Key takeaways
- Partnerships and corporations differ in formation, taxation and liability.
- Starting a partnership is generally easier and less expensive than forming a corporation.
- Corporations are typically a better choice if you want to raise investor funds.
When choosing a business entity structure, many small business owners decide between a partnership vs. corporation. The decision can impact your personal liability, management structure and, ultimately, your bottom line.
A partnership is the default business structure for a company with multiple owners. The business’s income and losses are reported on co-owners’ personal tax returns based on ownership share.
A corporation is a legally separate entity owned by shareholders. An elected board and board-appointed officers manage the corporation.
What is a partnership?
A partnership is a business jointly owned and run by two or more people. If you start a business with at least one other person and don’t choose a different structure, such as an LLC or corporation, you’ll be treated as a partnership by default.
A partnership is considered a pass-through entity for tax purposes. This means the partnership doesn’t typically pay business income tax. Instead, co-owners report their share of the business’s income and losses on their personal tax returns and pay their personal income tax rate.
There are three types of partnerships:
General partnership
A general partnership is the most common type, in which co-owners are personally liable for the business’s debts and obligations. For example, if a client gets injured on business property, they may be able to pursue the partnership’s assets and, in some cases, the owners’ personal assets as compensation for their injuries.
Limited partnership
A limited partnership has two classes of partners. General partners are responsible for running the day-to-day business and are personally liable for the company’s debts and obligations. Limited partners invest money in the business but don’t take part in daily decisions. Their liability is limited to the size of their investment in the business.
Limited liability partnership
A limited liability partnership is a partnership structure that is commonly used by professional service businesses, such as law firms, medical practices and accounting firms. Partners typically receive some personal liability protection, often including protection from claims arising from another partner’s negligence. Exact protections vary by state, and partners generally remain personally liable for their own wrongful acts.
What is a corporation?
A corporation is a separate legal entity. To create one, you must file formation documents (often called articles of incorporation) with the state. The owners, called shareholders, are not personally liable for the business’s debts or obligations.
Corporations are commonly organized as either a C corporation or an S corporation.
1. C corporation
With C corporations, the business usually pays corporate income tax and shareholders also pay personal taxes on any dividends they receive. A C corp can have an unlimited number of shareholders and can issue multiple classes of stock.
2. S corporation
Corporations can elect to be taxed as an S corporation, which, like a partnership, is a pass-through entity. Shareholders in an S corp report the business’s income and losses on their personal tax returns.
To qualify, an S corp is limited to 100 shareholders and one class of stock.
An S corp’s management structure is similar to a C corp’s. Shareholders own the company and elect a board of directors to make strategic decisions. The board appoints officers — like a CEO or CFO — to run the business on a day-to-day basis.
Key differences between partnership vs. corporation
The choice between a partnership and corporation affects taxes, liability, access to capital and management structure. If you are undecided on which business structure to choose, take some time to understand the major differences between the two.
| Partnership | Corporation | S corporation | |
|---|---|---|---|
| Formation | Business license + DBA + partnership agreement. | Articles of incorporation, corporate bylaws, shareholder agreement, stock certificates. | Articles of incorporation, corporate bylaws, shareholder agreement, stock certificates, IRS Form 2553. |
| Ownership | Two or more people. | One or more people, unlimited shareholders. | One or more people, no more than 100 shareholders. |
| Taxation | Personal taxes. | Personal tax + corporate income tax. | Personal taxes. |
| Liability | Unlimited personal liability, except for LPs and LLPs. | Limited personal liability. | Personal liability protection. |
| Ongoing costs and maintenance | Annual tax or filing fee (in some states). | Regular board meetings, shareholder meetings, record maintenance, annual report. | Regular board meetings, shareholder meetings, record maintenance, annual report. |
Formation
Partnerships
Starting a partnership is generally easier, less time-consuming and cheaper than forming a corporation. You can start a general partnership with minimal paperwork. You may only need to file for a business license and/or register a business name. Even when it isn’t legally required, a written partnership agreement is strongly recommended to outline each partner’s rights and responsibilities. Starting a limited partnership or limited liability partnership requires state filings and fees, so they are typically more involved than a general partnership.
Corporations
Forming a corporation usually requires formal state filings and recordkeeping. In addition to any required business licenses, you’ll typically file formation documents (such as articles of incorporation) and create internal documents (like corporate bylaws). You may also need to issue stock certificates and put shareholder agreement in place. If you want S corporation tax treatment, you’ll also file IRS Form 2553 after forming the corporation.
Ownership and management structure
Partnerships
Each partner typically brings a complementary skill set to the table. For instance, one partner works on customer acquisition and the other on technical needs. Whatever the division of work is, though, the partners actively run and manage the business together.
Corporations
A corporation has more layers of ownership and management. Shareholders collectively own the business, but don’t directly engage in company decision-making. Instead, shareholders elect a board of directors to make major strategic decisions and appoint officers to run the organization.
A corporation has the ability to issue stock and easily transfer pieces of ownership in the company to third parties. This makes corporations the preferred business structure of most investors.
In particular, investors like C corporations because they can purchase preferred stock in your business. As your company grows, stock will increase in value and the investor can earn a return on their investment. In a partnership, there isn’t a similar item of value that you can easily exchange for an investor’s money.
Taxation
Partnerships
A partnership is simpler from a tax perspective. Business partners 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.
Corporations
A corporation’s tax status depends on whether it’s structured as a C corp or S corp. You might have heard of the term “double taxation” with C corps. This refers to C corporations paying a corporate income tax and then shareholders also paying personal capital gains taxes on 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.
Legal exposure
Partnerships
A general partnership leaves you open to personal liability for business debts or lawsuits. Limited personal liability is available to limited partners in an LP and to all partners in an LLP.
Corporations
One of the biggest benefits of a corporation is that it is a separate legal entity. Creditors and legal claimants can only come after your business assets. That can provide a sense of relief, especially if you operate in a higher-risk industry, like construction or shipping.
Ongoing costs and maintenance
Partnerships
Ongoing costs and maintenance requirements are minimal with a partnership. Some states charge an annual tax or annual filing fee. But there’s not much in the way of paperwork.
Corporations
Corporations are highly regulated. You need to have regular board and shareholder meetings, document meeting minutes and maintain records of important resolutions. Corporations also have to file an annual report documenting their activities over the previous year.
How to choose between a partnership and a corporation
To decide between a partnership and a corporation, you can distill the decision down to three things — your tax bill, preferred method for raising capital and appetite for legal risk.
1. Minimize your tax bill
C corporations are subject to double taxation, meaning they pay a flat income tax rate of 21%, and shareholders are taxed on their personal tax returns when profits are distributed as dividends.
However, a C corporation also enjoys more tax savings than other types of businesses, such as shifting income around to different fiscal years. A C corporation can also deduct payroll taxes and 100% of fringe benefits given to employees.
2. Consider how you want to raise capital
If you want to raise money from investors, a corporation may be the better choice and may even be required. Many angel investors and venture capitalists won’t invest money in a business unless they can receive stock in a corporation in exchange for their support. Stock is the reason that investors can make returns on their initial investment.
3. Weigh your appetite for legal risk
If you have a general partnership, your personal assets — like your car, home and personal bank accounts — are open to creditors. This might not be a scary proposition when first starting out and the business doesn’t yet have a steady revenue stream.
But most business owners protect themselves by establishing a corporation once they start making a significant amount of money. The trade-off is that it’s costlier and more time-intensive to create and maintain a corporation.
Setting up a partnership or corporation
To form your partnership, contact your state’s or city’s business filing department and find out if your industry requires a business permit. You’ll also need to file a doing business as/fictitious business name if you’re operating under a trade name.
For a corporation, you’ll need to file articles of incorporation. After that come your corporate bylaws, stock certificates and shareholder agreements. Most small business owners use an online legal service like LegalZoom or CorpNet, or hire a business attorney to help them comply with corporate formalities.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.
