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Maximizing Tax Deductions for Partnership Expenses

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It is common for partners to bear the costs associated with the business of the partnership. This is particularly true in service-based partnerships like architecture or law firms. For instance, partners in service partnerships may have expenses for entertaining clients in order to cultivate new relationships. They may also have expenses for transportation to attend client meetings, professional publications, continuing education, and maintaining a home office. How are these expenses treated for tax purposes? Below, you will find the answers.

What partnership expenses are reimbursable?

Partners can deduct expenses on Schedule E of Form 1040 as long as they are the type that partners are expected to pay without reimbursement according to the partnership agreement or firm policy, whether written or unwritten. However, if the partnership would have reimbursed the partner for the expenses, they cannot be deducted.

In general, the expenses related to a partner’s business in a partnership that are not reimbursed should be considered as deductions when calculating the partner’s net income from self-employment on Schedule SE.

To illustrate, let’s imagine you are a partner at a local architectural firm. According to the firm’s partnership agreement, partners are responsible for covering the expenses associated with seeking out potential new business, unless there are exceptional circumstances where attracting a significant new client is considered a goal for the entire firm. In your efforts to attract new clients this year, you personally spent $4,500 on meal expenses. Unfortunately, you did not receive any reimbursement from the firm. When filling out your Schedule E, you should report a deductible expense of $2,250 (which is 50% of $4,500). Additionally, you should include this $2,250 deduction when calculating your net self-employment income on Schedule SE.

The situation thus far seems favorable, but there is a particular concern to address: a partner is unable to claim deductions for expenses if they could have received reimbursement from the firm. Put simply, deductions are not permitted for “voluntary” out-of-pocket expenses. To ensure clarity regarding the appropriate tax treatment of unreimbursed partnership expenses, it is highly recommended to establish a written policy within the firm that explicitly outlines which expenses will be reimbursed and which will not. By doing so, partners can confidently deduct their unreimbursed business expenses related to the firm without encountering any issues with the IRS.

Home office rules for a partnership

According to the home office rules, a partner is able to deduct expenses related to the exclusive and regular use of a home office for partnership business, subject to the usual deduction limits. The deductible home office expenses incurred by the partner should be reported on Schedule E, similar to other unreimbursed partnership expenses.

If a partner possesses a deductible home office, the home office deduction on Schedule E can provide numerous advantages when it comes to saving on taxes. This deduction is applicable for both federal income tax and self-employment tax, offering multiple avenues for reducing tax liabilities.

Furthermore, if the partner’s deductible home office meets the criteria of being a primary location for conducting business, any mileage incurred while commuting from the home office to temporary work locations related to partnership business (such as client sites) and permanent work locations of the partnership (such as the official office) will be considered as business mileage.

There are two ways to meet the principal place of business test. The first way is if the partner primarily carries out partnership income-earning activities at their home office. The second way is if the partner meets the following criteria:

  • Uses their home office for partnership administrative and management tasks.
  • Does not extensively utilize any other fixed location, such as the official office of the partnership, for these administrative and management tasks.

Establish a clear policy for partnership expenses

When a partner is eligible for reimbursement of business expenses according to a partnership agreement or standard operating procedures, it is crucial for the partner to submit those expenses. Failure to do so will result in the partner being unable to deduct the expenses. On the partnership’s end, it is important for the business to establish a clear and written policy that outlines which expenses will be reimbursed and which will not. This policy should also include home office expenses if applicable. The same rule applies to LLC members who are classified as partnerships for federal tax purposes, as they are considered partners under tax law. Reach out to one of our tax professionals if you have questions about partnership expenses.