If you own a business taxed as a partnership, you may occasionally pay work-related expenses out of pocket. This raises a common question: Can you deduct those payments on your federal tax return? As with many tax matters, the answer depends on the circumstances.

Deciding Factor

In a nutshell, you can deduct allowable expenses on your Form 1040 as long as you’re required to pay them without reimbursement under the partnership agreement or another written or unwritten policy that’s equivalent to an agreement. By the same token, you can’t deduct an expense if, also under the partnership agreement or otherwise routine practice, the expense is reimbursable by the partnership — even if you choose not to request reimbursement.

Important: These rules also generally apply to members of limited liability companies taxed as partnerships for federal income tax purposes.

For example, let’s say your business’s partnership agreement generally requires partners to bear the costs of work-related meals and other client development or retention activities. In soliciting new clients and keeping existing ones, you spend $8,000 of your own money on meals during the year. Because your partnership’s policy says you won’t be reimbursed for these meals, you can deduct $4,000 (50% of $8,000) because qualifying business meals are generally subject to a 50% deduction limit under current tax rules.

Now suppose you incur an additional $4,000 in allowable vehicle expenses to travel for business-related meetings and another $7,000 in allowable home office expenses (see below). Because the partnership agreement generally states that you won’t be reimbursed for either type of expense, you can deduct a total of $15,000 ($4,000 for meals + $4,000 for vehicle expenses + $7,000 for the home office), assuming you meet all applicable substantiation and other requirements.

Home Office Deduction

Many business partners maintain home offices. You can deduct expenses allocable to the regular and exclusive use of your home office for partnership business, subject to the normal federal income tax limitations that apply to home office deductions. However, you may do so only if you’re required to bear those expenses under the partnership agreement or an established policy or practice.

When your home office qualifies as a principal place of business, mileage between the home office and other locations where you conduct the same partnership business (including client sites and the partnership’s dedicated office) generally counts as business mileage. That can result in bigger deductions under the rules for work-related vehicle use.

Important: Home office and business vehicle deductions can also reduce your federal income tax and self-employment tax (when applicable) — and possibly state income tax as well.

In determining whether your home office is your principal place of business, the IRS generally considers the relative importance of the activities performed at each work-related location and the amount of time spent at each. A home office may qualify based on those factors even if you conduct business elsewhere.

A home office can also qualify as your principal place of business if you use it exclusively and regularly to conduct partnership-related administrative or management tasks and don’t have another fixed location where you conduct substantial administrative or management activities. Examples of such activities include:

  • Scheduling appointments,
  • Writing reports required by management (such as employee evaluations), and
  • Conducting certain management activities (such as determining compensation for partners or employees under your supervision).

You should keep a log of these activities and the time spent on them to help substantiate that your home office qualifies as a principal place of business.

Case in Point

The U.S. Court of Appeals for the Fifth Circuit handed down a 2014 decision that underscored the importance of a partnership’s reimbursement policy when determining whether partners can deduct business expenses they pay personally. In McLauchlan v. Commissioner, the Fifth Circuit agreed with an earlier U.S. Tax Court finding that the IRS had properly disallowed a law firm partner’s claimed deductions for various business expenses.

Under the partnership agreement, partners generally bore expenses for business meals, travel, client entertainment, local transportation and continuing education unless the managing partner approved them for reimbursement. The partnership also routinely reimbursed professional organization and bar membership fees. Because the partner in question could have been reimbursed, he couldn’t deduct these expenses on his personal return.

Make It Clear

The tax treatment of out-of-pocket business expenses for partners largely depends on how the partnership typically handles reimbursement. A clearly written policy can reduce uncertainty by spelling out which costs partners must bear themselves and which the business will reimburse. If your partnership’s policy is informal, outdated or unclear, consider reviewing it with your tax advisor before year end.