Partnership Expenses Borne by Partners

Q: How do partners get to deduct the expenses they incur that are unreimbursed by a partnership?
Lisa, Abingdon MD

A: Partners are generally able to deduct partnership expenses they incur under certain circumstances and based on their relationship with the partnership.  Much depends on the activities involved, as well as the liability of the partner...

Basics on this can be found in IRS Publication 541, Partnerships, and the Instructions to IRS Form 1040, Schedule E.

Partnerships generally pass through profits and losses to their partners.  Most of the expenses are paid for by the partnership itself, and what's left has taxes paid on it by the partners themselves.  What happens, though, when a partner personally incurs a partnership expense?

According to the IRS, the first test is if the expense is really not simply a contribution of property, cash, or services in exchange for a greater partnership basis.  In that case, the cost is capitalized, and simply adds to the basis of the partner (thereby lowering any potential capital gain later).

Assuming that is not the case, then these ordinary and necessary business expenses can only be deducted by the partner if he is required to pay them under the partnership agreement.  These are deductible on the Schedule E (where partnership income is reported).  The only exception is when the expense is for an itemized deduction (like a charitable contribution, for example).  In this case, the deduction is taken on the Schedule A with the rest of the itemized deductions.

On the Schedule E deduction, the costs must be split between "passive activities" (where losses are generally suspended to future, profitable years), and "active activities" (where losses are more easily realized).  In either case "UPE" (for "unreimbursed partnership expenses") is written on the line.

If the partner is a general partner (one whose liability is not limited and who generally handles the day-to-day partnership affairs), the unreimbursed expense deduction is a deduction for both income tax and self-employment tax purposes.  If the partner is limited (generally defined as liability-limited and not involved day-to-day), then the deduction (as well as tax owed) is income-tax only.

Partners should not deduct health insurance premium costs using this method.  Limited partners either cannot get a tax advantage, or should arrange to have health insurance provided through an employer.  General partners can take a self-employed health insurance adjustment on the bottom of the 1040.