Negligence penalties for nondeductible, unreimbursed partnership expenses on individual returns.

• Author: Kozenko, Elizabeth E.

Clearly, taxpayers cannot deduct expenses paid on behalf of another on their individual returns. In Michael T. Hines, TC Suture. Op. 2004-55, the Tax Court expanded this principle to include a partner and his partnership. The court did not allow the taxpayer to deduct expenses on his Form 1040 he incurred and paid that were directly related to the business of the partnership of which he was a member. The taxpayer argued that his reportable income from the partnership should be reduced by unreimbursed partnership expenses. However, according to the Tax Court, unless an agreement between a partnership and a partner states otherwise, a partner cannot deduct expenses incurred on the partnership's behalf on his or her personal return.

Laws and Regs.

Sec. 162 provides for the deduction of ordinary and necessary expenses incurred by a trade or business. Under Regs. Sec. 1.162-1(b)(7) and Temp. Regs. Sec. 1.67-1T(a)(1), an employee can deduct unreimbursed employment-related expenses as an itemized deduction, to the extent they exceed 2% of the employee's adjusted gross income (AGI). According to Temp. Regs. Sec. 1.67-1T(a)(1)(i), such expenses include transportation, subscriptions to professional journals, continuing education, professional dues, entertainment, supplies, etc., as long as they meet Sec. 162's "ordinary and necessary" requirement.

For Sec. 162 purposes, an "ordinary" expense is one that is normal, customary or usual for a business. A "necessary" expense is one that is appropriate and helpful for the trade or business. Ordinary and necessary expenses also have to be reasonable, depending on the facts and circumstances. Thus, a taxpayer cannot deduct expenses paid on behalf of another, because they are not ordinary and necessary to the taxpayer.

Hines

On his 2000 individual return, the taxpayer reported $16,122 of partnership income on Schedule E, which was $33,415 less than the income shown on the partnership's Schedule K-1. Hines underreported his partnership income by netting his unreimbursed expenses against the partnership's flowthrough income.

The Service determined a $9,500 tax deficiency and a $1,897 accuracy-related penalty. The taxpayer conceded that he should have reported the full Schedule K-1 income on his Schedule E; however, he argued that he was entitled to a Sec. 162 deduction for the unreimbursed expenses attributable to the partnership income.

As discussed above, Sec. 162 does not allow a taxpayer to deduct expenses...