Allowable Partnership Deductions for a Business

A partnership is a legal relationship where two or more individuals join to conduct a business, with each member sharing in the profits and losses. For federal tax purposes, partnerships are “pass-through” entities, meaning the business itself does not pay income tax. Instead, it passes its financial results directly to the partners.

The partnership files an annual information return, Form 1065, U.S. Return of Partnership Income, which details its income and deductions. From this return, it prepares a Schedule K-1 for each partner, allocating a portion of the partnership’s financial items to that individual. Partners use the information on their Schedule K-1 to report their share of the business’s income or loss on their personal tax returns.

Deductible Ordinary and Necessary Business Expenses

A partnership can deduct expenses that are both “ordinary” and “necessary” for its trade or business. An ordinary expense is common in that field, while a necessary expense is helpful and appropriate for the business. These deductions are claimed on Form 1065 and are subtracted from the partnership’s gross income.

A primary category of these deductions includes salaries and wages paid to non-partner employees. The partnership’s share of employment taxes, such as Social Security, Medicare, and federal unemployment (FUTA) taxes, are also deductible. Payments made to partners are treated differently.

Rent or lease payments for property and equipment used in the business, such as office space, machinery, and vehicles, are another deduction. The cost of utilities like electricity, water, and internet service for the business premises is also fully deductible, along with expenses for office supplies.

Other deductible expenses include:
Premiums for business insurance, such as general liability, professional liability, and workers’ compensation.
Professional fees paid for services from lawyers, accountants, and consultants.
Business-related travel expenses, including airfare, lodging, and a portion of meal costs.
Interest paid on business loans, repair and maintenance costs, and bad debts that have become worthless.
Depreciation, the annual deduction for the cost of business assets like buildings and equipment, is calculated on Form 4562.

Understanding Separately Stated Items

Not all deductions are subtracted from the partnership’s ordinary business income. Certain items are kept separate and passed through directly to the partners on their Schedule K-1. This special treatment is because these items are subject to rules and limitations at the individual partner level, meaning their deductibility depends on each partner’s unique tax situation.

A common example is a charitable contribution made by the partnership. The partnership does not take the deduction. Instead, each partner’s share of the contribution is reported on their Schedule K-1, and the partner combines this amount with their personal contributions, subject to limitations on their individual Form 1040.

Another separately stated item is the Section 179 deduction, which allows a business to expense the full cost of qualifying equipment in the year it is placed in service. The partnership elects to take the deduction, but the limit on the amount that can be expensed is applied at both the partnership and the individual partner level.

Investment interest expense is also a separately stated deduction. This is interest paid on money borrowed to purchase investments. The partnership passes this expense to the partners, who can only deduct it on their personal returns to the extent that they have net investment income.

Guaranteed Payments and Partner Expenses

Guaranteed payments are payments made to a partner for services or for the use of their capital, calculated without regard to the partnership’s income. For instance, a partner might receive a fixed salary for managing the business. The partnership treats guaranteed payments as a deductible business expense, which reduces the ordinary income distributed to all partners. The receiving partner must report the guaranteed payment as ordinary income, which is also subject to self-employment taxes.

Partners sometimes pay for business expenses out of their own pockets, known as Unreimbursed Partner Expenses (UPE). For a partner to deduct these expenses, the partnership agreement must require the partner to pay these specific expenses personally. Without this provision, the IRS considers these payments to be nondeductible personal expenses. If the requirement exists, the partner can deduct the UPE on their Schedule E (Form 1040), reducing their taxable income from the partnership.

Limitations on a Partner’s Ability to Deduct Losses

Receiving a Schedule K-1 with a reported loss does not guarantee a partner can deduct the full amount. A partner’s ability to deduct their share of partnership losses is subject to a series of limitations applied at the individual level. Any loss disallowed by one of these limitations is suspended and carried forward to future years, where it can be deducted if the partner meets the necessary requirements.

Basis Limitation

A partner cannot deduct a loss that is greater than their adjusted basis in their partnership interest. A partner’s basis starts with the amount of money and property they contributed. It increases with their share of partnership income and additional contributions and decreases with distributions and their share of partnership losses.

At-Risk Rules

These rules prevent a partner from deducting losses that exceed the amount they are personally “at risk” of losing. An amount at risk includes the money and property a partner has contributed and their share of certain partnership debts for which they are personally liable. A partner is not considered at risk for amounts protected against loss through nonrecourse financing or other similar arrangements.

Passive Activity Loss Rules

The passive activity loss rules apply to partners who do not “materially participate” in the business. If a partnership activity is deemed passive for a partner, their losses from that activity can only be used to offset income from other passive activities. Any excess passive loss cannot be used to reduce nonpassive income, such as wages or portfolio income.