Setting up your business with the right entity selection can be the difference between getting off the ground and being crushed by unexpected tax burdens. Both partnerships and S corps can elect pass-through tax treatment, which means profits and losses of the entity are reported on the owners' tax returns. However, other things can make a difference in which structure is best for your company.
To create a partnership, you do not have to file any official paperwork. Instead, a partnership occurs when two or more people voluntarily carry on a for-profit business as co-owners. For example, if you and your brother create a lemonade stand, you've likely created a legal partnership without even realizing it. To create an S corp, your company must first be incorporated and then must make an S corp election when it files its income tax return. An S corp cannot happen by accident.
Partnerships generally do not have limited liability. For example, if one partner negligently crashes the partnership truck into a school bus, both partners could be personally liable. However, in some states, partnerships can register as limited liability partnerships and thus receive the added protection of limited liability. An S corp, on the other hand, always has limited liability because it is a type of corporation. Therefore, if an S corp has two owners, and one owner negligently crashes the partnership truck into a school bus, only the assets of the S corp and the personal assets of the negligent owner could be taken.
There are no limits on who can form a partnership with others. Individuals, corporations, LLCs, foreign citizens and even other partnerships can join to form new partnerships. For example, an individual researcher could partner with a corporation in a joint venture to develop new technology together and share the proceeds. Conversely, the IRS strictly regulates who can be an owner of an S corp. To be an S corp owner, an individual must be either a U.S. citizen or a U.S. resident. The only entities that can be S corp owners are estates and certain trusts. Corporations, partnerships and other entities cannot be S corp owners.
Restrictions on Entity Activities
A partnership is not limited to any particular type of activity. For example, if one year a partnership has all passive activity income, the partnership will not lose its partnership status. Passive income includes things like interest income or royalties. On the other hand, if an S corp has more than 25 percent of income from passive activities and accumulated earnings and profits, the IRS imposes an extra tax on it. If it has three consecutive years of more than 25 percent of passive income and accumulated earnings and profits, it loses its S corp status and reverts to a C corp.