Why Use a Partnership Instead of an S Corporation?

written by Eric Lampe

Taxpayers that plan to operate a business have a variety of choices. A single individual and partnership can operate as a C corporation, an S corporation, or a limited liability company (LLC). Single individuals also have the option to operate as a sole proprietorship, whereas two of more individuals can form a partnership.

Nontax considerations
State law and nontax considerations are an important consideration in choosing the form of the business and may play a decisive role. A general partner of a partnership has unlimited liability for the debts of the business. This can be modified by using a limited partnership (LP), which must have at least one general partner (still with unlimited liability) and at least one limited partner (liability is limited to its contribution to the partnership). A corporation has limited liability; shareholders generally are not responsible for the liabilities of the corporation beyond their contributions to the entity.

Federal tax considerations
At the same time, it is crucial to consider federal tax requirements and consequences when choosing the form of business entity. A primary federal tax consideration is avoiding a double layer of tax on business income. This can be accomplished by operating as a passthrough entity, such as a partnership or S corporation. Income is not taxed at the entity level. It passes through to partners and shareholders and is taxed at their rates. It must be noted that income of a passthrough entity is allocable and taxable to its owners, whether or not the income is actually distributed to the partner or shareholder.

In contrast, C corporations are taxable entities. Furthermore, when a C corporation pays a dividend to its shareholders, this generally is taxable to the shareholder. Unlike passthough entities, dividends are not taxed unless there is an actual distribution.

Advantages of partnerships
Unlike an S corporation shareholder, anyone or any entity can be a partner. S corporations are limited to 100 shareholders; only certain individuals, estates and trusts are eligible to be shareholders. C corporations and nonresident aliens cannot be shareholders of an S corporation.

S corporation’s income and losses must be allocated on the same basis to each shareholder. A partnership can have different classes of partners and has more flexibility for allocating income and losses to different types of partners.

Partnership liabilities can increase a partner’s basis in the partnership, offsetting distributions of cash and reducing their taxation. The increased basis allowed partners to use losses generated by the partnership. Liabilities of an S corporation do not create stock basis; separate bases in stock and debt must be calculated. This lack of basis may limit the use of losses generated by the S corporation.

In general, a partnership offers more flexibility than an S corporation in the treatment of taxes. However, S corporation shareholders do have limited legal liability, while general partners are not insulated from the partnership’s debts and liabilities. If you have any questions regarding a Partnership or S Corporation, please contact us 417-881-0145.


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