It’s common for business owners to pay various expenses from their own pockets. It just may be easy to do. But it can impact who takes the deduction for these business expenses. The entity used by your business dictates this…but you can change the results with reimbursement arrangements.
Impact of your legal entity on deducting out-of-pocket expenses
Say you’re out to lunch with a client and pick up the tab on your personal credit card. What now?
- If you’re a sole proprietor…claim the deduction on Schedule C. The same tax treatment applies if you are an independent contractor or a one-member limited liability company that hasn’t opted to be taxed differently (a “disregarded entity”). The problem here is proving the deduction was a legitimate business expense and not a personal one. Avoid this problem of handling out-of-pocket business expenses by only using a business credit card to pay them and keep your personal finances separate.
- If you’re a partner or a member of a multi-member LLC…claim the deduction as a subtraction on Schedule E of Form 1040 (labeled “UPE”…unreimbursed partnership expense). This can be done only if the owner is required by a partnership agreement or routine practice equal to an agreement to personally pay the expenses on behalf of the business. No deduction can be claimed if the terms of a partnership agreement/LLC operating agreement provide for reimbursement but the owner fails to submit a claim.
- If you’re a shareholder…you can’t take a deduction. Whether you have a regular C corporation or an S corporation, the tax treatment is the same. Before 2018 (and after 2025), you could have taken a miscellaneous itemized deduction for unreimbursed employee business expenses, but not now.
You don’t have to think about deducting out-of-pocket business expenses on your personal return if you have a reimbursement arrangement. For example, a corporation can set up an accountable plan to reimburse owner-employees for out-of-pocket business costs. Be sure the plan comports with IRS requirements:
- Your expenses must have a business connection—that is, you must have paid or incurred deductible expenses while performing services as an employee of the corporation.
- You must adequately account—on an expense account or other statement via paper, electronically, or mobile—to the corporation for these expenses within a reasonable period of time. “Reasonable” means within 60 days the expenses are paid or incurred.
- You must return any excess reimbursement or allowance within a reasonable period of time. “Reasonable” here means 120 days after the expenses are paid or incurred.
Because partners/LLC members aren’t employees, they don’t use accountable plans. But they do use reimbursement arrangements that should be spelled out in partnership agreements, etc. The agreement can get specific about what will or won’t be reimbursed. For example, the agreement may state it will reimburse a partner for all meals and travel expenses incurred on partnership business, but it won’t reimburse a partner for home internet access; this is up to the partnership to decide which costs are reimbursable. As in the case of accountable plans, partners must document their costs and timely submit them for reimbursement.
It’s smart for business owners to use best practices when it comes to business expenses in order to optimize tax write-offs. This means maintaining good records of business expenses, keeping business expenses separate from personal ones, and when in doubt talking to a CPA or other tax adviser.