When starting a new small business, figuring out whether an S corporation or partnership is a better business structure may significantly impact your future success. Your choice generally affects how you protect personal assets, minimize tax obligations, generate capital, maintain control over policies, and manage day-to-day operations. Below, we compare S corporations (S corps) and partnerships to help you determine which might work better for your business needs.
What is a partnership?
A partnership is a business arrangement where two or more people share ownership, contribute resources, divide profits, and typically share responsibility for business obligations. Partnerships form when multiple people operate a business without establishing another formal structure.
What is an S corporation?
An S corporation is a legal business entity that provides limited liability protection while allowing profits and some losses to pass through to owners' personal tax returns, avoiding corporate taxation while protecting personal assets from business liabilities.
Similarities between partnerships and S corporations
When comparing business structures, understanding what partnerships and S corporations have in common helps clarify your options. There are two major similarities between partnerships and S corporations:
Ownership structure. Both a partnership and an S corporation may have more than one owner. If you launch a small business with others without establishing a formal business structure, your business automatically becomes a partnership with the other business owners.
Pass-through entity status. When comparing S corp vs partnership taxes, neither business type pays business income tax directly. That's because both S corporations and partnerships function as pass-through entities, meaning all co-owners report their portion of business profits and losses on personal tax returns. Personal income tax applies to all co-owners instead of business income tax being applied to the business itself. Though, S corporations are responsible for tax on certain built-in gains and passive income at the entity level.
Key differences between partnerships and S corporations
The differences between partnerships and S corporations are more substantial than their similarities. Here are eight key distinctions:
1. Formation procedure and paperwork
Unlike an S corporation, a partnership does not require a formal business structure. This means no explicit procedure must be followed, and typically no paperwork is required. However, it is generally recommended that you launch your small business by signing contracts with your business partners detailing ownership structure, division of responsibilities, and other key business aspects.
If you register your small business as an S corporation, you generally need to complete and submit articles of incorporation alongside IRS Form 2553. When filing your articles of incorporation, you must choose a business name, designate a registered agent, apply for an employer identification number from the IRS, and open a bank account for your business.
2. Ownership changes
Ownership changes to your small business may be easier to execute in a partnership. Since a partnership is not a formal business structure, there are typically no strict rules guiding ownership changes. Additionally, this flexibility means that partnership co-owners aren't limited to individuals—for-profit businesses, private financial institutions, and estate planning companies may be partnership co-owners.
S corporations must follow specific rules regarding ownership changes. Although rules vary somewhat by state, ownership changes in S corporations most commonly require selling shares from one stockholder to another. Additionally, S corporations may have at most 100 shareholders, and these shareholders typically must be U.S. citizens or residents.
3. Structure flexibility
Since a partnership is not a formal business category, there are theoretically few limits on its structure. On the other hand, an S corporation must comply with specific rules regarding business structure.
An S corporation's shareholders must elect a board of directors to draft and approve bylaws. The board must meet with shareholders at least once per year and include a director, president, treasurer, and secretary (though one person may hold all four roles). The S corporation structure requires documenting all shareholders' capital contributions, stock certificate issuances, and share transfers.
4. Personal asset protection
Only S corporations, and limited partners in a partnership, benefit from personal asset protection. This distinction means that, in the event of a lawsuit, only co-owners of an S corporation, and limited partners in a partnership, not general partners, are protected from having their personal assets used as payment or compensation in legal matters.
To better understand this difference, consider this example: If your small business is an S corporation and your office space's landlord sues for unpaid rent, legal restitution may only come from your small business's assets rather than your personal finances. If your business is a partnership, and you are a general partner, in this situation, then your own money and possessions could potentially be taken as legal restitution as well.
5. Tax treatment
S corp vs partnership tax advantages are often the most-discussed factor in this decision. What do partnerships and S corporations have in common? Both are pass-through entities. However, only S corporations can divide their profits into two categories: salaries paid to shareholders and dividends. The latter category is passive income on which self-employment taxes typically cannot be levied. Partnership co-owners, on the other hand, generally must pay self-employment taxes on their share of profits.
6. Ongoing maintenance and costs
Since partnerships are informal business structures, they require minimal maintenance work when compared to S corporations.
If you register your small business as an S corporation instead, you must hold at least one meeting annually with board members and shareholders, take meeting minutes, and document all vital resolutions. Once per year, you must gather this information and compile it in an annual report.
7. Generating capital
A partnership does not explicitly set up a structure for stocks and shareholding, so generating capital from angel investors and venture capitalists may be more challenging if your small business is a partnership. S corporations allow for up to 100 shareholders, making it possible for angel investors or venture capitalists to own stock in your business—which may be a major incentive for them to invest.
8. Policies
In a partnership, all co-owners generally set the company policies together. If your small business is an S corporation, this responsibility falls to your board of directors, who answer to your shareholders. Even though your board of directors answers to, and is elected by, your shareholders, the structure of an S corporation means that your shareholders may have less immediate influence on your policies than in a partnership.
Partnership vs S corporation: How to choose
If you're deciding whether an S corp or partnership agreement is better for your business, consider these factors:
Taxes. Since an S corporation can divide its profits into one taxable and one non-taxable category, this business structure may present you with tax advantages that a partnership typically does not offer.
Capital generation. Given its shareholder structure, an S corporation may be better for your business if you need funding from angel investors or venture capitalists.
Legal risk. An S corporation may be better for your small business if you want to protect your personal assets from potential forfeiture in a lawsuit.
Simplicity. Given the lack of formalities and stockholder rules involved in a partnership, this structure may be better for your business if you want to avoid large amounts of paperwork and maintenance, allow for easy transference of ownership shares, or operate with fewer stipulations.
Policy considerations. If you want to maintain direct influence over your small business's policies, a partnership may give you more power than an S corporation.
Ultimately, the choice between a partnership and an S corporation depends on your specific business needs, goals, and circumstances. Consider consulting with a business attorney or tax professional before making this important decision. They can provide personalized guidance based on your industry, growth plans and financial situation to help you choose the structure that will best support your long-term success.
