The question every preparer faces
"She's starting a business with two partners. Should they be a partnership or an S corp?"
This is the entity selection conversation — and it's where tax preparers either earn their fee or lose the client. The answer isn't a formula. It depends on profitability, the nature of the business, the owners' expectations, and how much complexity they'll tolerate.
This guide walks through the practical differences between Form 1065 (partnership) and Form 1120-S (S corporation), so you can frame the conversation with your client and recommend the right structure.
The fundamental difference
A partnership (Form 1065) is a pass-through entity where income, deductions, and credits flow to the partners via Schedule K-1. The partnership pays no federal income tax itself.
An S corporation (Form 1120-S) is also a pass-through entity — income flows to shareholders via Schedule K-1. But the S corporation adds a critical layer: it can distinguish between wages and distributions.
That distinction is why most entity selection conversations eventually become conversations about self-employment tax.
Self-employment tax: the S corp advantage
For a partnership, all ordinary business income allocated to a general partner is subject to self-employment tax (15.3% up to the wage base, plus 2.35% Medicare on the excess). This is calculated on Schedule SE.
For an S corporation, only reasonable compensation paid as W-2 wages is subject to employment taxes. Distributions above that compensation are not subject to SE tax.
Example: A business generates $200,000 in profit.
| Structure | SE/Employment Tax Base | Approximate SE Tax |
|---|---|---|
| Partnership | $200,000 (all income) | ~$22,000 |
| S Corporation | $90,000 (reasonable salary) | ~$13,000 |
The $9,000 difference is why S corporations are popular among profitable small businesses.
The reasonable compensation requirement
The IRS requires S corporation owners who work in the business to pay themselves reasonable compensation — a salary that reflects what comparable businesses pay for similar services. This is a facts-and-circumstances test, not a formula.
Factors the IRS considers:
- Training and experience
- Duties and responsibilities
- Time devoted to the business
- Dividend history
- What comparable businesses pay for similar services
Low salaries + large distributions are an audit flag. The IRS has won reasonable compensation cases consistently. Your client's salary should be defensible.
Where partnerships win
1. Flexibility in allocations
Partnerships can allocate income, gains, losses, and credits among partners in almost any way the partners agree — as long as the allocation has substantial economic effect. This includes:
- Special allocations of depreciation
- Layered allocations (new partners get different percentages than existing)
- Profit-sharing interests that differ from capital interests
S corporations are strictly pro rata: every shareholder receives income in proportion to their share ownership. No special allocations. If one shareholder owns 33%, they get exactly 33% of every income and deduction item.
2. No salary requirement
Partnerships don't have the reasonable compensation issue. General partners pay SE tax on their distributive share, but there's no IRS-enforced salary structure. This simplifies payroll and reduces administrative overhead.
3. Capital account flexibility
Partnership capital accounts can be adjusted for contributed property, distributions, allocations, and liabilities in ways that S corporation stock basis cannot. This matters for:
- Contributing appreciated property
- Distributing property to specific partners
- Tracking outside basis for loss limitations
4. Step-up in basis
When a partnership interest is sold or inherited, the buyer or heir gets a step-up in the basis of the partnership's assets (inside basis). S corporation stock gets a step-up in the stock's basis, but the inside basis of the corporation's assets does not step up — which can create built-in gain issues.
Where S corporations win
1. Self-employment tax savings (covered above)
2. Employment benefits
S corporation shareholders who own more than 2% can receive tax-free fringe benefits including:
- Health insurance premiums
- HSA contributions
- Group-term life insurance (above $50,000)
Partners cannot receive these benefits tax-free in the same way.
3. State income tax
In some states, S corporations are treated more favorably than partnerships for state income tax purposes. This varies by state and should be evaluated for your client's specific situation.
4. QBI deduction interaction
Both partnerships and S corporations can pass through qualified business income (QBI) for the Section 199A deduction. However, the calculation differs:
- For partnerships, QBI is calculated at the partner level
- For S corporations, QBI is calculated at the shareholder level, but W-2 wages paid by the S corp count toward the wage limitation
This can be advantageous for S corporations that pay meaningful salaries.
The decision framework
When advising a client, consider these factors in order:
1. Is the business profitable enough?
If the business generates less than ~$40,000–$50,000 in annual profit, the self-employment tax savings from an S election may not justify the additional administrative costs (payroll, separate tax return, reasonable compensation analysis).
Rule of thumb: The SE tax savings should exceed the incremental administrative costs by a factor of 3–5x.
2. How many owners are active in the business?
Multiple active owners make the reasonable compensation conversation more complex. If three partners all work in the business, each needs a defensible salary — and they may disagree about what's "reasonable."
Partnerships avoid this entirely.
3. Will the owners want special allocations?
If the owners anticipate wanting to allocate income differently from ownership percentages — for example, a 50/50 partnership where one partner gets 70% of depreciation — a partnership is the only option.
4. Is the business capital-intensive?
Capital-intensive businesses (real estate, equipment-heavy operations) often benefit from partnership treatment because of the flexibility in allocating depreciation and the ability to distribute appreciated property without triggering gain.
5. What are the exit plans?
If the owners plan to sell the business or transfer interests to family members, the partnership's basis step-up may be more valuable than the S corporation's SE tax savings.
Common mistakes to avoid
Electing S status too early. A business that's not yet profitable doesn't benefit from SE tax savings but still incurs the administrative costs.
Setting unreasonably low salaries. $10,000 salaries for full-time owner-operators are an audit invitation. The IRS has a strong track record in reasonable compensation cases.
Ignoring state-level implications. Some states don't recognize S elections; others have different tax rates for partnerships vs corporations.
Forgetting the QBI interaction. The Section 199A deduction calculation differs between entities, and W-2 wages from an S corporation can help satisfy the limitation.
Not revisiting the decision. What's right at formation may not be right at $500K of profit. Annual entity review should be part of your engagement.
Products that go deeper
If you handle entity returns, these professional guides walk through the complete preparation and review process:
Form 1065 Partnership Tax Preparation: A Professional Practitioner's Guide — Complete partnership return system including capital account maintenance, special allocations, and Schedule K-1 reporting.
Form 1120-S: A Professional Practitioner's Guide — S corporation return preparation including reasonable compensation analysis, basis tracking, and shareholder reporting.
Entity Tax Practice Bundle — Both guides plus depreciation, QBI, and capital gains references at a discount.
This article is general educational information for tax professionals, not tax advice for a specific client's situation. For entity selection guidance on a specific matter, consult the referenced guides or engage our advisory services.