Unreimbursed Partners’ Expenses (and Paul Bunyan?)
Do I need to live in the U.P. to claim UPE?
Well, that’s not the case at all. So let me tell you the tale of a little known deduction known as Unreimbursed Partners’ Expenses (UPE).
What are we talking about here?
Let’s say Paul Bunyan decides to form a tree cutting partnership with his business friend, Jimmy Crack Corn (and let’s say you do care). Now, Paul lives quite frugally and aside from a new flannel shirt or the occasional new tuque (Canadian stocking cap), he’s happy to conduct business with his axe and his ox Ole Blue pulling the cart. All the while, Jimmy lives a flamboyant lifestyle, enjoying the better things in life such as gas chainsaws and motorized wagons. When these two decide to form a partnership, their attorney puts into the agreement that the partnership will not reimburse partners for any business-related expenses that Paul or Jimmy incur on their own while off doing their thing.
While far out in the woods, Paul finds himself having to pay for axe sharpening, lodging at the local campground (he’s quite a distance away from his normal home), and feed for Ole Blue. Unfortunately, because he incurred those expenses on his own, he can’t submit them to the partnership for reimbursement because his agreement specifically doesn’t allow for reimbursement.
What can Paul do?
He posed this question to the local campground owner, Nel. She states that under the new tax law, employees can’t deduct their unreimbursed business expenses. It looks like Paul might be out of luck and Ole Blue might just have to eat less or forage for himself.
Discouraged but not distraught, Paul decides to walk into town and meet with the local tax professional, Dudley DoGood. Dudley tells Paul he’s not an employee, but rather a partner – and that makes a difference!
It sure does and here’s how you explain it:
A partner can deduct unreimbursed business-related expenses on his or her Schedule E (the same tax form on which the partner’s share of partnership income is reported). To be eligible for this treatment, however, the unreimbursed expenses must be of the kind the partner is expected to pay out of his own pocket per the partnership agreement or firm policy. In theory, the agreement or policy can be written or unwritten (Paul and Jimmy have a written agreement).
The Schedule E instructions direct the partner to report the deduction for unreimbursed expenses on a separate line below the line reporting the partner’s share of income from the firm. The deduction can be described as “unreimbursed partnership business expenses,” or UPE.
If the expenses in question are for meals or entertainment, only 50% of the costs can be deducted on Schedule E.
But let’s be careful! Partners cannot deduct expenses that they could have turned into the partnership for reimbursement. That’s one of the reasons it’s beneficial that Paul and Jimmy had the provision written into their partnership agreement that they couldn’t submit expenses for reimbursement.
For a listing of various reasonable and necessary business expenses Paul might deduct, consult IRS Publication 535, Business Expenses.
You may also wish to consult IRC §162 regarding trade or business expenses and IRC §167 regarding when depreciation deductions are available.
Why is this provision available to partners?
In many ways, a partnership is no more than a collection of two or more self-employed persons. The self- employed can still deduct their reasonable and necessary business expenses (outside of entertainment), so why can’t partners?
So you ask Paul, “Did you keep track of your expenses and hold on to your receipts?” Paul smiles and pulls out a stuffed 50 gallon trash bag as well as a big sheet of butcher paper. On the butcher paper, he has all of his business-related expenses listed and he tells you the huge trash bag is just his back up (you and your staff breathe a sigh of relief).
Calculating your UPE
You compliment Paul (good idea) for documenting his unreimbursed expenses.
You don’t need to attach any documentation to the tax return, but you suggest using a Schedule C and associated forms such as Office Use of Home (Form 8829) to calculate and document Paul’s expenses and keep those notes and forms in your work papers. While you’re only going to be entering a total for all the expenses on Schedule E (as a negative entry), Paul needs to be able to support the deductions he’s claiming.
This strategy will NOT work for corporate clients! With a C Corp or S Corp, you’re not a partner, but rather an employee. And as stated earlier, unreimbursed expenses incurred by an employee are not deductible during the TCJA years.
Also, you will want to make certain your partners have the basis in their partnership interest to deduct expenses, although Dudley would argue incurring and personally paying expenses on behalf of the partnership increases basis…
Two additional impacts of deducting UPE:
- The expense will reduce Paul’s share of the net profit of the partnership and therefore reduce self-employment tax.
- The reduced profit will also reduce Paul’s potential QBI deduction.
by Tom O’Saben, EA