An enterprise owned by two or more people is, by default, a partnership, unless the co-owners elect otherwise. In a partnership business entity, partners report their share in business income and losses annually via their personal tax returns.
To set up a corporation, the founders file articles of incorporation, creating a separate entity in law. A corporation is overseen by an elected board, with board-appointed officers managing day-to-day operations.
When deciding how to structure their business, many small business owners find themselves weighing up the pros and cons of both partnerships and corporations. The decision ultimately has important ramifications in terms of management structure and legal exposure, as well as having significant tax implications, potentially impacting the business’s bottom line substantially.
For individuals who do not have a financial or legal background, choosing between a partnership and a corporation can be challenging. It is often difficult to predict how an enterprise will develop over time, leaving business owners struggling to quantify the amount of money and time they will need to invest in either kind of business.
In this article, we look how partnerships and corporations work, identifying the key differences, and pros and cons of each.
Under US law, a partnership is a business association of two or more people, via which partners share business profits, as well as responsibility for business liabilities. If multiple parties establish a business, it is a partnership by default, unless they specifically choose a different business structure, such as a corporation or LLC.
A partnership is a pass-through business entity, meaning that rather than the business itself being responsible for paying income tax, the individual co-owners report their share of income and liabilities on their personal tax returns, paying income tax at the relevant rate. There are three different types of business partnerships: general partnerships, limited partnerships, and limited liability partnerships.
With a general partnership, co-owners are liable for business debts. The second type of business partnership is the limited partnership, in which two separate classes of partner are created.
In a limited partnership, general partners are liable for the debts of the business and are also responsible for undertaking day-to-day operational obligations. On the other hand, limited partners are not involved in day-to-day business operations, and their personal liability is restricted to the amount of their capital investment.
The third type of business partnership is the limited liability partnership. Limited liability partnerships are a special type of partnership typically adopted by doctors, lawyers, accounting firms, and other professional services. With this form of partnership, co-owners are not liable for business debts.
Pros of Partnerships
– Converging knowledge and expertise.
– Simple to create with not much paperwork.
– Since it is a pass-through entity, there are fewer tax forms.
– Avoids double taxation.
Cons of Partnerships
– Lack of separation from business.
– Individual taxation.
– Divided profits.
– Potential for conflict.
In law, a corporation and its shareholders are regarded as separate entities. To establish a corporation, business founders must file a certificate of incorporation and ancillary paperwork with the state. Unlike business partners, shareholders are not liable for business debts. There are two types of corporations: C-corporations and S-corporations.
C-corporations pay corporate income tax. Individual shareholders also incur personal taxes on income received from the business, resulting in double taxation. A C-corporation can have multiple different classes of stack and an unlimited number of shareholders.
Some founders choose to incorporate their business as an S-corporation, which is taxed in a different way to a C-corporation. S-corporation shareholders report business income and losses via their own individual tax returns. An S-corporations can have no more than 100 shareholders, and can offer just one class of stock. With an S-corporation, all shareholders must be resident in the US.
Pros of Corporations
– Protection of the shareholders’ personal assets.
– Easier access to capital.
– Business continuity and security.
– S-corporations can confer tax benefits.
Cons of Corporations
– More complicated to set up than a partnership.
– More expensive to establish and operate.
– Rigid formalities, structure, and protocol.
– C-corporations result in double taxation.
Partnership or Corporation?
The most appropriate business structure depends on an assortment of factors. A corporation pays taxes at a corporate level, separately from the shareholders. Shareholders are also responsible for paying income tax on dividends, culminating in double taxation.
Limited partnerships pass profits through to the individual owners, who are only taxed on a personal level. However, limited partnerships only protect limited partners, with general partners retaining full responsibility for the debts and liabilities of the business.
Your choice of legal structure dictates a myriad of different aspects of the business, from establishing the venture and its day-to-day operations, to taxation, and the proportion of co-owners’ personal assets that are placed at risk. Identifying the optimum business structure can be a complex process that must be undertaken with a great care.
Consulting with specialists such as attorneys, accountants, and business counselors can provide valuable insights. Their acumen can enable co-owners to identify the optimum business structure to not only get their enterprise off the ground, but ensure it runs smoothly in the future. This will not only save them considerable sums, it will potentially alleviate a great deal of heartache in the long run.