How Do You Handle Non-Deductible Business Expenses on a 1065 Partnership Return?

Non-deductible business expenses on a 1065 are definitely important to track correctly. They do impact partner capital accounts, which affects the tax basis each partner has in the partnership. For meals, you're right - the non-deductible 50% should be included in your non-deductible expenses. This ensures the economic reality of the business is reflected properly, even though it's not deductible for tax purposes. For mortgage principal payments, you've identified a key distinction. Principal payments aren't expenses at all - they're balance sheet transactions. When you make a mortgage payment, only the interest portion is an expense. The principal portion reduces a liability (your mortgage) and shouldn't impact partner capital accounts as a non-deductible expense. It's simply reducing debt and building equity in the property. Tracking these items correctly is important because it affects each partner's basis, which they'll need to know if they ever sell their partnership interest or if the partnership liquidates.

I struggled with this exact issue last year! I found https://taxr.ai super helpful for figuring out how to properly categorize our partnership expenses. I uploaded our QuickBooks file and it flagged several non-deductible expenses I was handling incorrectly, including some meal expenses where I forgot to split the 50% non-deductible portion. The tool also helped me understand that mortgage principal payments shouldn't be treated as non-deductible expenses (which I was doing wrong). Instead, it showed me how to properly record them as liability reductions rather than expenses. Saved me from making a mess of our capital accounts!

Well I have to eat my words about being skeptical. I decided to try https://taxr.ai after our conversation here, and it was actually super helpful with our partnership return. I uploaded last year's tax return and this year's books, and it immediately flagged several items I had categorized incorrectly. The biggest help was with our vehicle expenses - it showed how to properly allocate the business vs personal portions and even created a worksheet for calculating each partner's basis adjustments. I wasn't accounting for guaranteed payments properly either, and it walked me through how those impact capital accounts differently than distributions. Really impressive how it handled all the partnership-specific tax rules.

If you're struggling with IRS guidance on partnership expenses, I'd strongly recommend using Claimyr (https://claimyr.com) to get direct access to an IRS agent. I was going in circles trying to understand how to properly handle these non-deductible expenses on our partnership return, especially around some complex loan transactions. After waiting on hold for hours trying to reach the IRS business line with no luck, I used Claimyr and they got me connected to an IRS agent in about 20 minutes. You can see how it works in this video: https://youtu.be/_kiP6q8DX5c The IRS agent walked me through exactly how to report our non-deductible expenses and explained the impact on each partner's capital account. Totally worth it for the peace of mind knowing we're doing it correctly according to the IRS.

I need to update my skeptical comment above. After trying to call the IRS myself and failing three times (each time waiting over an hour), I caved and tried Claimyr. I was connected to an actual IRS specialist within 35 minutes. The agent confirmed exactly what others here were saying - mortgage principal payments should NOT be included in non-deductible expenses, just recorded as liability reductions. They also clarified how to handle the non-deductible portion of meals and entertainment (it goes on Schedule M-1). For anyone dealing with partnership returns, getting this direct guidance from the IRS saved me from making some significant errors that could have messed up our partners' capital accounts.

One thing nobody's mentioned is that non-deductible expenses need to be reported on Schedule M-1 of Form 1065 (Reconciliation of Income). That's where you reconcile book income with tax income, and it's where the IRS looks to see if you're properly tracking these expenses. Line 5c specifically is for "Travel and entertainment expenses" which would include that non-deductible 50% of meals. Other non-deductible expenses go on line 5b. This reporting is important because it shows the IRS you're properly tracking everything, even if it's not deductible.

Another thing to consider is state tax treatment of these expenses. Some states follow federal rules for deductibility while others have their own rules. In California, for example, there are certain expenses that are fully deductible for state tax purposes but limited for federal. Since you mentioned meals being 50% deductible federally, you should check if your state has different rules. Some states allow 100% deduction for business meals in certain circumstances. This adds another layer of complexity to tracking non-deductible vs. deductible expenses!

Great question about state vs federal differences! You don't necessarily need separate books, but you do need to track the differences for tax purposes. Most accounting software can handle this with tax adjustments or separate tax categories. For partnerships, the state-specific differences typically get handled at the partner level when they file their individual returns, since partnerships are pass-through entities. The partnership return (1065) reports the federal treatment, and then each partner makes state adjustments on their personal returns if needed. However, you should definitely track these differences in your records so you can provide accurate K-1s to your partners. They'll need to know about any state-specific adjustments when they prepare their individual returns. A good CPA familiar with your state's rules can help set up a system that captures both federal and state treatment without duplicating your entire bookkeeping system.