Choice of entity: benefits of a partnership.

• Author: Klahsen, Rick

When starting a new business one of the first questions an entrepreneur asks is, "What type of entity should I use?" This question is not one that should be taken lightly, nor is there a one-size-fits-all answer. There should be a great deal of discussion with the client and his or her attorney about the business operations, who the owners are today, who might participate in the ownership tomorrow, how the business will be financed, liabilities associated with the business, and what the eventual exit strategy might look like.

Most small businesses today are organized as S corporations for tax purposes because the S corporation avoids potential double taxation (unlike C corporations), allows working owners to be treated as employees, and limits employment taxes to reasonable salaries drawn by owners. The S corporation is not without its disadvantages, however. There are rigid rules about the number and type of shareholders and limitations on how income is allocated among shareholders. An S corporation may issue only one class of stock, although voting and nonvoting shares are permitted. Further, once property goes in, the owners generally cannot take it back out tax free, and when shares in an S corporation are sold, there are limited situations in which the basis of corporate assets may be adjusted.

The partnership tax structure, on the other hand, eliminates all those S corporation disadvantages in that:

* Anyone or any entity can be a partner;

* Profits and losses of the business may be allocated to owners in any reasonable manner that has substantial economic effect;

* Differing classes of ownership shares or units may be issued;

* In many cases property can be distributed out to a partner in a tax-deferred manner; and

* A purchase of partnership interests can often lead to an increase in the basis of partnership property.

The major disadvantages to a partnership are:

* All earnings allocated to a partner involved in the business are subject to self-employment taxes; and

* The flexible structure can make accounting for transactions and preparing tax returns more complex.

When taxpayers seek advice on entity choice, the analysis often focuses on two items: simplicity of operation and self-employment or payroll tax. When these are the only two items considered, it is no wonder the S corporation form is so popular. However, there are other important aspects that practitioners should consider when consulting on business structure.

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