How to Deduct Unreimbursed Business Expenses Without Itemizing

Recent tax law changes have gutted many itemized deductions. State and local taxes are limited starting with tax year 2018. What many people are forgetting is that certain miscellaneous deductions and job expenses are also no longer deductible.

Schedule A has suffered many changes. Miscellaneous deductions, subject to 2%, are eliminated. Common deductions in this area include tax preparation fees, safe deposit box fee, legal expenses to protect income, certain job related expenses and unreimbursed employee business expenses.

Most people paid no attention to this area of their tax return because most of these deductions are small even when added together. Since these deductions only count when the total exceeds 2% of AGI, most people received no deduction.

Certain taxpayers made heavy use of these deductions. It’s common for sales people to have large out-of-pocket expenses. Mileage and other travel expenses can add up fast. The only option for these taxpayers is to have the employer reimburse the expenses. The income received from the employer for reimbursed expenses is not reportable income if paid under an accountable plan where the taxpayer provides the employer with evidence of the expense (mileage logs, receipts, et cetera).

Exceptions to the Rule

Unreimbursed business expenses aren’t always claimed on Schedule A. Sometimes the deduction can be reported on page two of Schedule E.

Whereas, the only option remaining for regular employees is to have the expenses reimbursed (or the deduction is lost), small business owners have unique opportunities to claim (and benefit from) all business related expenses.

One-owner firms can easily deduct expenses on the business return since the single owner will want to have a policy of reimbursing all expenses paid for the business.

The problems begin when there are multiple owners.

Partnerships (or LLCs treated as partnerships for tax purposes) can have partners with an office in the home, phone expenses and mileage. These expenses are probably disproportionate among partners. One partner may work on the road in sales while another works from a home office and the remainder working at the company office building.

Partners can disagree as to the amount of deduction that should be reimbursed. One partner may feel the mileage rate is an added benefit to one particular partner since it could contain a non-cash deduction portion. The office in the home might cause friction between partners because the partner with the home office has a more expensive home.

In such situations the partner (if she is a general partner) can deduct unreimbursed expenses on page two of Schedule E. The deduction is reported and listed as “UPE”. Do NOT adjust the K-1. Report the K-1 information from the partner exactly as received. The UPE adjustment listed separately will reduce self-employment tax on Schedule SE automatically.

One final point. To deduct general partner unreimbursed expenses the partnership agreement MUST require these expenses be covered by the partner.

Confusion Accountant’s Sometimes Have with This

This summer a client came in off the street from another tax firm. They deducted expenses exactly as I outlined above with exception of the company reporting as an S corporation.

This does NOT work for regular or S corporations. Unreimbursed expenses, even from shareholders, are considered an unreimbursed “employee” business expense. This means no deduction for 2018 and after or until the tax code is changed allowing the deduction again.

The only way to solve this is to have the company reimburse the expense. The UPE adjustment outlined above is for partnerships ONLY!

For the new client the fix was easy since it was a sole-owner business.

What happened at the previous tax firm was the S corporation filed by the due date which is March 15^th. The individual return was filed later, a normal occurrence since the business return has to filed first to file an accurate personal return. Additional expenses for the business were discovered after the S corporation was filed, but before the personal return was.

Rather than amend the S corporation return (the correct answer), the tax preparer took the deductions on page two of Schedule E. The IRS promptly disallowed the deduction. This brought the taxpayer to my office.

Since the company really reimbursed the expenses it was easily resolved with an amended return. If the error were discovered prior to the due date, plus valid extensions, a superseding return could have been filed. (I’ll have an article on superseding returns this tax season.)

My new client was lucky. He was able to deduct the entire amount through amended returns. However, it could have ended poorly if the circumstances were different.

Planning Tip

Over the years I’ve acquired several rock bands as clients. Once a reasonable level of profitability is reached it usually makes sense for the band to organize as an S corporation, replacing the self-employment tax with FICA taxes on only the reasonable compensation of the owners with the rest of the profits avoiding FICA and SE taxes.

Band members frequently have unreimbursed out-of-pocket expenses, such as: mileage, meal per diems, hotels and repairs and maintenance of their instruments. Guitar players need strings periodically and drummers need new sticks.

Each player is usually responsible for their own instrument purchases. Musical instruments aren’t cheap! And now they can’t deduct the expense on Schedule A as they have in the past.

For bands and similar types of businesses the S corporation may no longer be the preferred method of organization.

Regular corporations pay a flat 21% tax now, while S corporations pass all the profits through to the shareholders where income taxes can rape the shareholder of as much as 29.6%! With the loss of unreimbursed expenses, the S corporation structure may prove, ah, taxing.

The partnership has its place among business structures. The big issue with partnerships is general partners pay SE tax on all their proration of profits, plus guaranteed payments to the partner.

Since general partners are NOT employees, they don’t get a deduction for unreimbursed employee business expenses. And good thing! That avenue evaporated faster than morning mist.

But they do get to deduct unreimbursed partner expenses in full on page two of Schedule E!

Tax professionals have a perfect opportunity this year to earn their keep. More than ever the tax professional must review business client’s data for restructuring of their businesses.

The default for many years was to encourage our business clients to become S corporations (or LLCs treated as such) when profits reached a level where the savings would justify the additional cost.

This is no longer the case. The choice is more than sole proprietor or S corporation. Partnerships and regular corporations are real possibilities for our clients.

My office prepared fewer than 25 regular corporation and partnership returns combined in recent years.  There is no doubt that will change this year!

An honest tax professional will review all the options and present them to her clients. We will prepare more partnership and C corporation returns in the next years than ever in my career.

To do any different would be malpractice.

It’s been a long time since we’ve seen such draconian tax changes. Tax professionals have become complacent in recent years with fewer new opportunities available to save clients money.

This all changed with the TAX CUTS AND JOBS ACT of 2017. This is our moment to shine, tax professionals. We can’t let the public down. We can, and must, do this.

Right, the first time.

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