What to Know About Partnerships and S Corporations

 

When you start a business, it usually makes sense to keep things simple. Many owners begin as a sole proprietorship and form a limited liability company (LLC), reporting income and expenses on their personal tax return. As your business grows, however, it’s worth considering whether another tax structure might be a better fit.

That’s where passthrough entities (partnerships and S corporations) come into play. These structures don’t pay federal income tax at the business level. Instead, income and deductions “pass through” to the owners and are reported on their individual returns. These are “tax only” classifications that do not affect the legal structure of the entity.

Understanding how these entities work can help you manage taxes more effectively and avoid costly surprises.

What Is a Passthrough Entity?

A passthrough entity doesn’t pay federal income tax at the business level. Instead, it “passes through” the profits, losses, deductions and credits to the owners, who report them on their personal tax returns.

Here’s how it works in practice:

  • Partnerships and multi-member LLCs file a partnership tax return. Each owner receives a Schedule K-1 showing their share of income, expenses and other items.
  • S Corporations file their own return and also issue a Schedule K-1 to each shareholder.

Owners then report the information from the K-1 on their personal returns.

A Common Misconception About Distributions

One of the most frequent misunderstandings we see is this: “I’ll only be taxed on the money I take out of the business.”

That’s not the case. You’re taxed on the net income the entity earns, whether or not you actually distribute that money to yourself.

For example:

  • If your business earns $100,000 and you leave all the money in the company’s bank account, you’ll still be taxed on $100,000.
  • On the flip side, if your business had a bad year and reported a loss, you won’t owe federal tax—even if you still have cash reserves and pay yourself from that balance.

This distinction between taxable income and cash in hand is critical for managing cash flow and avoiding surprises at tax time.

Why Equity (Basis) Matters

Another area that often trips up business owners is equity, sometimes called “basis.”

Think of equity as your ownership stake in the business. It increases when you contribute capital or when the business earns income. It decreases when you take distributions or the business incurs losses.

Here’s why it matters:

  • If you take distributions greater than your equity, you may trigger a taxable gain, even if it feels like you’re just withdrawing “your” money.
  • Staying within your basis protects you from unexpected tax bills.

In short: profits can be distributed tax-free if you’ve already paid tax on them in prior years, but taking out more than your ownership stake allows creates a taxable event.

How to Choose the Right Structure

Deciding whether to remain a sole proprietorship, move to a partnership or elect S corporation status depends on:

  • How you pay yourself – S corporations can offer payroll and distribution flexibility.
  • Number of owners – Partnerships make sense when you’re not going it alone.
  • Tax planning opportunities – Each structure comes with different reporting and potential savings strategies.
  • Future growth – Investors and lenders sometimes prefer one structure over another.

There’s no one-size-fits-all answer, and the IRS rules can be complicated.

Taxes are only one piece of your company’s financial puzzle. Choosing the wrong entity structure can cost you thousands of dollars in unnecessary taxes, or worse, create compliance issues with the IRS.

Our role as CPAs is to walk you through the options, explain how each structure would impact your personal and business taxes and help you choose the path that aligns with your goals.

If you’re considering a change or just want to make sure your current setup is working for you, contact an Adams Brown tax advisor. The earlier you plan, the more flexibility you’ll have to manage taxes and build equity in your business.