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.