An S Corporation Vs. a Partnership: Pros and Cons

By Tom Speranza, J.D.

An S Corporation Vs. a Partnership: Pros and Cons

By Tom Speranza, J.D.

When starting a small business, many owners consider operating either as an S corporation or as a partnership, possibly because they've heard that these legal arrangements are similar. The truth is that, although S corporations and partnerships share some common characteristics, they are very different in how they're formed, who can own them, the formalities they must follow, and how they function for tax purposes.

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Forming an S Corporation or a Partnership

A partnership is much easier to form than an S corporation because a partnership is not a formal entity that requires registration with the state. You and your fellow owners can decide one day to operate a business together as a partnership and figure out how to divide management responsibilities and the business's expenses and income. Of course, a written partnership agreement is always a good idea to avoid future disputes and consider important issues such as what happens if a partner wants to withdraw but there is no legal requirement for such an agreement.

In contrast, forming an S corporation involves several steps. You first need to form a corporation in your state by choosing an available name, appointing a registered agent, drafting and filing articles of incorporation, paying the required filing fees, obtaining an employer identification number from the U.S. Internal Revenue Service (IRS), and opening a bank account.

To obtain S corporation status, the newly formed corporation completes and files the Election by a Small Business Corporation (Form 2553).

Entity Formalities and Documentation

To maintain the protection by a corporation, formalities, or formal actions, are imperative. Corporations require more ongoing formalities and paperwork than a partnership. For example:

  • A corporation's shareholders must annually elect a board of directors consisting of at least one director.
  • The corporation's board must adopt a set of bylaws setting forth the rules of shareholder and director meetings, voting and approvals, and the titles and powers of the corporation's officers.
  • The board must appoint officers to hold the president, treasurer, and secretary titles.
  • Although a single person can be the sole shareholder, sole director, and holder of the three required officer positions, a corporation must hold meetings of the shareholders and directors at least once annually—either in person or by written consent—and maintain the minutes and resolutions of such meetings.
  • Corporations must keep careful records of the shareholders' capital contributions, the stock certificates issued to them, and any transfers of shares.

As mentioned above, a partnership doesn't require a formal agreement documenting the partners' relationship with each other and the business. A partnership is also not required to hold meetings of the partners or managers, maintain records of resolutions approved by the partners or managers, or issue certificates memorializing partnership interests.

Ownership and Capital Structure

Partnerships can be owned by individual people, other for-profit business entities, and financial and estate-planning structures. Partnerships are also free to create and issue different classes of partnership interest, each with its own bundle of voting, management, and capital contribution and income distribution rights and obligations.

S corporations, in contrast, are strictly limited by federal tax law to a specific capital structure and ownership profile:

  • An S corporation must have only one class of stock, but it can issue non-voting shares that are otherwise identical to the voting shares.
  • An S corporation can have no more than 100 shareholders, but spouses, certain family members, and their estates sometimes count as single shareholders for purposes of this limit.
  • All S corporation shareholders must be individuals, estates, certain kinds of trusts, or entities that are exempt from federal income tax under Sections 401(a) or 501(c)(3) of the U.S. Tax Code.
  • No S corporation shareholder can be a nonresident alien.

Liability Protection

S corporations provide liability protection to their owners. That means that customers, employees, suppliers, tax authorities, landlords, and anyone else who might have a legal claim against the corporation can only look to the corporation's assets for payment or compensation. For example, a supplier with an unpaid invoice can sue the company, win a judgment in court, and place a lien on the corporation's bank account, but it cannot seek remedies against the shareholders or their personal assets.

A partnership is very different: all partners are personally liable for the debts and other legal obligations of the partnership. As a result, employees who do not receive their wages, landlords with unpaid rent, and all other legal claimants can try to recover damages from both the partnership's assets and those of the individual partners.

Tax Treatment

From a tax standpoint, S corporations and partnerships are similar. They each pass profits, losses, tax credits, and tax deductions to the owners using IRS Schedule K-1. The owners then report such items on their individual tax returns.

S corporations, however, have the option of characterizing some of their profits as salary paid to the shareholders for services provided to the corporation, with the remainder of the profits designated as dividends. This bifurcated approach to income distributions can reduce the amount of self-employment taxes the shareholders pay, but there are technical requirements to comply with and limitations on salary. S corporation owners should consult an experienced tax lawyer and an accountant for guidance on these issues.

One of the issues that owners of pass-through entities might want to explore with the assistance of an attorney is the 20 percent self-employment income deduction included in the 2017 federal tax cut legislation. An attorney can help you decide which type of entity would work best for your business as well as helping with the process of starting one.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.