Running a law practice costs money, and business expenses are often deductible from one's taxes. But if you've entered into a partnership, as many lawyers do, beware that your partnership agreement could greatly restrict your ability to deduct routine business expenses.
Attorney Peter McLauchlan learned that lesson the hard way. The Fifth Circuit recently ruled against him in a tax dispute after he deducted items that seemed routine (advertising, contract labor, wages) but were not listed as reimbursable in his partnership agreement.
The opinion provides guidance about being vigilant when drafting your partnership agreement, as well as when requesting reimbursement from your firm.
Partnership Agreement Is Determinative
The AR partnership agreement specifically provided for expenses McLauchlan was required to incur. Any additional expenses McLauchlan chose to incur, such as those for advertising, contract labor, home office, or supplies, are not deductible as partnership expenses. Further, AR's reimbursement practices show that the remainder of McLauchlan's expenses, ones he was required to incur, were all reimbursable per AR's liberal reimbursement policy.
Contract labor? Office supplies? These are common expenses for any partnership, likely covered by a partner, but not provided for in this particular partnership agreement. The one exception to the rule that partnership expenses aren't deductible is where "under a partnership agreement, a partner has been required to pay certain partnership expenses out of his own funds."
That, right there, is the lesson folks: Your partnership agreement governs for tax purposes. If the agreement provides for reimbursement, it is seen as a required expense for which you should seek reimbursement, not a deduction.
If it doesn't provide for reimbursement? Even if it seems like a common-sense expense, like contract labor, the IRS is going to classify those expenses as voluntary and therefore not deductible. Draft accordingly.
If It's Reimbursable, It's Not Deductible
The general rule is that an expense is deductible if the partnership agreement requires the partner to "bear the ... unreimbursed expenses out of his personal funds." Laziness, therefore, is no excuse:
"[I]f a partnership agreement provides for reimbursement of an expense, it is not one a partner is required to bear out of his own funds," the per curiam panel noted. "Additionally, if a partner has a right to reimbursement and does not elect to pursue it, that partner should not be entitled to deduct the expenses."
In other words, request reimbursement early and often.
- McLauchlan v. Commissioner of Internal Revenue (Fifth Circuit Court of Appeals)
- Supreme Court Overturns 5th Circuit Tax-Shelter Decision (FindLaw's U.S. Fifth Circuit Blog)
- Texas Arbitration Agreements Can Be One-Sided and Legal (FindLaw's U.S. Fifth Circuit Blog)