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Someone wrote:

"If liability is not a concern, a partnership is simple. There's no need for articles of incorporation to be filed with the state, no need for bylaws, operating agreements, etc., so you can get going with a lot less paperwork. You ought to talk to a lawyer, though --- focus on the legal issues, not the taxes, because the S-corp, LLC and partnership are substantially the same

For liability reasons, I would never recommend that a business be conducted as a partnership, unless someone simply didn't have the relatively small amount of money it takes to form an LLC (or corporation, although I rarely recommend them anymore). If you conduct business as a partnership, and your partner skips town or otherwise makes it impossible for the business's creditors to get their bills paid, you can be stuck with all of the partnership liabilities, which could include not only the utility bills, suppliers bills, etc., but also a judgment against the partnership for sexual harassment of an employee or an auto wreck involving company business, etc.. Sure, once you've couged up all of the cash, you have a right to get back some of it from the deadbeat partner, but good luck. On the other hand, members of an LLC don't have personal liability for LLC debts. Furthermore, from a tax point of view, an LLC can choose to be taxed as a partnership (or as a Schedule C sole proprietorship if there's only one owner) or a corporation, and if it chooses to be taxed as a corporation it can also choose to be taxed as an S corporation.

While both are passthrough entities, there are very significant differences in the taxation of partnerships (which is how most LLCs choose to be taxed) and S corps. Partners in a partnership (i.e., any time I say 'partnership,' I mean an LLC taxed as a partnership) can include non-guaranteed entity debt in the basis of their partnership interests, shareholders of an S corp cannot. A partnership can have multiple classes of interests, an S corp cannot - this would be crucial if a business ever wanted any outside investment. A partnership can make special allocations of income, gain, loss, deductions, credits, etc. among the partners as needed, an S corp cannot - everything must be pro rata. A partnership can step up its inside basis on the sale of a partnership interest or on the death of a partner, an S corp cannot. Partnership property can generally be flipped in and out of the partnership to and from the partners with no adverse tax consequences. S corp property cannot. And the list goes on...

The one great advantage S corps still have (for businesses with no passive investors, that is) is the ability to control the amount of income that is subject to social security tax (as an aside, LLCs taxed as partnerships with one or more passive investors can control self-employment income even better than S corps, but that's beyond the scope of this thread for now). However, if there's going to be little or no income in the beginning of a startup, social security tax is probably not much of a concern. Besides, it's easier taxwise to go from being taxed as a partnership to being taxed as an S corp than vice versa. So, you can always start out being taxed as a partnership, then "convert" to being taxed as an S corp, if that seems like it makes sense.

I agree that first, you should focus on the legal issues as to what kind of entity to form. I think that in 99% of the cases for small startups, the LLC will be the way to go. Once that's decided, focus on the tax issues, because the LLC can be taxed in any way it chooses. It's my opinion that the majority of startups will find that partnership taxation will work very nicely for them.

Chris Riser
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