S Corporations vs Partnerships

Are you interested in starting a new business? Or have you been asked to be part of a new business? There are many things to consider when choosing to embark on the path of business ownership. An important decision is whether your business will be an S corporation or a partnership. There are many different factors to take into account, and this article will help outline the similarities and differences between S corporations and partnerships.

An S corporation, also known as an S subchapter, is a closely held corporation that does not, in general, pay federal income taxes. Instead, shareholders of an S corporation split the income and losses and claim this on their personal tax returns. An S corporation has 100 shareholders or less and therefore receives the benefit for being an incorporation but is taxed as a partnership.

A partnership also does not pay federal income taxes, and is an arrangement between two or more individuals, businesses, or organizations that oversee business operations and share profits and losses. From a legal perspective, a partnership is not a separate entity from the individual owners. Federal income tax is divided among the partners who pay income tax on their individual tax return.

Similarities Between an S Corporation and a Partnership

There are two main similarities between an S corporation and partnership.

Ownership

 Both S corporations and partnerships are owned by more than one person.

            Pass-Through Entity

Federal business income tax is not applied to S corporations or partnerships. Instead, all co-owners report their portion of the business’s profits and losses on their personal income tax return.

Differences Between an S Corporation and a Partnership

While an S corporation and partnership sound similar based on their definitions, there are specific differences that account for why one is selected for a business over the other.

Formation and Paperwork

An S Corporation requires you to file Articles Of Incorporation and IRS Form 2553, which must be signed by all shareholders.

A partnership does not have a formal business structure, so there aren’t guidelines to follow and paperwork is not required.

Transfer of Ownership

S corporations have specific rules for ownership changes, and generally require the selling of shares from one stockholder to another. However, there are no tax consequences when ownership is transferred in an S corporation.

Since a partnership doesn’t have a formal business structure, there aren’t rules for ownership changes. Additionally, partnerships are not limited to people, and instead may include businesses, organizations, etc. The downside is that if more than 50% of the interest is transferred in a partnership, it could result in termination of the entity.

            Structure Flexibility

Shareholders of an S corporation must elect a board of directors (director, president, treasurer, secretary) who are responsible for drafting and approving bylaws. The board must meet with shareholders at least once a year. Documentation of all shareholders’ capital contributions, stock certificate issuances, and share transfers is required.

Again, since a partnership does not have a formal business structure, it can be structured however the partners choose.

Secured Personal Assets

Owners of S corporations receive limited liability protection regardless of tax status. This means that owners’ personal assets are shielded from the claims of business creditors. A shareholder does not have personal liability for the business debts and liabilities of the corporation.

In a partnership, the owners and business are legally considered the same, which means that personal assets are vulnerable. 

Allocating Income and Loss

Since there is only one class of stock allowed for an S corporation, the allocation of income and loss is administered by stock ownership. The adjustment account is complicated and requires assistance from an accounting professional.

The allocation of income and loss can be included in the operating agreement of a partnership.

Taxation

S corporations can divide profits into two categories: salaries paid to shareholders and distributions (also known as dividends.) Distributions are considered passive income, which means that an S corporation is not subject to the self-employment tax. If a shareholder owns more than 2% of an S corporation, the fringe benefits are taxable.

Partners in a partnership who are not considered passive investors are required to pay self-employment taxes on their share of the taxes.

Ongoing Rules and Maintenance

Along with at least one annual shareholder meeting, S corporations are required to keep minutes and document resolutions. In addition, this information must be compiled into an annual report.

Partnerships typically involve minimal upkeep, although some states require the payment of an annual filing fee.

Choosing Between an S Corporation or Partnership

Clearly, there are advantages and disadvantages for both S corporations and partnerships. If tax advantages and secured personal assets are most important, then an S corporation may be best. If you prefer simplicity and the ability to have greater influence over policies, a partnership may be more beneficial.

As a CPA who specializes in working with small businesses and entrepreneurs, I am happy to discuss S corporations and partnerships with you. Please contact me to schedule a time to meet.