September 22, 2020 By SmartBiz Team

When starting a new small business, you may want to figure out whether an S-corporation or partnership is a better business structure for you. Your choice can be crucial for protecting your personal assets, minimizing your tax burden, generating capital, maintaining control over your small business’s policies, and keeping business operations simple. Below, find a comparison of S-corporations (also called an S-corp) and partnerships and some potential advantages and disadvantages of each.

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Partnership v. S Corp: How are they the same?

There are two major similarities between a partnership and an S-corp:

  1. Ownership structure. Both a partnership and an S-corp are owned not by one person but by many entities. If you launch a new small business with other people without establishing a formal business structure, your business is automatically a partnership with the other business owners.
  2. Pass-through entity. When it comes to S-corp vs. partnership tax advantages, both business types do not have business income tax applied to them. That’s because both S-corporations and partnerships are pass-through entities, meaning that all co-owners of your business report their portion of your business’s profits and losses on their personal tax returns. Personal income tax is then applied to all co-owners instead of business income tax being applied to your business.

The difference between a partnership and an S Corp: Eight examples

The difference between a partnership and an S-corp is far more pronounced than the overlap. The eight most prominent examples distinguishing a partnership from an S-corporation are:

1. Formation procedure and paperwork

A partnership, unlike an S-corporation, is not a formal business structure. The lack of formal guidelines regarding partnership formation means that there is no explicit procedure that must be followed, and no paperwork required. That said, you may feel more secure in launching your small business if you sign 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 will need to complete and submit articles of incorporation alongside IRS Form 2553. When you file your articles of incorporation, you must choose a business name, designate a registered agent, apply for an employer identification number from the IRS, and start a bank account for your business.

2. Ownership changes

In a partnership, ownership changes to your small business may be easier to execute. Since a partnership is not a formal business structure, there are no rules guiding ownership changes. Additionally, this lack of rules means that the owners of a partnership aren’t limited to people – for-profit businesses, private financial institutions, and estate planning companies can be partnership co-owners.

S-corporations must follow strict rules regarding ownership changes. Although rules vary somewhat by state, ownership changes in S-corporations generally require the selling of shares from one stockholder to another. Additionally, S-corporations may have at most 100 shareholders.

3. Structure flexibility

Since a partnership is not a formal business category, there are theoretically no limits on its structure. An S-corporation, on the other hand, must comply with strict rules when it comes to business structure.

An S-corporation’s shareholders must elect a board of directors responsible for drafting and approving bylaws. The board of directors must meet with shareholders at least once per year, and the board must include a director, president, treasurer, and secretary (though one person may hold all four roles). S-corporation structure requires that you document all your shareholders' capital contributions, stock certificate issuances, and share transfers.

4. Personal asset protection

Only an S-corporation offers personal asset protection to its co-owners. This distinction means that, in the event of a lawsuit, only co-owners of an S-corporation, not a partnership, 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 can only come from your small business’s money and possessions rather than your own. If your business is a partnership in this situation, then your own money and possessions could be taken as legal restitution too.

5. Tax treatment

S-corp vs partnership tax advantages are often the most-discussed factor in the partnership v. S-corp decision. Although both are pass-through entities, 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 cannot be levied. Partnership co-owners, on the other hand, 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. At most, you may have to pay annual filing fees if your business is registered in certain states.

If you register your small business as an S-corporation instead, not only must you hold at least one meeting annually with board members and shareholders, but you must also 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 tougher if your small business is a partnership. S-corporations require stockholders and allow for as many as 100 co-owners, so this ability for an angel investor or venture capitalist to own stock in your business is a major incentive for them to invest.

8. Policies

In a partnership, all co-owners set the company policies. 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.

How to choose between a partnership v. S corp

If you’re deciding whether an S-corp or partnership agreement is better for your business, consider the following 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 does not.
  • 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. If you want to protect your personal assets from forfeiture in a lawsuit, an S-corporation may be better for your small business.
  • 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 worries about strict compliance with government regulations.
  • Policy considerations. If you want to maintain direct influence over your small business’s policies, a partnership may give you more power to do so than an S-corporation.

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