Thinking about starting a business but not sure how to set it up?  Choosing the right structure can impact your taxes, liability, and future growth.  Two common options—Partnerships and S Corporations—come with their respective advantages and rules.  In this post, we will highlight the key elements of each to help you decide which structure may be the better fit for your business.

What Is a Partnership?

A partnership as a form of doing business is one of the easiest to establish and operate when two or more people are involved.  In this arrangement, each person—called a partner—contributes something to the business, such as money, skills, property, or time.  In return, the contributing partner shares in the business’s profits, losses, and responsibilities.  A partnership offers a flexible structure, depending on the type of partnership formed.

Being a partner in a partnership means sharing the responsibility of running the business, which might otherwise be a too much work for one person.  Operating a business can be difficult, and having a partner or partners means being able to share the load.  Partners can also pool their resources, meaning they can contribute capital, equipment, or even a network that can help the business grow faster.

Partnerships are based on an agreement between the partners. This can be a formal written contract or even an informal verbal understanding, though a written agreement is always recommended and preferred.  This agreement outlines the following:

  • Each partner’s role and responsibilities
  • How profits (and losses) will be shared
  • How decisions will be made
  • What happens if a partner leaves the business

Types of Partnerships

  • General Partnership (GP): All partners share equally in running the business and are personally responsible for its debts.
  • Limited Partnership (LP): Includes both general partners (who manage the business and have full liability) and limited partners (who invest money but have limited liability).
  • Limited Liability Partnership (LLP): Protects all partners from being personally responsible for certain business debts and liabilities.

What Is an S Corporation?

An S corporation is a specific type of corporation that meets certain federal requirements, whereby it elects to be taxed under Subchapter S of the Internal Revenue Code.  The S corporation structure provides the benefit of limited liability protection to its shareholders, like a C corporation, while allowing for the tax advantages of a partnership.

However, not all corporations meet all the requirements to be taxed as an S Corporation, and certain corporations are specifically ineligible to elect S corporation status.  Those that are specifically ineligible include certain financial institutions, insurance companies, Domestic International Sales Corporations (DISCs), and corporations that are members of an affiliated group.

To qualify, the corporation must be a domestic corporation, meaning it must have been created or organized in the United States or under the law of any State.  It cannot have more than 100 shareholders or more than one class of stock.  Shareholders must be individuals, certain trusts, or estates.  Corporations, partnerships, and non-resident aliens cannot be shareholders.

Taxability of a Partnership

Filing federal Form 1065 as a partnership means all the income and expenses are passed through to the partners.  This avoids the double-taxation of a C corporation.  There are fewer tax restrictions than an S corporation has, such as the one-class-of-stock requirement and the strict rules regarding shareholders.  Partnerships can also make special allocations of income and other tax items that pass through to the partners.

One significant downside to filing as a partnership is that active partners are exposed to self-employment tax.  This means 12.4% Social Security tax and 2.9% Medicare tax are applied to the income passed through to those partners.  Higher income taxpayers pay an additional 0.9% of Medicare tax.  However, half of these taxes (6.2% Social Security tax and 1.45% Medicare tax) is also reported as a deduction on the partner’s return.

The partnership itself does not pay federal income taxes directly.  Instead, the partnership passes income, losses, deductions, and credits directly to each partner on federal Schedule K-1, based on the partnership agreement.  This information is then reported directly on the partner’s federal Form 1040.

Taxability of an S Corporation

Compared to a partnership, an S corporation offers specific tax benefits when it comes to self-employment taxes and income taxes.  S corporation owners who actively work in the business can pay themselves a reasonable salary that is subject to payroll taxes.  As such, this income is not subject to self-employment taxes.  This owner salary can also be treated as a business deduction that reduces the net income of the S corporation.  S corporation rules also allow owner-employees to access fringe benefits, such as retirement plans, that are treated less favorably in partnerships.  With these tax benefits, S corporations provide great flexibility with tax planning strategies.

Like a partnership, the S corporation itself does not pay federal income taxes.  Instead, the S corporation passes income, losses, deductions, and credits directly to each shareholder on federal Schedule K-1, based on each shareholder’s respective ownership percentage.  This information is then reported on the shareholder’s federal Form 1040.

Conclusion

In conclusion, both partnerships and S corporations offer distinct advantages depending on the goals and circumstances of the business owners.  Partnerships provide flexibility, simplicity in formation, and pass-through taxation, making them attractive for small businesses that value ease of management and shared decision-making.  S corporations, on the other hand, offer potential tax savings through salary and fringe benefit structuring, as well as limited liability protection that can better shield personal assets.  Ultimately, the choice between a partnership and an S corporation should be guided by factors such as tax strategy, liability concerns, administrative complexity, and long-term growth plans.  Careful evaluation of these considerations can help business owners select the structure that best supports their financial and operational objectives.

 

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The information contained in the Knowledge Center is intended solely to provide general guidance on matters of interest for the personal use of the reader, who accepts full responsibility for its use. In no event will CST or its partners, employees or agents, be liable to you or anyone else for any decision made or action taken in reliance on the information in this Knowledge Center or for any consequential, special or similar damages, even if advised of the possibility of such damages.