Should Owners and Partners Pay Company Expenses Out of Pocket?

This is a common issue I encounter when working with small business owners. When running a business, it is common for owners or partners to use personal funds to cover company expenses with the idea of sorting it out later. While this may seem efficient, it often creates tax and compliance problems if not handled correctly. The first and best suggestion is simple: the business entity should pay its own expenses directly.

Why Documentation Matters

The Internal Revenue Code and Treasury Regulations establish a clear separation between a business and its owners. Without proper agreements and records, the IRS may:

• Reclassify payments as constructive dividends (IRC §301, IRC §316)

• Deny business deductions (IRC §162; Treas. Reg. §1.162-1)

• Misstate a shareholder’s basis or a partner’s capital account (IRC §705, IRC §1366(d))

IRS Publication 535, Business Expenses reminds taxpayers that only expenses that are ordinary, necessary, and paid or incurred by the business itself are deductible. When owners pay directly, that principle can be compromised.

Treatment by Entity Type

C Corporations

If a shareholder pays expenses on behalf of the corporation:

• They may be treated as a loan (recorded as a liability owed back to the shareholder) or a capital contribution (increasing stock basis).

• If not properly documented, the IRS may treat them as constructive dividends under IRC §301, which are not deductible to the corporation and taxable to the shareholder.

• Proper handling requires either an accountable reimbursement plan (Treas. Reg. §1.62-2) or a written loan agreement.

S Corporations

S Corporations follow similar rules, but with added complexity:

• Shareholder payments can increase stock basis only if properly treated as contributions (IRC §1367).

• Improper handling may distort allocations on Schedule K-1 and affect the shareholder’s ability to deduct losses (IRC §1366(d)).

• A documented reimbursement policy under Treas. Reg. §1.62-2 is the cleanest solution.

Partnerships

Partners paying partnership expenses is particularly tricky:

• A partner may deduct expenses only if the partnership agreement specifically requires the partner to incur them personally. This principle comes from long-standing case law, most notably Klein v. Commissioner, 25 T.C. 1045 (1956).

• If the partnership agreement does not require such payments, the IRS may disallow the deduction and treat the outlay as a nondeductible personal expense.

• While Treas. Reg. §1.162-17 primarily addresses how employees substantiate expenses to employers, its substantiation framework has been applied by analogy in partnership cases. However, the controlling authority remains the case law and IRC §162.

• The safer and more defensible route is for the partnership itself to pay the expenses directly, or to reimburse the partner under an accountable plan.

IRS Publication 541, Partnerships reinforces the importance of maintaining accurate capital accounts and handling expenses in accordance with the partnership agreement.

Required Agreements and Documentation

1. Written Agreements

   • Partnership agreements should clearly specify which expenses partners may pay directly.

   • Corporate board minutes or loan agreements should document shareholder advances.

2. Accountable Reimbursement Plans (Treas. Reg. §1.62-2)
   To avoid taxable reimbursements, expenses must meet three tests:

   • Business connection

   • Substantiation with receipts, logs, or invoices

   • Return of any excess advances

3. Accurate Books and Records

   • Corporations must track shareholder loans and contributions separately.

   • Partnerships must adjust capital accounts and basis properly (IRC §705; Treas. Reg. §1.704-1(b)).

Practical Examples

The best practice is for the entity to pay its own costs directly.

• Travel: Airfare should be purchased with the company’s credit card. If a shareholder pays, they must submit for reimbursement with receipts.

• Supplies: Office supplies should be ordered and paid by the business. If a partner uses personal funds, reimbursement should flow through the partnership’s books.

• Professional Services: Legal and accounting invoices should be addressed to and paid by the business, not by owners personally.

Final Thought

Businesses should pay their own expenses. If owners or partners step in, the transactions must be documented as loans, capital contributions, or reimbursed expenses under an accountable plan. This preserves tax deductions, prevents IRS reclassification, and ensures accurate financial records.

If you want to make sure your entity is handling expenses correctly, whether an S Corporation, C Corporation, or partnership schedule a consultation with me. I focus on the tax side of these issues so you can remain compliant and maximize your deductions.