The tax treatment of unreimbursed business expenses for partners and S corporation shareholders differ. Unreimbursed business expenses are ordinary and necessary expenses incurred by a partner or shareholder which are not reimbursed. Individual partners and shareholders may deduct unreimbursed employee expenses that are:
- ordinary and necessary,
- paid or incurred during the tax year, and
- are for carrying on a trade or business of being an employee.
An ordinary expense is one that is common and accepted in your field of trade, business, or profession. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be required to be considered necessary. Some examples of unreimbursed employee expenses include:
- business liability insurance premiums;
- dues to professional societies;
- work related education expenses;
- legal fees related to your job;
- malpractice insurance premiums;
- tools and supplies; union dues and expenses;
- work clothes and uniforms;
- travel, transportation,
- meals & entertainment,
- gifts and
- lodging related to work.
A partner cannot deduct expenses incurred on behalf of the partnership if the partnership would have reimbursed the partner for those expenses. The IRS has ruled that if, under the partnership agreement or practice, a partner must pay certain partnership expenses out of his or her own funds, he or she can deduct such expenses on the individual tax return. When deductible, these expenses are claimed on Schedule E. The instructions for Form 1040, Schedule E, state that unreimbursed ordinary and necessary partnership expenses paid on behalf of the partnership may be deducted on Schedule E if a partner was required to pay these expenses under the partnership agreement (except amounts deductible only as itemized deductions, which must be entered on Schedule A). Enter deductible unreimbursed partnership expenses from activities on a separate line on Schedule E, Part II with the description “UPE”. If the unreimbursed business expenses are from a passive activity, the passive activity loss limitations are likely to apply. If the partnership agreement specifically states that the partnership has a non-reimbursement policy when expenses are incurred outside of the partnership or that it does not specifically require partners to pay for certain expenses, the deduction may be disallowed at the partner level. The routine practice of the partnership is also considered if there is no direction provided in the partnership agreement.
Deductible unreimbursed business expenses reduce a partner’s earned income from the partnership. Which will also generally, reduce a partner’s earned income for self-employment tax purposes.
S Corporation Shareholders
S corporation shareholders generally cannot deduct unreimbursed business expenses on Schedule E because the shareholders are categorized as employees when performing services for the corporation. These expenses, if not subject to reimbursement from the corporation, are unreimbursed employee business expenses treated as miscellaneous itemized deductions subject to the 2% of the adjusted gross income (AGI) floor. When a corporate officer or controlling shareholder incurs unreimbursed business expenses, the IRS has ruled that they are deductible only by the corporation when they relate to corporate business rather than that of the officer or shareholder.
Whether you are a partner or an S corporation shareholder, you should keep adequate records to support the business expenses eligible for deduction or have sufficient evidence that will support your own statement and tax returns. Written records, such as an account book, diary, log, statement of expense, trip sheet or similar record should be maintained to support the adequate records requirements. Documentary evidence, such as receipts and cancelled checks, that, together with records or logs, will support each element of an expense should also be saved. For example, a hotel receipt is enough to support expenses for business travel if it has all the following information: the name and location of the hotel, the dates you stayed there and separate amounts for charges such as lodging, meals and telephone calls. A canceled check along with a bill from the payee ordinarily establishes the cost. A canceled check by itself does not prove a business expense. A written statement of the business purpose of an expense should also be included.
The degree of proof varies according to the circumstances in each case. Upon examination, the IRS may request additional information needed to clarify or to establish accuracy or reliability of information before a deduction is allowed.