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Originally published on Forbes.com April 15th, 2014

Peter McLauchlan’s recent loss in the Fifth Circuit appealing a Tax Court decision has two important lessons. The first is a clause that should be in almost every professional partnership agreement.  The second is something that brings to mind my favorite review note from those far gone days when we still did many tax returns by hand. RTFI.  That stood for “Read The Instructions”.

RTFI

We’ll tackle the instruction part first, as I suspect that it may have been the source of Mr. McLauchlan’s problems.  Mr. McLauchlan is an attorney and a partner in a partnership that is referred to as AR.  The partnership probably provided him with a K-1 that showed his share of the partnership’s income. The instructions will tell you to put various numbers from various lines of the K-1 on various forms on your 1040.  In all that variety, there will not be an instruction that tells you to put anything on Schedule C.  That did not stop Mr. McLauchlan

McLauchlan had reported income from the partnership on Schedule C, which is used for reporting “Profit or Loss from Business” as well as deductions for business expenses for those years. In support of its claim for increased deficiencies, the IRS argued McLauchlan was not entitled to claim Schedule C profits and losses arising from his partnership at AR. Thus, he was not entitled to the business expense deductions claimed on Schedule C.

Plan B

Mr. McLauchlan had an argument that even though the expenses were not deductible on Schedule C, they were still deductible.

McLauchlan conceded that, due to being a partner at AR, the expenses could not be deducted on Schedule C. He countered that the disallowed Schedule C expenses were properly deductible as unreimbursed partnership expenses on Schedule E, which reports “Supplemental Income and Loss.”

There was a problem with Plan B.

Generally, a partner may not deduct the expenses of the partnership on his individual return , even if the expenses were incurred by the partner in furtherance of partnership business.

There is an exception.

The exception to this rule is where “under a partnership agreement, a partner has been required to pay certain partnership expenses out of his own funds, he is entitled to deduct the amount thereof from his individual gross income.”

The AR partnership agreement had some language that was helpful, but not enough.

 The AR partnership agreement expressly provided that expenses partners incurred for “business meals, automobiles, travel and entertainment, conventions, continuing legal education seminars and professional organizations”—termed “indirect expenses” by the tax court—would be borne by the partner unless approved for reimbursement by the managing partner. The testimony did not demonstrate that AR had a routine practice requiring partners to pay any AR expenses outside the terms of the partnership agreement, contrary to McLauchlan’s assertions. Accordingly, expenses McLauchlan claimed as deductions beyond those identified in the partnership agreement, such as for advertising, contract labor, home insurance, interest, office supplies, utilities, and wages, were expenses McLauchlan chose to incur, rather than ones called for by AR’s partnership agreement. They therefore were not deductible on McLauchlan’s individual tax return.

McLauchlan urges that partners at AR were expected to self-fund various business expenses without reimbursement, including expenses for cellular phones, office furniture, advertising, computers, home office, and a number of other expenditures. The tax court declined to credit McLauchlan’s vague and general testimony regarding expenses he was allegedly expected to incur as a partner without reimbursement. It concluded it was self-serving, unverified, and undocumented and therefore the court was not required to accept it.

The Moral

The AICPA standards of tax practice forbid me from giving audit lottery advice to my clients.  I think I would still be within bounds to say that you are more likely to have problems if you blatantly don’t follow the instructions.  There is a good chance that if Mr. McClauchlan had put his pass-through income and the extra expenses on Schedule E that his return would have sailed through.  The RTFI (READ THE INSTRUCTIONS) maxim is pretty obvious.

The other lesson is more subtle.  It would be a good idea for professional partnerships to look closely at the expense language in their agreements.  Particularly in partnerships with “Eat what you kill” compensation structures, the agreement should be very clear that partners might be expected to spend money on all sorts of things that might not be reimbursed.  Certainly, in regional public accounting where the favored governance model seems to be dictatorial managing partners with varying degrees of benevolence or sociopathy, partners will have a strong factual case that they could not get necessary expenditures approved.  The language in the partnership agreement should be enough, but, in the event, you can always introduce the examining agent to the ogre in chief who will convince the GS-7, that government service has some real upsides.

Lew Taishoff drew another moral from the original Tax Court decision when reflecting on the penalty discussion.

Petitioner is well educated and has been an attorney for over 20 years. He prepared his own Federal income tax returns for the years at issue. Petitioner admitted that he had difficulty preparing his tax returns, yet he failed to seek the assistance of a tax professional.

Takeaway–Hire your tax professional before you get to trial. Hire them even before you do your own return.

You can follow me on twitter @peterreillycpa.