S-corporation vs partnership: it's important to understand the definition of each before choosing between them. A partnership is a group of people who organize and run a business. No paperwork is needed to form a partnership. This can be created even without the intention of starting one if two people decide to work on a business together. S-corporations come with more complex requirements.

Background on Partnerships

Regular partnerships have the advantage of being easy to organize. There's more flexibility in partnerships due to how the structure of the company is set up, both in profit and loss allocation and in management. The standard provision allows every partner to have equal say, no matter what ownership share they have. However, partners are allowed to agree to a different arrangement.

Partners could decide that one of them will be the managing partner and make the day-to-day decisions. They could also decide that each partner has an equal share in decisions that are made. Partners may contract for different shares of profits or losses, no matter what their ownership interest is. General partnerships make every partner personally liable, which means they're liable for debts that the partnership incurs.

Unlimited personal liability can be modified with a limited partnership. This type of partnership must have a minimum of one general partner and one limited partner. The general partner has unlimited liability for the limited partnership. However, their liability is limited to the partnership's contribution. If one of the partners runs over someone while they are on a delivery, the court can find the partnership to be liable. That means personal bank accounts, as well as other assets, can be taken in order to satisfy the judgment.

Rules of a Partnership

Being a member of a partnership means the IRS qualifies any income made as self-employment income. This means the members are in charge of paying income taxes and self-employment taxes. Partners won't have money withheld by their employer because they're self-employed. Instead, they will need to make estimated tax payments.

Any entity or person can be a partner, which is different from an S-corporation shareholder. There can be varying classes of partners for a partnership. They also have greater flexibility for distributing income and losses to their partners.

The liabilities of a partnership can improve the basis that a partner has in the partnership. This offsets distributions of cash and decreases their taxation. Partners can use losses from the partnership with this increased basis. The following rules apply to partnerships:

  • Contributions of property that's appreciated aren't usually taxable. 
  • Special allocation rules must be followed to handle gains that are built in on a contributed property. 
  • A partnership has an advantage over S-corporations as far as having an easier business structure
  • Partnerships can start with a simple handshake to begin business. 

There are many partnerships that write an operating agreement in an attempt to avoid any disputes in the future. This agreement is also a way to resolve any problems that might come up. There isn't a legal separation between partners and their company in a general partnership. This means the company takes on debt and can be sued. The personal assets of the partners are at risk, as they might be used to pay off a claim.

Background on S-Corporations

With an S-corporation, income does not get taxed at the entity level because it passes through to shareholders and partners, and it gets taxed at their individual rates. The double taxation that happens with a C-corporation is avoided with pass-through taxation. Double taxation happens when a corporate tax is paid by the company on profits and then profits are taxed once again when they are distributed to shareholders. 

There are more complex requirements for registration with an S-corporation. A business needs to register as a limited liability corporation (LLC) or a corporation in the state it decides to conduct business in. This normally means creating Article of Organization or Articles of Incorporation. The incorporation papers are filed in the state where the company is based. The company then needs to apply to the IRS to get Subchapter S designation. IRS Form 2553 must be complete to make the S-corporation election.

If you need help choosing between an S-corporation and a partnership, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.