The structure of your business determines many of your responsibilities as a business owner, such as what taxes you pay and your level of personal liability.
Of the available business structures, also called entities, a partnership and a corporation are common options. Both can be operated by more than one person, but there are differences in how you must manage each type of business.
While you may be able to change business structures throughout the life of your company, it could be a difficult process. To help you choose the right structure for your business, we’ll help you understand the details of a partnership and a corporation.
Partnership
A partnership is a business with two or more owners who each contribute money, property, labor or skills to the operation. The IRS considers a partnership a pass-through business, meaning all partners share the profits and losses of the business and add their portion to their personal income.
Partners must pay personal income taxes on their share of the business. Partners may also be responsible for self-employment taxes and estimated taxes, while the business itself may owe employment taxes and industry-specific excise taxes.
There are three types of partnerships that allow you to adjust the amount of liability for business owners.
General partnership
When you establish a partnership, you’re likely forming a general partnership, which occurs when two people work together to earn a profit. You may not have to officially file with a government agency when you form a general partnership, depending on the state in which you live.
A general partnership does not provide any personal liability protection. You and your partner would bear the responsibility for the business’s debts, and your personal assets would be at risk if the business were sued.
Although a general partnership doesn’t offer legal protection, it requires less paperwork and simpler tax filing than other entities. It may be a good structure for small businesses just starting out.
Limited partnership
A limited partnership offers some protection for partners. While one general partner must assume personal liability, the other partners, called limited partners, would be protected from personal liability.
Limited partnerships must be formed through a state government agency. This structure would be best for a business with one partner who is active in daily operations and could take on liability, as well as one or more less-active partners who contribute to the business but would not want to be fully liable. Limited partners cannot be involved in day-to-day business functions.
A limited liability partnership provides liability protection for all partners. Although regulation of limited liability partnerships varies at the state level, the structure allows all partners to shield their personal assets. Partners also would not be responsible for the actions of other partners within the business.
Corporation
A corporation is a legal entity that is separate from its owners. A corporation can act independently and make a profit, be taxed and be held legally liable. This business structure offers business owners full protection from personal liability.
A corporation is held to a higher standard of record-keeping than other business entities. Corporation owners must file annual reports, hold annual shareholder meetings, elect a board of directors to oversee the business and follow company bylaws. Because of these extra responsibilities, a corporation can be an expensive business to run.
There are several types of corporations from which you could choose, but the two common options are C corporations and S corporations. Here’s how they differ:
C corporation
A group of business owners called shareholders must file articles of incorporation with their secretary of state office to form a C-corp. Shareholders have limited liability and are not responsible for the company’s debt. They can also sell shares of company stock. If you plan to take your company public, it must be classified as a C-corp.
There’s no limit to how many shareholders a C-corp can have. If an owner decides to leave the company or sell their shares, the company would mostly be unaffected and could continue operating.
The IRS requires C-corps to pay corporate tax. A C-corp is subject to double taxation because the company has to pay corporate taxes, while shareholders must pay taxes on the dividends they receive on their personal tax returns.
S corporation
To form an S-corp, shareholders would have to file articles of incorporation with the secretary of state. Like a C-corp, an S-corp provides limited liability for owners, meaning they are not responsible for the company’s debts. But an S-corp cannot have more than 100 shareholders, and all shareholders must be U.S. citizens.
An S-corp is considered a pass-through entity, like a partnership, and does not pay corporate taxes. The company’s profit and losses are passed through to shareholders’ individual income taxes, and their portion is taxed at the personal income tax rate. Some states impose a second tax on S-corps, so you may not be able to completely avoid double taxation.
Key similarities and differences between Partnership and Coporations in how net income is taxed while deciding form of business
Taxation Rules
The next difference between a partnership vs. corporation is taxes. Most people place greatest emphasis on taxation because of the direct impact to a business’s bottom line. A partnership is simpler from a tax perspective, whether you have a GP, LP, or LLP. Business partners simply file Schedule K-1 along with their personal 1040 tax return. Schedule K-1 lists each partner’s share of the company’s income, losses, credits, and deductions.
A corporation’s tax status depends on whether you’re structured as a C-corp or S-corp. You might have heard of the term “double taxation” with regards to C-corps. This refers to the fact that C-corporations pay a corporate income tax, and then shareholders have to also pay personal capital gains taxes on any dividends they receive from the company. An S-corp is a pass-through entity like a partnership, and isn’t subject to a corporate tax.
Partnership Tax Rules
A partnership is a business structure where ownership and management responsibility of a company is split between two or more individuals. A partnership is not a legal entity that is separate from the owners and therefore the partnership itself does not pay taxes. The Internal Revenue Service says that under a partnership structure, the profits a business earns flow directly to the personal income tax returns of the owners. For example, if a partnership with two owners makes $500,000 in profit and the owners split profits equally, each would have to report $250,000 in income on their personal tax returns. Partners are responsible for paying self-employment taxes on business income.
Corporation Tax Rules
A corporation is a business that is owned by a group of shareholders who purchase stock in the company. A corporation is a legal entity that is separate from the owners for tax purposes. According to the IRS, the corporations pay income taxes on profits when they are earned. Unlike the owners of partnerships, shareholders are not responsible for paying taxes on the profits a corporation earns. Shareholders of corporations are not subject to self-employment taxes.
Considerations
A dividend is payment of cash or stock that a corporation pays to shareholders. While the shareholders of corporations do not pay taxes on corporate profits, they do pay taxes on profits that the corporation distributes as cash dividends. In addition, if a shareholder sells shares of stock in a company that have increased in value over time, he must pay capital gains tax on the profit realized from the sale of stock.
How non liquidating distributions are taxed at both the entity and the owner level.
In Corporation
A non-taxable distribution is a payment to shareholders that is similar to a dividend but that represents a share of a company's capital rather than its earnings. In any case, it's not really "non-taxable." It's just not taxed until the investor sells the stock in the company that issued the distribution. Nondividend distributions reduce the basis of the stock.
A non-taxable distribution to shareholders is not paid from the earnings or profits of a company or a mutual fund. It is a return of capital, meaning that investors are getting back some of the money they invested in the company.
Not Really 'Non-Taxable': The distribution is a non-taxable event when it is disbursed, but it will be taxable when the stock is sold.Shareholders who receive non-taxable distributions must reduce the cost basis of their stock accordingly. When the shareholder sells the stock, the capital gain or loss that results will be calculated from the adjusted basis.
In Partnership:
liquidating distribution pays the entire capital account to the partner, thereby eliminating the partner's equity interest in the partnership.
No gain is recognized from a distribution of cash or marketable securities that can easily be converted to cash, unless the distribution is more than the partner's outside basis, in which case, the excess is taxable as a capital gain.
When property is distributed to a partner, then the partnership must treat it as a sale at fair market value (FMV). The partner's capital account is decreased by the FMV of the property distributed. The book gain or loss on the constructive sale is apportioned to each of the partners' accounts. If the FMV of the property exceeds the partner's outside basis in the partnership, then the partner's interest in the partnership is reduced to 0 and the receiving partner's basis in the distributed property equals his outside basis in the partnership before the distribution. The property basis that remains after subtracting the outside basis is taxable as a gain.
For Example: Your adjusted basis in a partnership is $14,000. You receive a distribution of $8000 cash and land with a FMV of $3000 and an adjusted basis of $2000. Since the amount of cash received is less than your interest in the partnership, there is no taxable transaction. However, your outside basis in the partnership declines to $4000 (= $14,000 – $8000 – $2000). Subsequently, you receive a distribution of land with an adjusted inside basis of $10,000. Since your outside basis in the partnership is only $4000, your adjusted basis in the land is also $4000, and you must report a gain of $6000 (= $10,000 – $4000).
Note: If Student find the answer lengthy then he/ she can reduce or decrease the introduction part, according to his/ her need, which is provided at the begining of the answer.
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