How to Deduct Partnership Expenses Paid Personally

It is a common occurrence for partners in a business to personally cover operational costs. This situation often arises in service-oriented partnerships, such as law or architecture firms, where partners might pay for expenses out of their own funds. When these business expenses are paid with personal money, the methods for handling these costs for tax purposes depend on the partnership’s own rules and IRS guidelines.

Conditions for Deductibility

For any expense to be considered for a tax deduction by an individual partner, the partnership agreement must explicitly state that partners are required to pay for specific business expenses using their personal funds without being paid back by the company. An expense paid voluntarily by a partner, without such a requirement in the agreement, generally cannot be deducted by that partner.

Beyond the partnership agreement, the expense must also satisfy the IRS standard of being both “ordinary and necessary.” An ordinary expense is one that is common and accepted in your specific trade or business. A necessary expense is one that is helpful and appropriate for your business; it does not have to be indispensable to be considered necessary.

The partnership agreement provides the authority for the partner to incur the cost, while the ordinary and necessary standard ensures the expense has a legitimate business purpose. Without a formal policy in the agreement, the IRS may disallow a partner’s personal deduction, arguing that the expense was the responsibility of the partnership.

Handling Expenses via Partnership Reimbursement

The most common method for managing partner-paid expenses is through a formal reimbursement process established by the partnership, known as an accountable plan. An accountable plan is a set of rules that allows a business to reimburse partners for business expenses without the reimbursement being counted as taxable income. For the plan to be accountable, it must meet three IRS requirements: the expenses must have a business connection, be substantiated within a reasonable period, and any excess reimbursement must be returned.

Using this method, the partnership pays the expense, records it on its books, and claims the full business deduction on its Form 1065 tax return. For the partner, the reimbursement they receive is not considered income and does not need to be reported on their personal tax return. This avoids any impact on the partner’s adjusted gross income or self-employment tax calculations.

The process is initiated by the partner submitting a detailed expense report. This report should include all necessary documentation, such as receipts and logs, to prove the business nature of the costs. The partnership then reviews the report and issues a payment to the partner for the exact amount of the substantiated expenses, creating a clear paper trail.

Deducting Unreimbursed Partner Expenses

When a partnership agreement requires a partner to pay for certain expenses without reimbursement, the partner can deduct these costs on their personal tax return. These are known as Unreimbursed Partner Expenses (UPE). This applies only if the partnership has a formal policy that specific expenses are the partner’s responsibility. If the partner could have received a reimbursement but chose not to, they cannot deduct the expense.

The deduction for UPE is claimed on Schedule E (Form 1040), the same form where the partner reports their share of the partnership’s income from Schedule K-1. The UPE is not treated as an itemized deduction on Schedule A, but as a direct reduction of the income received from the partnership. This lowers the partner’s adjusted gross income and can also reduce their self-employment tax liability.

To report UPE, the partner lists the total amount of the qualifying expenses as a separate line item on Schedule E, directly offsetting the partnership income. For example, if a partner with a required home office incurs $5,000 in deductible home office expenses, that amount would be entered on Schedule E. This reduces their taxable partnership income by $5,000.

Essential Recordkeeping and Documentation

Whether a partner seeks reimbursement or deducts the expenses personally, recordkeeping is required. The IRS requires detailed documentation to substantiate any business expense claimed. This proof is necessary to verify that the expenses were for the amount claimed and directly related to the partnership’s business. Without adequate records, a deduction can be disallowed during an audit.

Required documentation includes items that create a clear financial trail. Partners must keep records such as:

• Original, dated receipts, paid invoices, and canceled checks
• Bank or credit card statements showing the transactions, used to support original receipts
• For business use of a vehicle, a mileage log detailing the date, destination, business purpose, and miles driven for each trip

These records serve as the primary evidence for expense reports or for the UPE claimed on a partner’s Schedule E. The burden of proof lies with the taxpayer, so maintaining organized and complete records throughout the year is necessary to justify all claimed expenses to the IRS.