Profit Sharing and Unreimbursed Partnership Expenses

[Vilgan]

Hi all,

Just wanted to clarify something:

If I max out profit sharing when doing business taxes for an LLC (partnership) on our 1065 and my K-1 and then have a bunch of unreimbursed partnership expenses that I include when I file personal taxes, is that okay?

Here are two approaches that make me a bit confused about this:

Approach 1
100k income
20k expenses that are included with the 1065 and then on the K-1
Profit sharing would only be ~20% of 80k, or 16k

Approach 2
100k income
Partnership agreement states the 20k expenses won't be reimbursed
Profit sharing is 20% of 100k, or 20k
Then the partner still gets all those deductions when filing personal, marking those expenses as unreimbursed partnership expenses

Am I understanding these things correctly? It seems like Approach 2 allows for more pretax tax sheltering.

[maizefolk]

Okay this one has me stumped and now I'm curious to know the answer too.

I.A.N.A.A. (I Am Not An Accountant). However, I think that there are some other downsides to turning business spending into unreimbursed business expenses:

You can only deduct unreimbursed expenses to the extent that they exceed 2% of your AGI. Based on your other thread about profit sharing you could have an AGI of around $150k this year, which would mean if you go the non-reimbursable business expense route, you'd end up with an additional $20,000 of business income on paper but only a $17,000 deduction to balance it out. Assuming you're in the 28% tax bracket, that would add $840 to the tax bill. In addition, while the deduction would reduce your income tax liability but it wouldn't reduce your payroll tax liability. You're making enough not to worry about social security, but medicare self-employment taxes would still increase by $580 (20,000*2.9%).

So getting that extra $4,000 dollars of tax deferred space might require paying an extra $1,420 in taxes.

[Vilgan]

The 2% rule is only applicable if reporting on Schedule A, aka if you are a W-2 employee rather than a partner in a multi partner LLC. Some links:

http://finance.zacks.com/can-put-unreimbursed-partner-business-expenses-schedule-a-11645.html

https://ttlc.intuit.com/questions/1267526-where-to-deduct-unreimbursed-expenses-for-a-multi-partner-llc

[maizefolk]

In this case you're obviously beyond my own limited knowledge, but it sounds like you may have discovered an honest to goodness optimization strategy. Only applicable to partnerships where each of the partners are able to spend a portion of the needed expenses of doing business that is approximately equal to their ownership stake in the company (or share of taxible income if the two are different).

Good luck!

[skuzuker28]

Either approach would work, but option 1 would result in more cash in your pocket (assuming all the expenses are your own).

Approach 1:
100k income
20k reimbursement check to you
80k net
16k profit sharing
36 gross cash to you, 16k subject to tax

Approach 2:
100k income
No expenses
20k profit sharing
20k subject to tax, minus the 20k UPE, 0 taxable.  However, net cash to you is also 0 as the 20k income was pre-spent on the 20k of expenses.

[Vilgan]

Either approach would work, but option 1 would result in more cash in your pocket (assuming all the expenses are your own).

Approach 1:
100k income
20k reimbursement check to you
80k net
16k profit sharing
36 gross cash to you, 16k subject to tax

Approach 2:
100k income
No expenses
20k profit sharing
20k subject to tax, minus the 20k UPE, 0 taxable.  However, net cash to you is also 0 as the 20k income was pre-spent on the 20k of expenses.

I'm not sure I understand this. The 100k income is just my portion on a k-1 as are the expenses. It would have been 200k and 40k at the partnership level in this example. If one partner did bear all the expenses, then the agreement can make up the difference in income distribution differences rather than just blindly passing through 50/50 income and 100/0 UPE.

[skuzuker28]

Either approach would work, but option 1 would result in more cash in your pocket (assuming all the expenses are your own).

Approach 1:
100k income
20k reimbursement check to you
80k net
16k profit sharing
36 gross cash to you, 16k subject to tax

Approach 2:
100k income
No expenses
20k profit sharing
20k subject to tax, minus the 20k UPE, 0 taxable.  However, net cash to you is also 0 as the 20k income was pre-spent on the 20k of expenses.

I'm not sure I understand this. The 100k income is just my portion on a k-1 as are the expenses. It would have been 200k and 40k at the partnership level in this example. If one partner did bear all the expenses, then the agreement can make up the difference in income distribution differences rather than just blindly passing through 50/50 income and 100/0 UPE.

If the expenses are equal and the "profit sharing" (Guaranteed Payments?) are equal, then both scenarios will result in the same taxable income.

#1:
100k Income
-20k Expenses
-16k Profit Sharing
=64k taxable income on K-1 box 1
+16k Profit Sharing (in box 4 of K-1)
=80k total taxable income Sch. E pg.2

#2:
100k Income
-20k Profit Sharing
=80k taxable income on K-1 Box 1
-20k UPE
+20k Profit Sharing
=80k total taxable income on Sch. E pg.2

So if everything is equal, then there is no difference from a taxable income perspective.

[Vilgan]

So if everything is equal, then there is no difference from a taxable income perspective.

Eh? Isn't that the whole point of profit sharing is that it is pretax? It might be taxable for a SE tax purposes but shouldn't be for income tax.

It sounds like you are confirming that approach 2 nets out the same but lets you put more in profit sharing though.

[jwright]

The deductions for unreimbursed partner expenses reduce your Self Employment income and your earned income.  The retirement contribution is based on a earned income.

Your pension provider is supposed to take the unreimbursed expenses into account when calculating your contribution amount.  If you do not, you are over contributing for your income level.

Also make sure your partnership agreement is set up properly.  The expenses aren't deductible on your 1040 unless the partnership obligates or requires the partner to pay those expenses on behalf of the partnership.

[skuzuker28]

So if everything is equal, then there is no difference from a taxable income perspective.

Eh? Isn't that the whole point of profit sharing is that it is pretax? It might be taxable for a SE tax purposes but shouldn't be for income tax.

It sounds like you are confirming that approach 2 nets out the same but lets you put more in profit sharing though.

Sounds like there was some miscommunication. :)  When you said "profit sharing" I assumed either Guaranteed Payments or Partnership Distributions.  However, it sounds like you are referring to a contribution to a retirement plan.

In that case, jwright is correct.  The limitations are based off of the net number at the bottom of Schedule E page 2, so the contribution limit is the same in both cases.

[Vilgan]

The deductions for unreimbursed partner expenses reduce your Self Employment income and your earned income.  The retirement contribution is based on a earned income.

Your pension provider is supposed to take the unreimbursed expenses into account when calculating your contribution amount.  If you do not, you are over contributing for your income level.

Also make sure your partnership agreement is set up properly.  The expenses aren't deductible on your 1040 unless the partnership obligates or requires the partner to pay those expenses on behalf of the partnership.

That's helpful, thanks. Partnership agreement is set up correctly, but it sounds like we need to tally UPE before determining profit sharing amounts. Needing to know personal UPE before creating the partnership return does seem a bit backwards tho :)

[jwright]

The deductions for unreimbursed partner expenses reduce your Self Employment income and your earned income.  The retirement contribution is based on a earned income.

Your pension provider is supposed to take the unreimbursed expenses into account when calculating your contribution amount.  If you do not, you are over contributing for your income level.

Also make sure your partnership agreement is set up properly.  The expenses aren't deductible on your 1040 unless the partnership obligates or requires the partner to pay those expenses on behalf of the partnership.

That's helpful, thanks. Partnership agreement is set up correctly, but it sounds like we need to tally UPE before determining profit sharing amounts. Needing to know personal UPE before creating the partnership return does seem a bit backwards tho :)

Well, if you are running the partnership truly as a business there shouldn't be too many unreimbursed expenses.  Ordinary and necessary expenses should be paid from the business bank account.  I've seen a lot of small LLC's that don't truly operate as a business and the partners just use the name and go about the business as individuals.  It delegitimizes the partnership as a trade/business.

[Vilgan]

Well, if you are running the partnership truly as a business there shouldn't be too many unreimbursed expenses.  Ordinary and necessary expenses should be paid from the business bank account.  I've seen a lot of small LLC's that don't truly operate as a business and the partners just use the name and go about the business as individuals.  It delegitimizes the partnership as a trade/business.

The numbers I was quoting were to make the question/potential loophole more obvious, actual UPE way tinier than that. I don't think this "there shouldn't be too many" makes sense tho, as the profit sharing % is still going to be "too much" after factoring in UPE no matter the amount. 100 UPE results in over contributing just like 20k does, assuming the profit sharing was set to max.