Partnership vs. Corporation: Taxes, Liability & Perks

Business entity selection may be the most critical early decision that entrepreneurs and small business owners must make. This choice will have a ripple effect that impacts many aspects of your business, from your day-to-day operations and personal liability to how much you pay in taxes. While there are several excellent business entities to choose from, for many entrepreneurs, the decision boils down to operating as either a partnership or a corporation. While both entities have their merits, they offer very different paths for growth, protection, and profitability.

This guide will walk you through the key differences in taxes, liability, and benefits to help you decide which structure is in closest alignment with your long-term business goals. And if you’re still unsure by the end, our small business experts are offering a free, 30-minute personalized consultation to begin mapping out the smartest path forward. 

Key Highlights

• Core Difference: A corporation is a separate legal entity from its owners, offering liability protection. A partnership is legally tied to its owners, offering greater simplicity.

• Taxation: Partnerships and S corps feature "pass-through" taxation, where profits are taxed on owners' personal returns. C corps face "double taxation" (at the corporate level and again on shareholder dividends) but can retain earnings for growth.

• Liability: Corporations provide the strongest personal liability protection. General partnerships expose owners to unlimited personal liability for business debts.

• Owner Pay: S corp and C corp owners can be paid a W-2 salary. Partners take draws or guaranteed payments and are considered self-employed.

• Best Use Cases: Partnerships are great for professional firms and real estate ventures. C corps are ideal for raising capital, while S corps offer tax efficiency for profitable owner-operated businesses.

Partnership vs. Corporation

At a high level, the main distinction between a partnership and a corporation lies in legal separation. A corporation is a distinct legal entity separate from its owners (shareholders), while a partnership is legally synonymous with its owners. This fundamental difference impacts liability, taxation, and administrative requirements.

Here is a quick overview of the two structures:

An important note on limited liability companies (LLCs): An LLC is a popular hybrid structure that can be taxed as a partnership or a corporation. Some professionals feel it's the best entity for small business taxes. While this article focuses on comparing partnership and corporation frameworks, many of the tax and liability principles discussed apply to LLCs as well. For a deeper dive, you can compare LLC, S, and C options in our blog. 

How profits are taxed for each (and why it matters)

Partnership tax vs. corporate tax considerations are often weighted as the most significant factor for small business owners when deliberating over entity selection. The way your profits are taxed affects not only your annual tax bill but also your ability to reinvest in the business and build personal wealth.

Partnership Taxation (Pass-Through)

Partnerships are considered "pass-through" entities, meaning the business itself doesn’t pay income tax. Instead, the profits, losses, deductions, and credits are "passed through" to the partners. Each partner reports their share of the income on their personal tax return (via a Schedule K-1) and pays taxes at their individual income tax rate.

Key Tax Implications for Partnerships:

• Self-Employment (SE) Tax: General partners are typically considered self-employed and must pay the 15.3% self-employment tax that funds Social Security and Medicare on their share of the partnership's earnings. This can be a significant cost, although partners may deduct half of what they paid in SE tax. The treatment for limited partners can be complex and may depend on their level of involvement in the business.

• Qualified Business Income (QBI) Deduction: Many partners may be eligible for the valuable QBI deduction, which allows them to deduct up to 20% of their qualified business income. This deduction, established by the Tax Cuts and Jobs Act of 2017 and made permanent by the One Big Beautiful Bill Act of 2025, helps level the playing field with the lower corporate tax rate.

• Filing Requirements: Partnerships file an annual information return, Form 1065, to report their income and expenses to the IRS. They also provide each partner with a Schedule K-1, which details each individual share of the financial results.

C corporation Taxation (Entity-Level + Dividends)

C corporations are taxed as separate entities, which leads to a phenomenon known as "double taxation." This is a critical concept for a business owner considering this entity type to understand.

Here’s how double taxation works:

1. The corporation pays tax on its profits at the federal corporate tax rate (currently a flat 21%).

2. If the corporation distributes its after-tax profits to shareholders as dividends, those shareholders must pay taxes on that dividend income on their personal tax returns.

This is why C corps face double taxation. However, there are strategic reasons why this structure can still be advantageous:

• Retained Earnings: C corps can retain earnings within the company to reinvest in growth, and those retained profits are only taxed at the corporate rate. This is a powerful tool for scaling a business.

• Fringe Benefits: C corps can often offer a broader range of tax-deductible fringe benefits to owner-employees, such as health insurance and retirement plans.

• Filing Requirements: C corps file their own tax return, IRS Form 1120, U.S. Corporation Income Tax Return, and often need to make quarterly estimated tax payments. The C corp federal tax framework is more complex than that for partnerships.

S corporation Taxation (Pass-Through with Payroll Rules)

An S corporation is a special tax election that offers a hybrid approach. It combines the pass-through taxation of a partnership with the limited liability of a corporation. Like a partnership, an S corp’s profits and losses are passed through to the shareholders’ personal tax returns, avoiding the double taxation of a C corp.

However, there’s a crucial difference: owner-employees of an S corp must be paid a "reasonable salary" before they can receive non-payroll distributions. 

Key Tax Implications for S corporations:

• Reasonable Compensation S corp: The IRS requires that any shareholder-employee who provides significant services to the business must be paid a reasonable salary. This salary is subject to standard payroll taxes (Social Security and Medicare). The key is to pay a reasonable salary before distributions to remain compliant.

• Distributions:Profits distributed to shareholders after a reasonable salary has been paid are generally not subject to self-employment or payroll taxes. This is the primary tax advantage of an S corp and can lead to significant savings.

• Eligibility: To qualify for S corp status, a business must meet specific S corp shareholder & stock limits, including being a domestic corporation with no more than 100 shareholders, who must be U.S. citizens or residents, and having only one class of stock.

Liability & Legal Protections

Beyond partnership vs. corporation taxes, your choice of business entity determines your level of personal legal and financial risk. This is where the corporate liability shield becomes a significant consideration, particularly for owners operating in high-risk industries.

Partnership flavors and risk

Corporation liability

When it comes to partnership vs. corporation liability, corporations offer the strongest form of personal liability protection. Because the corporation is a separate legal entity, shareholders are typically only at risk for the amount of their investment in the company. Creditors and legal claimants generally cannot pursue the personal assets of shareholders to satisfy business debts.

However, this protection is not absolute. Courts can "pierce the corporate veil" if a business fails to maintain corporate formalities (like holding regular meetings and keeping minutes) or in cases of fraud.

Owner Pay, Payroll, and Benefits

Paying owners

How you get paid from your business is directly tied to its structure.

• Partnerships: Partners are not employees and do not receive a W-2 salary. Instead, they take draws or guaranteed payments from business profits.

• S corporations: As discussed, owner-employees must receive a W-2 salary that is considered reasonable compensation. Any additional profits can be taken as distributions. This structure requires running formal payroll.

• C corporations: Owner-employees are paid a salary like any other employee. The corporation can also issue dividends to shareholders.

Fringe benefits & health insurance

C corps generally offer the most flexibility for providing tax-advantaged employee benefits. For S corp owners who hold more than 2% of the company stock, there are special rules regarding the 2% S corp shareholder health insurance treatment.

Costs, compliance, and admin load

Startup and ongoing requirements

There are startup obligations and ongoing requirements you must address regardless of the entity type you choose to form as. 

Partnerships:

• Draft partnership agreement

• Fewer formalities (varies by state)

• Ongoing annual returns and potential SE tax complexities

Corporations:

• Draft corporate bylaws

• Regular board or shareholder meetings, minutes 

C corps often face more filings, but can be better for raising capital and offering equity incentives. To elect S corp status, timing is essential, as is maintaining the entity's eligibility via shareholder, stock, and other rules. 

When a partnership makes sense

Review these scenarios and considerations for when forming your business as a partnership makes the most sense. 

• Professional Service Firms: Businesses like consulting firms or agencies where partners want direct involvement and management.

• Real Estate Investments: LPs are commonly used for real estate ventures where some partners (limited partners) provide capital and want limited liability, while others (general partners) manage the property.

• Businesses Needing Flexibility: Partnerships allow for flexible allocation of profits and losses that are not strictly tied to ownership percentages.

When a corporation makes sense

Review these scenarios and considerations for when forming your business as an S corp or C corp makes the most sense.

C corp 

• Businesses Seeking to Raise Capital: C corporations are the preferred structure for venture capital and outside investors because they can issue multiple classes of stock.

• High-Growth Companies: The ability to retain earnings for reinvestment makes C corps ideal for businesses on a rapid growth trajectory.

S corp

• Owner-Operators Seeking Tax Efficiency: An S corp can be highly effective for profitable businesses where the owner can justify a reasonable salary and take the rest of the profits as distributions, saving on payroll taxes. This is often when S corp beats a sole proprietor.

State taxes and multi-state considerations

Some states impose taxes even on pass-throughs or S corps, including: 

• Franchise tax

• Privilege tax 

• Corporate income tax

For example, California imposes an $800 annual franchise tax on limited and limited liability partnerships. Review this current state rates map to determine if you should build franchise, privilege, or corporate income tax considerations into your annual tax strategy. 

Switching Structures or Making Elections

Common paths & timing

Your initial choice of entity isn’t set in stone. It’s common for businesses to evolve. A successful partnership may decide to become a corporation to limit liability or attract investors.

• Partnership to S corp: You can switch from partnership to S corp. Many partnerships and LLCs elect to be taxed as an S corp to gain liability protection and tax advantages. Wondering how to elect S corp status? This is typically done by filing IRS Form 2553, Election by a Small Business Corporation, with the IRS.

• C corp to S corp (and vice-versa): It is also possible to switch between C corp and S corp status, though there are specific rules and potential tax consequences to consider.

Transitioning between entities can trigger tax events like built-in gains, so it’s crucial to plan the transition carefully with a professional. This is where expert help can be invaluable to form your business the right way.

Business Structure Decision Checklist

As you weigh your options, consider these key questions:

• Profitability: How profitable is your business now, and what do you project for the future? This will influence whether pass-through taxation or the corporate rate is more favorable.

• Liability Risk: What is your personal tolerance for risk? Does your industry expose you to significant legal liability?

• Funding Needs: Do you plan to seek investment from venture capitalists or angel investors?

• Administrative Burden: How much time and resources are you willing to dedicate to compliance and paperwork?

• Benefits: Are health and retirement benefits, along with owner participation, important?  

• Exit Strategy: Do you plan to sell the business one day or take it public?

FAQs

Can partners be on payroll?

No, partners aren't employees and shouldn't receive a W-2. They receive distributions or guaranteed payments taken from the partnership's profits.

Do S corp distributions avoid payroll tax?

Yes, distributions of profit after paying a reasonable salary are not subject to payroll taxes, which is one reason S corporations are popular. 

Is the corporate tax rate still 21%?

Yes, the federal corporate tax rate is 21% under current law. While there have been numerous tweaks and changes to the tax code in 2025, the corporate tax rate has remained unchanged. For more on this, see the corporate rate and state taxes context.

Will the QBI deduction still apply next year?

Yes, the QBI deduction 2025 was made permanent and applies for previous tax years, 2025, and beyond.

The Right Choice for Your Business

Choosing between a partnership and a corporation is a foundational decision with long-term consequences for your:

• Taxes

• Liability

• Future growth potential

While a partnership offers more simplicity, a corporation provides a powerful liability shield and greater potential for attracting investment. The S corp election offers a compelling middle ground, blending pass-through taxation with liability protection.

Entity selection isn't difficult with expert guidance. When you trust 1-800Accountant, America's leading virtual accounting firm, for entity structuring and tax advisory, your designated team handles these tasks for you, ensuring the optimal entity structure and a minimal tax liability, while maintaining year-round compliance. 

Schedule your free 30-minute consultation with a small business expert today. We’ll review your numbers and map the smartest path forward, so you can focus on what you do best—running your business.