S - Corporations Vs Partnerships - Which is best for your entity?

S-Corporations appear to be the big talk the last few years in the finance and tax world. What is an S-Corp and is it suitable for your business? In some cases, business owner(s) may have to make a decision whether to form an S - Corp or Partnership. Knowing their difference and the costs associated with each are key to making this vital business decision.

S Corporation (S Corp) vs. Partnership:

• S Corporation:

  • Definition: A corporation that elects S status under IRS rules, allowing income, losses, deductions, and credits to pass through to shareholders for tax purposes.

  • Structure: A legal entity separate from its owners (shareholders), with a maximum of 100 shareholders (U.S. citizens/residents, certain trusts, or estates).

  • Taxation: Pass-through taxation—profits/losses reported on shareholders’ personal tax returns (Form 1120S, Schedule K-1). Avoids corporate income tax but requires reasonable salaries for owner-employees, subject to payroll taxes. This is normally where the owner will “pay themselves a salary”. You will need to partner with a company like ADP to pay yourself a salary, withhold applicable federal and state taxes, and ensure compliance.

  • Liability: Limited liability—shareholders are generally not personally liable for business debts or lawsuits.

  • Ownership: Restricted to individuals, certain trusts, or estates; no partnerships, corporations, or nonresident aliens as shareholders. One class of stock only.

  • Management: Managed by a board of directors and officers, with formal governance requirements (e.g., bylaws, annual meetings).

  • Formation: Requires filing Articles of Incorporation with the state and IRS Form 2553 for S status election. This is the form you must submit by March 15th of the tax year you are requesting S - Corp election status for.

  • Advantages:

    • Limited liability protection.

    • Pass-through taxation avoids double taxation.

    • Potential payroll tax savings on distributions (vs. salary).

  • Disadvantages:

    • Strict eligibility rules (e.g., shareholder limits).

    • More formalities (e.g., meetings, records). Will lead to more costs.

    • Reasonable salary requirement for owner-employees.

  • Example: A small consulting firm with 10 shareholders elects S Corp status to avoid corporate taxes while protecting personal assets.

  • Prior to election S - Corp, it is important to speak with your CPA and ensure the cost benefit makes sense. There will be increased filing fees and compliance costs with an S - Corp when compare to a normally Schedule C business filing.

• Partnership:

  • Definition: A business owned by two or more individuals or entities, sharing profits, losses, and management responsibilities.

  • Normally governed by an operating agreement between partners. This is a legal document that outlines the rights, responsibilities, and operational procedures for partners in a business.

  • Structure: Can be a general partnership (equal management/liability), limited partnership (LP, with general and limited partners), or limited liability partnership (LLP, often for professionals like lawyers).

  • Taxation: Pass-through taxation—profits/losses reported on partners’ personal tax returns (Form 1065, Schedule K-1). No entity-level tax. All income typically subject to self-employment taxes for general partners.

  • Liability:

    • General Partnership: Unlimited personal liability for all partners.

    • Limited Partnership: General partners have unlimited liability; limited partners have liability limited to their investment.

    • LLP: Partners protected from personal liability for business debts and other partners’ actions (varies by state).

  • Ownership: Flexible—partners can be individuals, corporations, or other partnerships, with no limit on number or type.

  • Management: Typically managed by partners, with flexibility in structure (per partnership agreement).

  • Formation: Requires a partnership agreement (written or oral) and state registration for LPs/LLPs. No federal election needed.

  • Partners in a partnership normally pay themselves a “Guaranteed Payment” which is similar to a salary. This amount is normally specified in the operating agreement between partners.

  • Advantages:

    • Flexible ownership and management structure.

    • Simple formation (especially for general partnerships).

    • Pass-through taxation.

  • Disadvantages:

    • Unlimited liability in general partnerships.

    • All income may be subject to self-employment taxes. (S - Corp Profits do not pay self employment taxes)

    • Potential for partner disputes without clear agreements.

  • Example: Two freelancers form a general partnership to share profits and losses, managing the business together under a partnership agreement.

Key Differences:

• Liability: S Corps offer limited liability to all shareholders; partnerships vary (unlimited for general partners, limited for LPs/LLPs).

• Taxation: S Corps may save on self-employment taxes via distributions; partnerships typically subject all income to self-employment taxes (except limited partners).

• Ownership: S Corps have strict shareholder limits and eligibility; partnerships are flexible with no restrictions.

• Formalities: S Corps require more formal governance (e.g., bylaws, meetings); partnerships are less formal, guided by agreements.

• Formation: S Corps need state incorporation and IRS election; partnerships require minimal filings (except LPs/LLPs).

Choosing Between Them:

• S Corp: Ideal for small businesses seeking limited liability, potential tax savings, and a formal structure, but with fewer than 100 shareholders and eligible owners.

• Partnership: Suited for businesses with flexible ownership needs, simpler setup, or professional practices (LLPs), but may expose partners to liability or higher taxes. Normally accounting and legal firms with more than one owner are set up as partnerships.