Whether you choose to run your business as an S corporation or a partnership has a number of significant effects, especially in management and taxes. A partnership is an association of people who run a business together. An S corp is a corporation or limited liability corporation that made a special election to allow the owners to take advantage of pass-through taxation while still maintaining the benefits of limited liability.
Forming a partnership doesn't require any paperwork. In fact, you can create a partnership without even intending to do so if you and another person start working together on a business. An S corp, on the other hand, requires more complex registration requirements. First, the business must register as a corporation or limited liability corporation in the state in which it's doing business, which generally requires creating either articles of incorporation or articles of organization. Then, the company must complete IRS Form 2553 to make the S corp election.
Partnerships offer more flexibility in terms of the structure of the company, both in management and profit and loss allocations. The default provision is that all partners have an equal say, regardless of ownership share, but the partners can agree to another arrangement. For example, partners could agree that one partner will act as the managing partner and make all the day-to-day decisions, or the partners could all maintain an equal say in all decisions. In addition, partners can also contract for different shares of profits and losses, regardless of ownership interest. S corps, on the other hand, are more rigid. S corp shareholders elect a board of directors that oversees the management of the company, and they appoint officers to oversee the day-to-day operations. In addition, S corp allocations of profits and losses must be made on the basis of shares owned and no alterations can be made.
General partnerships expose all the partners to unlimited personal liability, which means that all the partners are jointly and severally liable for any debts incurred by the partnership. For example, if one of your partners runs over a pedestrian while on a delivery and a court finds the partnership liable, you could lose your personal bank accounts and other personal assets to satisfy the judgment. S corp owners have limited liability, which means their personal assets typically aren't at risk if the S corp has financial difficulties.
If you're a member of a partnership, the IRS considers your income self-employment income. This means you're responsible for paying self-employment taxes in addition to income taxes. Because they're self-employed, partners don't have any money withheld by an employer, which means they typically must make estimated tax payments. S corps, on the other hand, are more complicated. S corp owners must pay themselves a "reasonable salary" for the work that they do for the business. This amount counts as employee income, which means the S corp owner receives a W-2 form. The remainder of the income from the S corp passes through to the owners and is taxed at ordinary income tax rates.
References & Resources
- McDonald Law Group: Accidental Partnership
- Internal Revenue Service: S Corporations
- Internal Revenue Service: Partnerships
- Internal Revenue Service: Wage Compensation for S Corporation Officers
- Cendrowski: Partnerships and S Corporations: Not All Flow-through Entities are Created Equal
- The Entrepreneur's Help Page: Partnerships
- Internal Revenue Service: Form 2553