Deducting Out-of-Pocket Partnership & S Corporation Expenses

Many businesses are operated as tax partnerships and S corporations, including limited liability companies treated as one or the other.  These entities are known as “flow-through” or “pass-through” entities, meaning that the entity’s items of income and deduction are reported on the owners’ personal tax returns via Schedules K-1.  A tax advantage of pass-through entities is the ability for the owner to deduct losses (depending upon tax basis and participation levels) and to avoid double taxation on income and gains.  Sometimes owners will incur unreimbursed expenses relating to their work in the business.  Since the business is operated as a pass-through entity, may the owners claim their unreimbursed expenses as deductions in addition to the amounts reported from Schedule K-1?

Partnerships

In order to deduct an out-of-pocket expense, the regular deduction rules must first be met:  the expense must be incurred in a trade or business and the expense must be ordinary and necessary in nature.  Next, the partnership agreement must be examined.  If the agreement provides for the reimbursement of business expenses incurred directly by the owner, then the owner may not deduct the unreimbursed expense.  In this case, the owner should seek reimbursement so that the partnership may deduct the expense.  If the expenses are of a nature that the owner is expected to pay without reimbursement, then the unreimbursed expenses may be deducted.  It is best that the partnership agreement state that the partners are expected to bear their own expenses without reimbursement such as, for example, expenses incurred to develop or market their business.  Tax form instructions require that deductible unreimbursed expenses be reported on a separate line from the K-1 information.  Note that as a partner, these expenses will be deducted on Schedule E instead of Schedule A.  Schedule A is used by employees and a partner is not considered to be an employee for tax purposes.  A Schedule E business deduction is much more favorable tax-wise than a Schedule A itemized deduction.  In addition to reducing taxable income, such expenses may also reduce self-employment income tax.

S Corporations

Unlike for a partnership, an owner working in an S corporation is considered to be an employee.  Therefore, unreimbursed expenses that are not reimbursable by the corporation may not be deducted on Schedule E even though that is where the K-1 information is reported.  Instead, the expenses must be reported on Schedule A as a miscellaneous itemized deduction.  The Schedule A deduction does not result in income tax savings until total miscellaneous itemized deductions exceed 2% of adjusted gross income.  Furthermore, miscellaneous itemized deductions will not save any income taxes if the owner is subject to the alternative minimum tax.  For these reasons an owner-employee should seek reimbursement from the S corporation so that the business expenses can be deducted by the corporation against business income, thereby avoiding the tax limitations on unreimbursed business expenses.

What is Longevity Insurance?

Longevity insurance, also known as a longevity annuity or a deferred income annuity, is a risk-shifting tool to insure against the risk of outliving your retirement assets.  The risk of outliving retirement assets has become a very real possibility given increasing life expectancies and the decline of employer-provided defined benefit retirement plans.  With longevity insurance, you invest a lump-sum of money now with the objective of waiting for many years (e.g. until age 85) before receiving a stream of payments for the rest of your life.  If you die before the starting date, your heirs receive nothing.  Requesting a payback guarantee so your heirs receive back your investment if you die early will significantly reduce the annuity payment, defeating some of the benefit of the longevity policy.  The objective is to provide an enhanced income stream in your old age when much of your retirement assets may have been depleted.  So in a sense, longevity insurance is like any other insurance policy that pays when some event occurs, such as a car wreck, a fire in your home, etc.  But with longevity insurance, the event is living to a certain age.

The fact that not everyone lives to old age enables the insurance company to pay a fairly high amount in relation to the premium.  The longer you wait to receive the annuity the higher the payout.  However, you must remember that the stated benefit is in future dollars, meaning that the real purchasing power of the annuity will have been reduced by inflation.  For example, assuming a 3% inflation rate, today’s dollar will only buy 55 cents worth of goods and services in 20 years.  Some policies provide an inflation adjustment for an additional premium payment.

Who should consider a longevity annuity?  A person in their 50’s or 60’s who is in good health.  A person having family members who lived to an old age.  Those who have sufficient retirement assets and Social Security or other pension benefits and can afford to make the lump-sum premium payment and wait until the annuity begins.  On the other hand, longevity insurance doesn’t make financial sense for those persons with sufficient money that the risk of outliving their retirement funds is remote.

Generally no more than 10% to 25% of retirement assets would be placed in longevity insurance.  The money paid in is generally not accessible to you during the time period before payout.  The payout amount depends upon your age and upon interest rates at the time of purchase.  The younger you are when purchasing the policy, the higher the future payout.  The higher interest rates are at the time of purchase, the greater the future payout.

Only financially sound and historically stable insurance companies should be considered for this type of policy.  If the insurance company were to fail before you receive your benefits, you would receive nothing or only some amount from the state insurance guaranty fund.  For this reason, it makes sense to use more than one insurance company in order to reduce the risk of loss if an insurance company goes bankrupt.  Longevity insurance policies are relatively new to the financial landscape, and it is anticipated that the policies will improve once more competition arrives.

In the past, purchasing a longevity annuity in an IRA or 401(k) plan has been problematic because of the start of the required minimum distribution (RMD) rules at age 70 ½.  If the RMD isn’t distributed on time, a 50% penalty applies.  Since the longevity annuity doesn’t typically start paying until well after the age of 70 ½, this financial product didn’t fit well within these plans.  However, the government just issued new regulations permitting IRA owners and 401(k) plan participants to invest in qualifying longevity annuity contracts (QLAC) inside their retirement accounts without having to worry about the RMD rules.  In essence, the value of the QLAC is removed from the year-end account value used each year in calculating RMDs.  However, the regulations limit the amount that may be invested in a QLAC to 25% of the account balance or $125,000 whichever is less.  The QLAC must be a fixed annuity but may be adjusted for inflation.  The $125,000 ceiling will be adjusted for inflation in $10,000 increments.  The 25% limit for IRAs is applied by aggregating the account values of all traditional IRAs as of December 31^st of the year before the year the premium is paid.  The QLAC must begin payout no later than age 85.  Each spouse can have his or her own QLAC without impacting the limitations on the other spouse’s IRA or 401(k).  Because Roth IRAs are not subject to the RMD rules during the account owner’s lifetime, there appears to be no limitation on the amount or percentage of a Roth IRA that can be used to purchase a longevity annuity.