S corp vs. partnership: What are the differences?
Choosing a business structure is a big decision that affects your responsibilities, taxes, and personal liability. Two popular options for US-based small business owners are an S corporation and a partnership. Each comes with its own set of advantages and drawbacks.
This blog post will explain the differences between S corporations and partnerships. We will also provide expert advice to assist you in selecting the best option for your business.
What is an S corporation?
An S corporation is a particular type of corporation recognized under Subchapter S of the Internal Revenue Code. An S corporation is not an entity type but a tax classification: You can not form an S corp, but you can select your business to be taxed as such.
An S corp is a pass-through entity, meaning a business can pass corporate income, losses, deductions, and credits through to shareholders and avoid double taxation on corporate income.
Some states like New Hampshire, Tennessee, and Texas levy taxes on S corporations. Louisiana taxes S corporations similarly to C corporations. However, shareholders can exclude the portion of income they've already paid Louisiana income tax on from their taxable income.
Before deciding on the S corporation tax status, carefully review your state's tax regulations and consult a tax professional.
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Key characteristics of an S corporation
Limited liability protection
S corps provide limited liability protection, meaning the shareholders are not personally liable for the business's debts and obligations. Generally, the company protects your personal assets if it faces legal issues or bankruptcy.
Pass-through taxation
The primary benefit of an S corporation is its pass-through taxation. This means the corporation itself does not pay federal income taxes. Instead, the company's profits and losses are passed through to the shareholders' personal tax returns and are taxed at the individual's tax rate.
Ownership restrictions
S corporations can only have up to 100 shareholders who must be US citizens or residents.
Compliance requirements
S corporations have strict compliance requirements, such as filing articles of incorporation, holding regular shareholder meetings, and maintaining corporate records.
Pro tip. The S corporation structure allows easy ownership transfer as shares can be sold or transferred without changing the company's legal status. However, the growth potential of an S corporation may be limited.
What is a partnership?
A partnership is an entity where two or more people co-own a business and contribute money, property, labor, or skills.
Similarly to S corporations, the Internal Revenue Service (IRS) considers a partnership a pass-through tax entity, meaning all partners share the business's profits and losses and add their portion to their personal income.
Partners might be liable for taxes related to self-employment and projected taxes, whereas the partnership as an entity might be subject to employment taxes and excise taxes specific to its industry.
The IRS assigns partnership as a default tax classification for multi-member limited liability companies (LLCs). However, an LLC can change its tax status to a corporation or an S corporation.
What are the different types of partnerships?
General partnership (GP): In a GP, all partners share equal responsibility for the business's liabilities and operations. A general partnership does not provide any personal liability protection.
Limited partnership (LP): This entity includes general and limited partners. General partners manage the business and assume personal liability, while limited partners contribute capital and share profits but do not participate in daily operations and have limited liability.
Limited liability partnership (LLP): All partners have limited liability protection in an LLP, shielding their personal assets from business debts.
Key characteristics of a partnership
Pass-through taxation
Partnerships benefit from pass-through taxation. This simplifies the tax process and potentially reduces the overall tax burden.
Shared ownership and decision-making
Partners share ownership and decision-making, leveraging each other's skills and resources. This collaborative approach allows for pooled resources and collective decisions.
Varying degrees of personal liability
In a general partnership, all partners share equal responsibility for liabilities. In a limited partnership, general partners have full liability, while limited partners are only liable for the amount they invested. In a limited liability partnership, all partners benefit from limited liability protection.
Flexibility in management
Partnerships offer flexible management, allowing partners to establish their own rules through a Partnership Agreement.
Forming partnerships is relatively easy and requires minimal legal requirements. However, partners have unlimited liability, meaning their personal assets can be at risk if the business has debts. This does not apply to LLPs.
What are the differences between an S corp and a partnership?
Ownership and management: S corps have a complex and formal structure with a board of directors and officers. In contrast, partnerships offer a more flexible structure, which varies based on the type of partnership.
Liability protection: S corps provide limited liability for all shareholders. Liability protection in partnerships depends on the type – general partners have unlimited liability, while limited and LLP partners have varying degrees of protection.
Taxation: S corps and partnerships benefit from pass-through taxation. S corporation owners can receive wages and distributions with different tax consequences. In contrast, active partners in a partnership are subject to self-employment tax on their income.
Compliance requirements: S corps face stricter compliance obligations, including annual reports, regular meetings, and detailed record-keeping. On the other hand, partnerships have fewer formalities, although requirements can vary by state and partnership type.
Flexibility and formation: S corps have higher administrative costs, while partnerships are more accessible to form. This makes them perfect for small businesses with simple requirements.
How to choose the proper structure for your business
Consider your long-term business goals when deciding between an S corp and a partnership. An S corp may be more appropriate if you plan to seek significant investment. A partnership might be a better fit if you value flexibility and simplicity. For instance, many real estate businesses are structured as partnerships.
Evaluate your need for liability protection. If you worry about personal risk, consider forming an S corp or a limited liability partnership for protection.
Tax implications are another critical factor. Compare each structure's potential tax benefits and obligations to determine which aligns best with your financial strategy.
Additionally, consider your administrative capacity. S corps are generally more demanding for small business owners. Partnerships may be easier to manage with their simpler formation and fewer requirements.
Prioritize strategic tax planning and consult with a tax professional to ensure your choices perfectly align with your business goals. At TFX, we bring over two decades of experience guiding businesses through the complexities of tax laws. Since 2001, our tax team has helped small businesses comply with IRS regulations and discover ways to reduce their tax burden.
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Book discovery callFAQ
Yes, S corporations have limited liability. This means that the shareholders of an S corporation are typically not personally liable for the business's debts and liabilities. Their financial risk is limited to the amount they have invested in the corporation.
Yes, an LLC can elect to be taxed as an S corp by filing Form 2553 with the IRS, provided it meets the eligibility requirements. This election allows the LLC to benefit from pass-through taxation while potentially avoiding some of the self-employment taxes associated with LLCs.
Yes, an S corporation can be a partner in a partnership. However, any income from the partnership will flow through to the S corporation's shareholders and must comply with the S corporation's rules and limitations.
S corporations offer limited liability protection to shareholders, shielding personal assets from business debts. They also have an easier transferability of ownership through stock and may provide tax advantages by potentially reducing self-employment taxes.
Partnerships are simpler and less costly to establish and maintain. They offer more flexibility in management and operations, and there are fewer restrictions on ownership and profit distribution. Partners also have direct control over business decisions.
Partnerships are agreements between individuals with personal liability and pass-through taxation. S corporations are separate legal entities with limited liability, pass-through taxation, and restrictions on the number and type of shareholders. S corps also require more formalities like issuing stock and holding meetings.
Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.
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