When starting out a new business venture, two of the most important aspects to consider are complying with legal registration requirements and potential tax implications that may arise in the future. The objective of the summary below, which focuses on partnerships and S-corporations, is to provide a better understanding of the legal registration and compliance regulations incurred by both types of entities, as well as the differences in how their “pass-through” income is taxed on the personal tax returns of partners and shareholders.
- In order to establish a partnership, two or more people who will be considered either general or limited partners are required.
- General partners are actively involved in the daily operations of the company and have the authority to make important business decisions. The drawback to having this power is that general partners are liable for all debts incurred by the business and face the potential risk of losing more than they have invested in the company. If all partners are considered general partners – then the entity is considered a general partnership.
- On the other hand, limited partners are not involved in business operations and do not have the authority to make important decisions. Limited partners are solely investors in the company. Additionally, limited partners are not responsible for the debts incurred by the partnership and only face the potential risk of losing up to the amount they have invested into the company. If there is a mix of both general and limited partners, then the entity is considered a limited partnership.
- Once the partners and type of partnership have been established, registering a partnership is a fairly simple process. Partnerships are required to apply for an Employer Identification Number (EIN) to establish an employer tax account with the IRS. The application is free and no additional forms are required to be filed with the IRS in order to register the partnership.
- Drafting a partnership agreement is recommended when establishing a general partnership, however, it is required when establishing a limited partnership. The objective of a partnership agreement is to avoid misunderstanding and potential conflict between partners
- A partnership agreement establishes the allocation of profits and losses amongst partners as well as the amounts of guaranteed payments and distributions each partner is entitled to.
S corporations are Corporations that elect an S status, by the means of which it elects to pass on the income and deductions to its shareholders and pay the tax at the individual level than at the Corporation level.
- To organize an entity as an S corporation., an entity must first be registered as domestic U.S. corporation or LLC.
- The entity can elect to be treated as an S-corporation by filing Form 2553, Election by a Small Business Corporation, with the IRS.
- Registering an S-corporation with the IRS entails additional steps in comparison to a partnership since the IRS has strict legal requirements including the requirement to file articles of incorporation upon establishing the S-corporation.
- Additionally, S-corporations need to have board of directors and are mandated to hold regularly scheduled meetings which require complex and tedious record keeping.
- The board of directors is responsible for establishing company policies and responding to shareholders of the company.
- Financial institutions, insurance companies and sales corporations cannot elect to become S-corporations.
- S-corporations cannot have more than 100 shareholders consisting of individuals which must be U.S. citizens or permanent residents, trusts or estates and cannot have more than one class of stock.
- A major incentive to an S-corporation is that it provides legal protection in the event court proceedings arise since it is considered a completely separate legal entity from its shareholders. This means that shareholder’s personal assets cannot be seized to cover debts incurred by the company.
- It is worth nothing that in general the IRS tends to be more thorough when examining the records of S-corporations. Any company who does not meet the designated registration requirements and are non-compliant with the IRS strict mandates including holding shareholder meetings could result in the S-corporation status being revoked and losing the advantageous tax treatment discussed below.
Allocation & Taxation
- General partners are subject to Federal and State income taxes and self-employment taxes (i.e. Social Security and Medicare Taxes) on their share of partnership net self-employment income, The total self-employment tax is 15.3% which includes Employer’s share and Employees share of tax.
- Limited partners are not subject to self-employment taxes on their share of partnership income. However, any guaranteed payments for services performed will be subject to the 15.3% self-employment tax rate previously mentioned.
- In order to bring parity between employed and self-employed individuals, Partners are allowed to deduct 50% of their self-employment tax liability as an adjustment to income on line 27 of Schedule 1 filed with their personal tax return.
- Partnership income is not required to be split based on ownership percentage – unless a legally-binding partnership agreement is established which clearly states the allocation of profits and losses amongst partners.
- Partnerships can make distributions of property to its Partners without any tax consequences.
- Profits are split amongst shareholders according to the number of shares they hold and are distributed as ordinary income or.
- Although this income is subject to Federal and State income taxes, unlike a partnership, the pass-through income from an S-corporation is not subject to self-employment tax.
- The allocation of income and deductions in an S-Corporation does not have much flexibility in comparison to a partnership since it is strictly based on the number of shares held by each shareholder which dictates their percentage of ownership in the company.
- Distributions from an S Corporation are required to be distributed between shareholders on their Pro-rata share of ownership.
- Distributions of property from an S Corporations are subject to recognition of capital gains at the S Corp level.
Wages & Payroll Taxes
- Partners are deemed to be self-employed; therefore, they do not qualify to be paid as W2 employees by the partnership. However, partners may be entitled to take distributions from the company and/or receive guaranteed payments for their services.
- A partnership is not liable for payroll taxes unless they have paid employees – excluding the partners.
- A disadvantage that comes with not being subject to self-employment taxes is that per IRS regulations, shareholders of an S-corporation (more than 2% ownership) who are employees and also actively participate in the business operations are required to be paid a “reasonable compensation” which meets industry standards. The wages paid to shareholders can be deducted as an expense by the S-corporation when computing their net income for the year.
- S-corporations will be required to set up a payroll in order to issue W2s to their employed shareholders. Additionally, S-corporations are also liable for the employer portion of Social Security and Medicare taxes due on the wages paid to shareholders.
- Amounts paid for partner’s health insurance premiums are deducted as a guaranteed payments expense and are deducted on Partners individual income tax return.
- Shareholders who own less than 2% of the company are not eligible to claim a self-employed health insurance deduction on their personal tax return.
- Health insurance premiums amounts paid for shareholders who own more than 2% of the company are required to be included in the gross compensation of the shareholder. The premiums are subject to Federal and State income taxes; Please note that health insurance premiums reported on Form W2 are not subject to the FICA and FUTA tax.
- It is very important to note that the health insurance premiums must be paid by S-Corporation directly or be reimbursed to the shareholder who paid the premiums to qualify to claim the self-employed health insurance deduction on their personal tax return.
- The taxation framework for partnerships and S-corporations is similar since both entities do not directly pay income taxes. As previously mentioned, both are known as “pass-through entities” since the profits, losses, credits, and deductions incurred by the company are passed down to the partners and shareholders to report on their own personal tax returns. Both entities use Schedule K-1 to allocate and report each partner’s/shareholder’s portion of the company’s pass-through activity for the designated tax year.
- The Tax Cuts and Jobs Act signed into law by former President Trump introduced a new tax deduction for owners of pass-through entities which allow qualifying individuals to deduct up to 20% of their net business income from their personal income taxes. Since partnerships and S-Corporations are classified as pass-through entities, both partners and shareholders can potentially capitalize on this deduction and possibly reduce their effective income tax rate by up to 20% on their personal tax return.
Both partnerships and S-corporations can provide significant tax advantages and incentives depending on the size and scale of business operations which is why our team of experienced tax professionals is ready to assist with minimization of taxes and with any questions or concerns you may have when setting out on your new business venture!