJA, the partner or member would then deduct these (often significant) expenses on Schedule A as a miscellaneous itemized deduction. However, the TCJA suspended the ability to deduct miscellaneous itemized deductions through the year 2025.
Moreover, there is a little-known exception that will allow a partner or member to continue to deduct these unreimbursed expenses. If these expenses are deductible, they are deducted directly on Schedule E with the notation “UPE”, and offset the distributive share of income which is also reported on Schedule E.
For these unreimbursed expenses to be deductible, the partnership or operating agree unreimbursed partnership expenses operating agreement (or firm policy) cannot provide for reimbursement. Therefore, it may be a good practice for the firm to actually amend their partnership or operating agreement to explicitly require the partner or member to pay these partnership expenses out of pocket.
The exception to the unreimbursed partnership expenses operating agreement
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 in the unreimbursed partnership expenses operating agreement. 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. Others include tax preparation or the trade or business of being an employee which should also be highlighted in the unreimbursed partnership expenses operating agreement.
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. This is even if the expenses were incurred by the partner or member in furtherance of the organization’s business hence it should be included in the unreimbursed partnership expenses operating agreement. 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 same is also included in the unreimbursed partnership expenses operating agreement.
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:
- the partnership agreement must require the partner to pay such expenses without having a right to be reimbursed;
- the claimed expenses must be able to be substantiated in the case of an audit by the Internal Revenue Service.
Managing the exception to an unreimbursed partnership expenses operating agreement
Careful planning is required to take advantage of this exception. Such is including amending the language of any existing partnership or operating agreement. This provides 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. This includes the heightened requirements for substantiation of automobile travel costs. However, this exception is not available for shareholders of S corporations nor included in some unreimbursed partnership expenses operating agreements. 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 the governing documents I beneficial. It would allow them to take advantage of this exception. It may also be advantageous for the business and the partners.
Deduction of reimbursable expenses by partners at professional services firms
Partners in professional service firms must at times pay for certain firm-related business expenses out of their own pockets hence an unreimbursed partnership expenses operating agreement. For example, a law firm partner may have to personally absorb the costs of entertaining prospective clients who are not on a designated firm-wide list of potential clients for which the firm will reimburse the costs of wining and dining. Also, a partner may incur personal auto expenses to drive to and from client meetings and to and from other locations where firm-related business is undertaken. Some partners also may have to pay for some — or all — of their continuing education expenses. All this is covered in the unreimbursed partnership expenses operating agreement.
The good news is these unreimbursed business-related outlays can generally be deducted on the partner’s personal federal income tax return as agreed in the unreimbursed partnership expenses operating agreement. The bad news is partners cannot deduct expenses that would have been reimbursed if they had turned them into the firm. One Tax Court decision illustrates that point. Here’s what you need to know, starting with some necessary background information.
Partner business expense deduction basics – reimbursable expenses
For federal income tax purposes, a partner can write off unreimbursed partnership-related business expenses included in the unreimbursed partnership expenses operating agreement. Nonetheless, for deductions to be allowed, the expenses must be the type that the partner is expected to pay out of his or her own pocket. This should be within the unreimbursed partnership expenses operating agreement or firm policy. In theory, the unreimbursed partnership expenses operating agreement or policy can be written or unwritten; more on that later.
Of course, only 50 percent of unreimbursed meal and entertainment expenses can be deducted in some instances as prescribed by the unreimbursed partnership expenses operating agreement. The partner should also include the deductible amount as an expense for self-employment tax calculation purposes in the unreimbursed partnership expenses operating agreement. That way the partner receives an SE tax-saving benefit as well as an income tax-saving benefit. This is within the ambit of the unreimbursed partnership expenses operating agreement.
However, partners cannot deduct expenses if they could have turned them into their firms and been reimbursed. In other words, no deduction is allowed for “voluntary” out-of-pocket expenses (consistent with the principle that no-good deed goes unpunished). The best way to eliminate any doubt about the proper tax treatment of unreimbursed partnership expenses is to draft a unreimbursed partnership expenses operating agreement that clearly states what will and will not be reimbursed. That way, the firm’s partners can deduct their unreimbursed firm-related business expenses without any static from the IRS.
References
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