What is a partnership?
A partnership is a business structure composed of two or more people, but is unincorporated. Since a partnership is unincorporated, it is not a separate legal entity.
There isn’t a separation between the business and the business owners. The business owners have what’s called “liability” for the business debts.
Each partner has equal control of the business and equal responsibility for the business’s debts, liabilities, and taxes.
If the business defaults on a loan or other debt, then the owners take on a personal liability for the outstanding balance. It’s possible that debtors will come after personal assets in this situation.
There are two main types of partnerships: general partnership and limited partnership. The difference between the two is that limited partnerships have limited partners: partners whose only involvement is contributing money and receiving dividends
Limited partners don't have personal liability in the same way general partners do.
It's also possible to form a limited liability partnership. In this case, there's a limited liability partner who is similar to a limited partner, but contributes to the business's operations beyond the financial backing.
How do I start a partnership?
General partnerships are a common business entity type in part because of how easy it is to start one.
Technically, you don’t need to file paperwork or fill out forms to get your partnership launched. Instead, the moment you and your partners start conducting business, you are a partnership.
While starting a partnership is easy, it’s still best to take some early steps before you launch.
Every partnership should have a written partnership agreement. Partnership agreements outline essential details about the business relationship, especially in cases of whether something goes wrong. While you trust your business partner, the written agreement is cheap insurance.
The partnership agreement should include:
- The name of the partnership
- The distribution of profits
- The proportion of responsibility for losses
- What happens in the case of someone wanting to exit the business.
To take out some of the guesswork, use a free partnership agreement template to ensure all the bases are covered.
Limited partnerships and limited liability partnerships aren't as easy to start. The rules for the licenses and permits required vary by state. Get started by looking up your specific state and industry on the Small Business Administration website.
How is a partnership taxed?
Partnerships fall under a category of business types called “pass-through entities.” What this means is that any profit or loss and the tax liability it creates “passes through” to the owners.
The partnership files IRS Form 1065 at the end of its fiscal year. Form 1065 reports information about the business like its net income, deductions, and how they are distributed to each partner.
The partners each receive a Schedule K-1 from the partnership. The Schedule K-1 outlines what the partner reports on their personal tax returns.
What this means is that the business isn’t taxed, but the business owners. The tax rate the business pays is determined by the personal income tax rate of the business partners.
Part of the taxes partners pay is self employment taxes. These are the self-employed equivalent of payroll taxes and cover Social Security and Medicare.
Suggested reading: How Are Partnerships Taxed? A Guide
What is a corporation?
A corporation is a business structure where the business has been established as a separate entity. It has its own assets, liabilities, and corporate tax rate.
Because a corporation is a separate entity, the business owners don’t have liability in the same way that a partnership does. Their personal assets are protected in the case of a business defaulting on its debts.
Corporations also benefit by more easily bringing on outside investment. Incorporating allows you to issue stock and bring on shareholders with formal stock certificates.
What are the different types of corporations?
Once a business is incorporated, it isn’t just a “corporation.” There are actually different types of corporations that businesses can become.
The most common type of corporation, and the one that businesses default as when incorporating, is the C corporation (or C corp). Once you’ve successfully incorporated, you’re considered a C corporation.
Alternate options are S corporation and LLC—limited liability corporation or limited liability company.
S corporation (or S corp) is a special tax designation corporations apply for, and if approved, it let's them be treated as a pass-through entity (sound familiar?). This means that, similar to partnerships, the shareholders report their portion of the business’s income, credits, and deductions on their personal tax return.
Since S corporations are a tax designation and not their own entity type, you can’t incorporate as an S corporation. You first incorporate and then apply for the tax designation using IRS Form 2553.
LLCs on the other hand are a separate entity type. They are unique in that they are created at the state level so the rules that are enforced vary by location. For example, an LLC created in Delaware has different rules than one created in California.
An LLC grants its owners (called members) liability protection so their personal assets are protected. But they’re also taxed as a pass-through entity. This hybrid model offers some of the benefits of a corporation without some of the drawbacks, however it also has its own disadvantages when it comes to transferring ownership or seeking outside investment.
Suggested reading: S Corp vs. LLC: What Are They and How Are They Different?
How do I start a corporation?
Establishing your business as a corporation isn’t a quick process. Give yourself time to do each step properly. You’ll want to have the flexibility to double-check all of the details before completing any part of the process.
There are 12 steps to incorporating:
- Pick your type of corporation
- Pick a state to incorporate in
- Pick a name
- Files articles of incorporation with your state
- Adopt a set of bylaws for your incorporation
- Elect a board of directors
- Issue shares
- Appoint officers
- Secure any licenses and permits you need
- Get an Employer Identification Number from the IRS
- Sign up for payroll tax payments with the IRS
- Sign up with Social Security Business Services Online
Get a more in depth breakdown of the steps in our guide to incorporating.
How is a corporation taxed?
Since a corporation is a separate entity, it’s taxed as a separate entity.
C corporations have a corporate tax rate of 21%. To calculate the tax bill of a C corporation, simply take the taxable income and multiply it by 0.21.
The owners then pay taxes based on their personal earnings from the corporation. The tax rate used in this calculation is their personal income tax rate.
Since C corporations and its owners pay taxes separately, they are subject to what’s called “double taxation.” This is unique to C corporations; pass-through entities like partnerships don’t need to worry about it.
This doesn’t automatically mean C corporations pay more in taxes. Depending on the unique situation and context of the business, incorporating as a C corporation could save your business money in taxes.
It’s best to talk with an accountant to understand the full impact of how incorporating could affect your tax situation.
Partnership vs corporation comparison
There are four main considerations when comparing partnerships and corporations. We’ve compiled them in a table for reference below.
What to consider when choosing between a partnership and a corporation
Before you commit to an entity type, it’s best to talk to an accountant or business professional who can consult you based on your specific circumstances. However, the following questions are things to consider before making the switch between partnership and corporation.
How fast do you want to launch?
You don’t need to incorporate your business right away. It’s common for businesses to wait to incorporate until it’s advantageous to do so. Typically, this is when the business's earnings are high enough that it would benefit from the 21% flat corporate income tax rate.
If you want to get your business started fast, a partnership is the quickest way to do so. Then, some time down the line, you can re-evaluate whether a corporation is a better fit.
Do you need liability protection?
Having liability protection gives you peace of mind as you work on growing your business. If you’re going to be taking on debt as a way of raising capital, it’s worth considering an entity type that protects your personal assets as you develop your operations.
Are you looking for external investment?
If you’re looking to raise money through selling stock, then you'll have to consider incorporating. When incorporated, you have the option of issuing stock (shares in the company) and bringing people on as shareholders. People are more likely to invest in a company when there's a formalized system in place they can depend on.
As a partnership, you’re limited to informal agreements like a handshake deal or IOU.
Do you want to cover the costs of incorporation?
Launching a business comes with a fair few start up costs. In between all of these early stage expenses, will you have enough to cover the costs of incorporating?
The costs of incorporating vary by state. Depending on where you incorporate and whether you choose to bring on help with the process, you could be looking at a cost of $200 to $1,200 plus legal fees just to have everything in order to begin operating.
Incorporating comes with recurring fees, as well. These annual charges add up for newer businesses that would rather put that cash into growing their operations. Filing fees range from $50 to $250 and some states charge a franchise tax based on either the business's revenue or net income amount.
Since these costs vary by state, it's often part of a business's decision making process when choosing which state to incorporate in.
Do you mind stricter reporting requirements?
Corporations have stricter rules and reporting requirements. There’s extra paperwork and reporting required at both the federal and state level. Partnerships don’t have to worry about all the extra admin work.
Working with the combination of a bookkeeper (like Bench) and an accountant makes staying on top of reporting requirements easier regardless of your business’s legal entity type.
