IRS acknowledges partner expenses.

In Letter Ruling (TAM) 9316003, the IRS has acknowledged the validity of allowing partners to deduct business expenses incurred on behalf of their partnerships against partnership income in arriving at adjusted gross income. The facts and holding of this ruling are very similar to the decision in Klein, 25 TC 1045 (1956). In both the ruling and in Klein, a partner incurred business travel and entertainment expenses on behalf of the partnership. In the ruling, the partnership had previously had a partnership agreement that was silent as to partner expenses and reimbursements. The partnership agreement was later amended to specifically state that partners could not seek reimbursement from the partnership for such expenses but would be required to pay those expenses out of their own pockets. Prior to this amendment, the partnership's established practice was that it would not reimburse these expenses.

The court and the Service now agree that although partners are not in the trade or business of the partnership, ordinary and necessary business expenses incurred by a partner on behalf of the partnership, when those expenses are not to be reimbursed by the partnership, are very similar to a special allocation of expenses to a partner via the partnership agreement. Since the substance would be the same, the deduction of actually incurred expenses by the partner is consistent with the rationale of special allocations of such expenses had the partnership paid those expenses on the partner's behalf.

Since case law had previously sanctioned this treatment, the letter ruling, although generating much interest in the business community, merely restated what was already thought to be the law. Taxpayers now, however, should feel comfortable deducting these expenses on Schedule E without fear of IRS challenge.

The ability to deduct these expenses directly against partnership income "above the line" may be significant. Most obviously, if such expenses were deemed to be miscellaneous itemized deductions (as the ruling implied), they would be subject to a 2% floor requirement and, if significant in amount, could create alternative minimum tax complications. Also, depending on the tax structure of a particular state, the deduction "above the line" could create a tax benefit not available for itemized deductions.

Another significant aspect of being able to deduct these expenses above, the line is that income from self-employment will be reduced by these expenses, similarly reducing self-employment tax. It should be noted, however, that this can be a double-edged sword. In addition to reducing self-employment income for purposes of computing self-employment tax, the expenses also would appear to reduce income from self-employment for purposes of computing the partner's deductible qualified plan contribution. In some situations this may become a qualification issue for the plan as a whole with respect to all partners.

Typically, a partnership that sponsors a self-employed plan will calculate the amount of the deductible contribution by using the percentage of income of the partner from the entity. If a partner is in a separate trade or business outside of the partnership, this will not affect the calculation of the qualified plan contribution. However, if expenses from that trade or business are deductible on a partner's tax return, self-employment income will be reduced with respect to that trade or business. For a partnership contributing the maximum amount to the self-employed plan, a reduction of a partner's self-employment income may cause a violation of the Sec. 415 limits and the plan as a whole may find itself disqualified.

One way to prevent this would be for the partnership to pay all these expenses and specifically allocate those deductions to the partner incurring them. Barring this, the partnership may either ask its partners to certify to the partnership the amount of expenses that they plan to deduct on their personal tax returns prior to the partnership's contribution to the plan, or require that partners not deduct such expenses on their personal tax returns.

Some taxpayers in reading this letter ruling may try to analogize the treatment of expenses for partners to S shareholders. It does not appear as though this analogy can be properly made. Ordinarily, shareholders who are active in an S corporation's trade or business are treated as employees. The S corporation flowthrough income is not self-employment income subject to the self-employment tax (Rev. Rul. 59-221). Distributions from the corporation to employee shareholders generally are treated as wages subject to FICA and other payroll taxes. As a consequence, any expenses incurred by an S shareholder on the corporation's behalf that are not reimbursed by the corporation are ordinarily treated as miscellaneous itemized deductions subject to the 2% floor.

While this letter ruling is significant, it does not appear to make new law. Partners desiring to deduct expenses incurred on behalf of a partnership on their personal tax returns should be sure that the partnership does not allow these expenses to be reimbursed by the partnership. It would be best to have such a provision in the partnership agreement but an established partnership practice should suffice.