Should I Operate as a Partnership or an S Corporation?

When small to medium-sized businesses operate with multiple owners, a question is frequently asked about whether they should be set up as a partnership or as an S Corporation for tax purposes. 

This is the topic of our conversation today.

First, let me make a few background points. Legal entity classification may or may not have a bearing on the tax structure of the business. Generally speaking, limited liability companies with two or more individual owners can be treated as either a partnership or an S corporation for tax purposes. This distinction is important. 

Also, note that with a couple exceptions for estates and trusts, S corporations can generally have only individual shareholders who are residents or citizens of the United States. Other businesses or entities and foreign nationals cannot be shareholders of an S corporation. 

The default federal classification of an LLC with multiple owners is a partnership. However, your accountant (or even you) can file the paperwork with the Internal Revenue Service and have that LLC treated as an S corporation at any time.

Another background point to make is that C corporations differ significantly from S corporations in their tax treatment and they are not addressed in this video. C corporations pay corporate income tax while S corporations do not. When I talk about C Corporations, I talk about entities such as McDonalds, Microsoft Corporation and American Express. These businesses are subject to a flat corporation income tax rate of 21% that they pay on their taxable income. Then, the dividends paid out of the remaining after-tax earnings are taxed again on the individual tax returns on their shareholders. Because of this double-tax, C corporations are not very popular among small and medium-sized businesses and will not addressed any further.

Now, let’s return to the S corporations. S corporations do not pay income taxes (with some minor exceptions). Instead, distributive shares of their earnings flow to individual returns of the owners and taxed at their individual rates. Additionally, distributive shares of S corporation ordinary business income are not subject to the 15.3% self-employment tax which is generally paid by the sole proprietors and general partners in a partnership. 

S corporations have a requirement with respect to shareholders who perform services for the company—these shareholders must be paid reasonable wages. As a matter of fact, the Internal Revenue Service adjusts earnings of S corporations when officer compensation is missing or appears to be unreasonably low.

Wages paid to all S corporation employees are subject to standard income tax and FICA tax withholding rules. But note, that that amount is only paid on the gross wages of the owners, not the total ordinary business income of the company, as is the case with the partnerships.

Another benefit available to the S corporations is a much easier pathway in setting up their retirement plans (when compared to partnerships, although it’s doable for partnerships, but cumbersome from the tax reporting standpoint). The maximum contribution to retirement plans of S corporation employees is generally reflected as a percentage of their gross wages. S corporations may contribute to SEP IRA accounts of their owners, for example, at a maximum rate of 25% of their wages, limited to $61,000 in 2022.

Now, let’s switch to the tax treatment of partnerships and their partners. As mentioned earlier, the default tax classification of LLCs with multiple owners is a partnership. They are easy to set up and they are not allowed to pay wages to their partners (with the exception of guaranteed payments which are relatively narrow in scope). 

Similar to the S corporation’s shareholders, partner’s distributive shares of partnership income are taxable on their individual returns at their respective individual tax rates plus the 15.3% self-employment tax. That self-employment tax makes partnerships unattractive when compared to S corporations. 

With administrative and reporting difficulties in setting up retirement plans and payments for other benefits, such as medical plans (which are reclassified as guaranteed payments to partners), partnerships appear to be at a disadvantage when compared to S corporations. Or, are they?

Well, the answer to this question depends on the size of the business (meaning, how new and how big the business really is). 

As a rule of thumb, at Glasgow Knight, we recommend that multiple business owners operate as a partnership in the earlier years of operations due to the simplicity in their set-up, until the entity’s ordinary business income after all deductions reaches the following amount—the proposed reasonable compensation of its owners plus no more than $20,000. 

For example, let’s assume that the reasonable compensation of two owners would be $50,000 each. A good time to make the S corporation election would be when partnership revenue less deductible expenses is somewhere between $100,000 to $120,000. 

After that number exceeds $120,000 in our example, the entity should definitely make the S corporation election. 

This concept of switching from a partnership to an S corporation may be challenging to conceptualize when explained verbally. So, I am inviting you to take a look at a mathematical illustration at our site at www.GlasgowKnight.com/blog. 

In conclusion, lets recap what we talked about today:

• Partnerships and S corporations are subject to income taxes only on the partner or the shareholder level.
• Distributive shares of ordinary business income from partnerships are subject to the 15.3% self-employment tax when the same distributive shares of S corporations are not.
• Setting up a limited liability company taxed as a partnership in the earlier years of operation appears to be a prudent step. 
• At a certain point, an S corporation election may need to be made, as explained above. 
• After the election is made, former “partners” become “officers” of the S corporation and the S corporation is required to pay reasonable officer compensation to its actively working owners, which is subject to Federal income and FICA taxes in a manner consistent with all W-2 wages.

If you would like to get additional information on this topic or talk to us in more depth about your specific facts and circumstances, contact us at www.GlasgowKnight.com. We would be very happy to assist.

Thank you for your time and attention today. I really appreciate them.

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