Depends. It’s not just the brand of highly-absorbent adult diapers endorsed by Stern Show staffer Richard Christy for use at marathon Coheed and Cambria concerts, it’s also the go-to answer for many a tax professional, and quite often, the only correct one.
For example, assume a partner in a partnership incurs a number of expenses in his individual capacity that relate to the business of the partnership, and are not reimbursed by the partnership. Can the partner deduct the unreimbursed expenses on his individual return?
The answer? Depends. What it depends on, exactly, is whether the partnership agreement requires the partner to use his own funds to pay partnership expenses, without providing for the potential for reimbursement, either formally or in routine practice.
Consider the case of Mr. McLauchlan. McLauchlan was a lawyer, and he earned around $300K each year as a partner in his law firm, AR. In 2005 and 2006, McLauchlan paid various expenses in connection with practicing law at AR, including the following:
- home office,
- meals, entertainment,
- cell phone,
- professional organizations,
- continuing legal education,
- State bar membership.
AR reimbursed McLauchlan for over $60,000 of expenses for each of 2005 and 2006. McLauchlan contended, however, that he paid over $100,000 of AR expenses in each of those years for which he was not reimbursed. He categorized and claimed these expenses on Schedules C.
AR Partnership Agreement
AR had a written reimbursement policy that specifically provided for reimbursement of certain indirect AR expenses, such as lease and rental automobile expenses incurred for client travel, business meals and entertainment and continuing legal education expenses. In addition, as a matter of routine practice, AR would reimburse other indirect AR expenses that were not provided for in the written reimbursement policy, including State bar membership expenses and professional organization expenses.
Generally, a partner may not directly deduct the expenses of the partnership on his or her individual returns, even if the expenses were incurred by the partner in furtherance of partnership business.
An exception applies, however, when there is an agreement among partners, or a routine practice equal to an agreement, that requires a partner to use his or her own funds to pay a partnership expense. In this case, the partner can deduct the expenses, provided he meets any necessary substantiation requirements.
In McLauchlan, since AR provided for the potential for reimbursement — both formally and in its routine practice — of all expenses incurred by McLauchlan in his individual capacity, he was not permitted to deduct the expenses on his individual return.
One to Grow On
Clearly, if a partnership contemplates that a partner will be required to shell out his or her own cash to pay expenses of the partnership, the partnership agreement should expressly provide that no reimbursement will be made, and the partnership should not deviate from that agreement in routine practice. Of course, the partners should also be sure to comply with the substantiation requirements of Section 274 — for example, in deducting expenses related to the use of an auto — to secure the deduction.
McLauchlan v. Commissioner, T.C. Memo 2011-289