I've recently started an online photography business (LLC) with a
partner. Common expenses and profits are shared 50/50 and both
partners maintain home offices. Since we're small, we do not maintain
a checking account balance--we just purchase supplies out of pocket
and keep the receipt. We have agreed that most expenses will be shared
(web site, advertising, taxes/fees, photo studio equipment), but there
are also business-related expenses that only one of us use, or that
are discretionary (new camera lens, new computer for home office,
camera bag, etc). We've decided that these disretionary expenses,
although counted as business expenses for tax purposes, will be paid
solely by the partner who purchases them.

To account for this, we've been tracking expenses in a spreadsheet and
noting who paid for each one, and whether the expense was shared or
belonged to one of the partners. We then keep a running total of who
has contributed shared business expenses and we "true-up" (split the
gap) occasionally when one partner has been contributing more than the
other. We then add those discretionary expenses that each partner has
incurred to determine each partner's expenses for tax purposes. For
example, if Partner A paid $1,000 for the web site (shared) and 
Partner B purchased a $1,000 lens for his camera, Partner B would give
$500 to Partner A to "true-up." The business logs $2,000 in expenses,
but (assuming $0 income), Partner B would show $1,500 loss on his
taxes and Partner A would show $500 loss.

Up to this point, the spreadsheet has worked OK, but we really want to
formalize our accounting for reporting, tax purposes, etc. How should
we account for this? The best idea I've heard so far would be to show
each purchase as a cash expense to the business, and then 'reverse'
the cash expense by crediting cash and debiting a partner's equity
account. For example, assume Partner A purchased a new lighting system
for the studio and needs to be reimbursed later by Partner B for his
half:

Studio Equipment (Shared)          $1,000
        Cash                       $1,000
Cash                               $1,000
        Partner A Equity             $500
        Partner B Receivable         $500

Then when partner B pays Partner A the $500, we would record:

Partner B Receivable                 $500
        Partner B Equity             $500

Similarly, a purchase of a camera lens for Partner B's camera would
simply be recorded as:

Camera Lens          $1,000
   Cash              $1,000
Cash                 $1,000
   Partner B Equity  $1,000

Although it seems convoluted, this system gave a nice way to see how
much each partner had contributed, and which partner owed $$ to the
other (by looking at the Partner Receviable accounts).

However, this system presents a problem in that if one partner starts
to purchase discretionary equpment (new camera, new computer for home
office), their Equity account is inflated and it appears (on the
books) that they have more ownership in the company when in fact
everything is really shared 50/50.

Also, a CPA friend has suggested that we should not track
inter-partner IOUs through the business accounting system, and thus we
should get rid of the aforementioned "Partner Receivable" accounts and
just show each partner contributing equally to shared expenses, then
keep track of the IOUs elsewhere (spreadhseet, back of envelope, etc).
I'd like to have it all in one system if possible though.

Could someone suggest the proper way for us to account for this? We
need an accounting system that provides the following:
1) Tracks each individual's contributions to the business so that we
can properly "true up" when contributions become uneven (share
expenses 50/50).
2) Allows us to properly reflect each partner's cash input for tax purposes.
3) Does not skew the ownership of the LLC by inflating a partner's
equity account when they equip their home office, etc.

This must be a common problem among small businesses, so I'd like to
hear from someone who keeps books for businesses like ours. I have not
been able to find a good solution by searching online, so am not
looking for someone to do research via Google.

Here's how I did it with my partnership(s) with the same situation. 
For each expenditure, be it an expensible item or a capitalizable
item, those are of course debited.  For the credit (or source of funds
side of these entries), I credit them to what I call the "Master
Capital Account".  For example, purchase of supplies; an expense.

$100    Debit    Expense: Supplies
$100    Credit   Master Capital Account

I don't see the need to credit cash and add an unneeded step as you
suggest above.  In fact, this can be misleading b/c it's not
"partnership cash" that's being spent.  Since these expenditures by
the partners are otherwise expensible by the partnership, they are
expenditures by the *partners* and not the partnership and should
simply be contributions of capital to the partnership from the
partner.

I record these entries in Quickbooks and throughout the year I keep a
separate spreadsheet that keeps track of how much of each expenditure
should be paid by each partner (we have 3).  At the end of the year, I
make an adjusting entry from this Master Capital Account to each of
the partners in the right proportion.  Let's say Partner A is
allocated 40% of the expense and Partner B 60%.

$100    Debit   Master Capital Account
$40     Credit  Partner A
$60     Credit  Partner B

Perhaps a more direct way of doing this would be to allocate each and
every transaction to each partner when the entry is being made rather
than running them through the Master Capital Account.  THe problem is
with our partnership, we do not know the split until the end of the
year.  With yours, it sounds like you do know.  So, you could simply
Debit the Expense and Credit the Partner's capital account for each
expenditure.

Hope that helps.

Other things to keep in mind.  You say above: 
2) Allows us to properly reflect each partner's cash input for tax purposes.
There really isn't any tax implication for cash contributions or
distributions (not until you sell, liquidate or close down the
partnership).  Taxes have to do with profit and loss, not with
contributions and distributions.

This other issue you have is tougher.
3) Does not skew the ownership of the LLC by inflating a partner's
equity account when they equip their home office, etc.

I don't have a good answer for it.  The thing is, if a partner is
spending money on something and you want to count it as a partnership
expense then it's a *partnership* expense.  So it should be run
through the partnership and in doing so, the partner's capital account
increases.  What you can do though is take advantage of one of the
advantages of LLC's and that is to allocate profits/losses in a
different ratio than capital contributions.  Do some searches on this
to see what I mean.