When Is a Partner in a Partnership a 1099 Worker?

Situation

We operate a real estate brokerage LLC with four partners. I am the managing partner.

Last October, one of my partners picked up her personal return to be filed and was informed by her new CPA that she could not deduct real estate expenses of any kind on her personal return because she is a member of an LLC.

This hardly seems fair, because we pay the expenses personally for our real estate listings and sales. If the LLC partnership paid the expenses, then the expenses for our listings would be divided among the four partners, thereby reducing all four of our K-1s. Two of the four partners produce the majority of our real estate income.

Question

Can this be correct? We have always deducted those expenses we pay out personally (e.g., photos, advertising, staging items, temporary assistance) from our personal returns after receiving the K-1s from the partnership.

Answer

The CPA’s position is correct in the absence of a partnership agreement or business policy that requires personal absorption of such expenses.

But by the end of this article, you will see that your partner qualifies to deduct her expenses on her Form 1040. And you will also realize that you should reconfigure how you handle this situation for the partnership.

Two Solutions

Your 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.

You deduct the UPE on Schedule E on a separate line in column (i) of line 28, and enter “UPE” in column (a).

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, when one of the partners acts as a real estate sales agent on commission, the partnership would treat that activity as independent contractor activity and report the income to the partner on IRS Form 1099-NEC, Nonemployee Compensation.

Takeaways

The partnership agreement should clearly define how it will treat a partner’s individual production. In general, there are two solutions:

1. Allocate the income to the partner, with the expenses for that activity deducted by the partner as UPE on his or her personal Form 1040, Schedule E.
2. Treat the partner as an independent contractor for that individual production.

Also, based on your prior business practices, you may already have established the income allocation and partners’ ability to deduct individual production expenses as UPE. Even so, we recommend that you amend the partnership agreement to clearly state how it will treat individual partner production.

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