by Gary W. Smith

Choosing the right entity for your business isn’t easy.  In our first post, we listed questions you need to consider and the potential tax structures available to your business.  In this post, we will continue our look at the fourth structure, partnerships.

In the prior post, we looked at the state level issues to consider when selecting an entity taxed for income tax purposes as a partnership.  In this post, we will review the income and payroll tax issues to consider.

First, let’s look at payroll taxes.  If you are an owner of an entity taxed as a partnership, you are not a W-2 employee.  You will have to deal self-employment taxes, withholding, and estimated tax payments similar to a sole proprietor (see the post about sole proprietorships for details).

When you start a business and go through all the filings and forms with the IRS and state tax agencies, you develop an understanding of how this process works.  It’s not a major issue.  However, when you decide to provide ownership to an employee, the person changes from being a W-2 employee to having to deal with all of the tax and withholding issues individually.  This change is typically a big shock for employees.  If you offer ownership to employees, be thinking about how to help them with the transition in tax reporting and payments.

Now, let’s look at income taxes.  Entities taxed as partnerships (I’m going to refer to them generically as partnerships) have an amazing amount of flexibility for transactions that can be structured without creating taxable income.  They also have many traps that can trigger taxable income when you don’t have experience and knowledge in how to structure the transactions.

Partnerships are “flow through” entities similar to S corporations.  This means the partnership entity does not pay income tax.  The owners of the partnership pay that tax.  As a result, you are able to get the same benefits in income tax rates as you do for an S corporation.

With partnerships, you get additional benefits not available to owners of S corporations.  These benefits include the ability to transfer assets into and out of the partnership without triggering taxable income and the ability to structure different financial benefits for different owners (there is no second class of stock restriction).  You also have a better ability to use losses generated by the business in a partnership than in an S corporation.

One final point to consider is how you can change your entity structure during the life of your business.  You can typically go from sole proprietorship to partnership to S corporation to C corporation without creating taxable income.  However, you generally can’t go from being a corporation to a partnership or sole proprietorship without creating taxable income.  Moral of the story?  If you think you want a C corporation, be really certain you want a C corporation.

Please feel free to send me an e-mail at gary.smith@vennlawgroup.com if you have a question about these options.

Gary W. Smith is an attorney at Venn Law Group with more than 20 years’ experience providing legal counsel and innovative solutions to business owners and management teams. His areas of focus include mergers and acquisitions, succession and exit planning, securities and capital structures, business structures, and tax. He excels at navigating the legal complexities of diverse industries ranging from professional services and IT infrastructure to manufacturing and real estate.