Out of Pocket Business Expenses Are Not Always Deductible

Out of Pocket Business Expenses Are Not Always Deductible

How often have you gone to lunch with a prospective business partner, paid for a trade publication, or even incurred travel costs related to your activities in real estate, and paid for these expenses out of your own pocket?

Believe it or not, even if you paid for them, expenses like these may NOT always be deductible to you. Fortunately, with some minor planning you can turn potentially non-deductible expenses into deductible ones.

PARTNERSHIP TREATMENT

Generally, if a partner has paid for expenses on behalf of the partnerships business using his own funds outside the partnership, those expenses are NOT deductible personally by that partner. This applies when the partner is not required to pay for the expenses out of their own funds, or the partnership allows for the reimbursement of the expenses paid by the partner regardless of if the partner requests reimbursement or not.

Luckily there is an exception in which a deduction by the partner is allowed if the partnership:

  1. Requires the expenses to be paid by the partner out of his own funds,
  2. Does not provide for reimbursement of those expenses or the expenses are for costs that are not routinely reimbursed by the partnership, and
  3. This treatment of expenses is an established practice of the partnership.

The easiest way to ensure deductibility under the exception above is by adding a special provision in the partnership agreement that specifically requires the partners to pay for partnership expenditures out of their own funds, and without reimbursement.

 S CORPORATION SHAREHOLDERS

Although the partnership deductibility rules are more favorable, in certain circumstances, S corporation shareholders are also allowed a deduction for expenses paid using their own funds outside the corporation. Unfortunately, a deduction for these expenses is NOT allowed if the taxpayer is a corporate officer or controlling shareholder. In all other cases, these expenses, if not subject to reimbursement, will be deductible subject to the miscellaneous itemized deduction limitations.

However, a deduction can still be preserved if the shareholder is a corporate officer or controlling shareholder by:

  1. Having the corporation reimburse the shareholder, and taking the expense deduction on the corporation tax return, or
  2. Having the shareholder loan the funds to the corporation and having the corporation pay the expenses directly.

If you would like to discuss this in more detail to see how these rules may affect you, or need additional information regarding adding the appropriate provisions to your partnerships agreement(s), please do not hesitate to contact our office at (949) 260-1430.

Written by David Souza, Manager

SKINNER FOUCH & OLSON LLP