An appeals court recently affirmed the Tax Court's ruling that a partner may not deduct the expenses of the partnership in his or her individual return, even if the expenses incurred by the partner were to further partnership business.
In McLauchlan v. Commissioner, No. 12-60657 (March 6, 2014), the Fifth Circuit Court of Appeals reiterated that general principle. However, the court noted that when under a partnership agreement, a partner has been required to pay certain partnership expenses out of his or her own funds, the partner is entitled to deduct that amount from his or her individual gross income. Furthermore, if a partner has a right to reimbursement and elects not to pursue it, that partner should not be entitled to deduct the expenses.
Peter McLauchlan was a law firm partner who had reported income from his law firm partnership, as well as deductions for business expenses, on Schedule C of Form 1040, which is used for reporting "profit or loss from business." The IRS examined McLauchlan's return and argued that he was not entitled to claim Schedule C profits and losses arising from his partnership and accordingly was also not entitled to the business expense deductions.
McLauchlan conceded that, because of his being a partner at the law firm partnership, the expenses could not be deducted on Schedule C, but he countered that the disallowed Schedule C expenses were properly deductible as unreimbursed partnership expenses on Schedule E, which reports "supplemental income and loss."
The Tax Court (T.C. Memo 2011-289, Dec. 19, 2011) rejected all of McLauchlan's business expense deductions except depreciation expenses and charitable deductions deemed to be deductible flow-through partnership expenses. The court reasoned that those claimed deductions either did not constitute unreimbursed partnership expenses or were not properly substantiated.
In analyzing whether the deductions constituted unreimbursed partnership expenses, the Tax Court reviewed the partnership agreement, which provided for the reimbursement of certain expenses, if those expenses were approved by the law firm's managing partner. McLauchlan failed to present any evidence of those specific expenses for which the partnership had denied him reimbursement. The Tax Court concluded that McLauchlan was not required to pay, without reimbursement, any of the claimed expenses at issue and thus they were not properly deductible as unreimbursed partnership expenses. The Tax Court also assessed accuracy-related penalties.
On appeal, the Fifth Circuit affirmed all of the Tax Court's conclusions and remanded the case solely for the recomputation of McLauchlan's deficiencies and penalties, crediting McLauchlan the depreciation and charitable contribution deductions that were deemed to be deductible flow-through partnership expenses.
The McLauchlan case confirms the longstanding principle that partners do not have free rein to deduct partnership expenses based merely on the fact that they paid such expenses. For a partner to be permitted to deduct partnership expenses he or she paid, the partnership agreement must require the partner to pay such expenses without having a right to be reimbursed.
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