When the individual production activity of a partner is outside his or her capacity as a member of the partnership, the partnership has two choices:
- Allocate the production income to the partner, and have the partner treat the expenses as unreimbursed partner expenses (UPE).
- Treat the partner as a 1099 independent contractor for the individual production.
Unreimbursed Partner Expenses
As a partner in a partnership, you generally can’t deduct any of the partnership expenses on your individual tax return—the partnership should pay for and deduct its own business expenses.
But if your partnership agreement or business policy forces you as an individual partner to pay for expenses out of pocket, with no reimbursement available, then you can deduct the business expenses in full on your individual tax return as UPE.
Because the UPE is a trade or business expense, it also reduces your self-employment tax.
Treatment as a 1099 Independent Contractor
The tax code is clear on how this works. IRC Section 707(a)(1) states:
If a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.
Thus, under this treatment, you would treat that activity as independent contractor activity and report the income to the partner on IRS Form 1099-NEC, Nonemployee Compensation.
The partnership agreement should clearly define how it will treat a partner’s individual production. If you have questions on how to treat one of your partners, please don’t hesitate to call me on my direct line at (757) 410-8030.