C Corp vs S Corp vs Partnership

Special allocations under IRC Section 704(b)

Partnerships may allocate items of income, gain, loss, and deduction in any manner that has "substantial economic effect" under IRC Section 704(b) and the Treasury Regulations. A partnership may allocate 90 percent of depreciation to the partner who needs the deduction, 10 percent to another, even if their capital interests are 50-50.

S corps cannot do this. IRC Section 1366 requires that S corp income, loss, deduction, and credit flow through pro rata based on the number of shares held on each day of the tax year. A 50 percent shareholder gets 50 percent of every item.

For investor partnerships, real estate syndications, and any business where allocations need to track contribution-and-distribution waterfalls, partnership wins decisively.

Source: 26 U.S.C. Section 704(b); 26 U.S.C. Section 1366

Guaranteed payments under IRC Section 707(c)

A partnership may pay a partner a fixed amount (guaranteed payment) for services without regard to partnership profits. The guaranteed payment is deducted by the partnership, included in the partner's ordinary income, and subject to SE tax.

S corps use W-2 wages instead of guaranteed payments. The distinction matters for retirement plan contributions (W-2 wages support more plan options), state payroll tax filings, and unemployment insurance treatment. Functionally similar; mechanically different.

Source: 26 U.S.C. Section 707(c)

SE tax treatment (the key downside of partnership)

General partners owe SE tax on their entire distributive share of partnership ordinary income plus guaranteed payments. There is no S-corp-style "salary + tax-free distribution" split. For a general partner with $300,000 of partnership income, the SE tax may exceed $19,000 (12.4 percent OASDI capped at the wage base, plus 2.9 percent Medicare uncapped, plus 0.9 percent additional Medicare above $200,000).

Limited partners avoid SE tax on their distributive share of partnership income to the extent the income is attributable to capital rather than services. This rule under IRC Section 1402(a)(13) is the subject of significant ongoing litigation; current IRS audit posture is aggressive, and the limited partner exclusion is uncertain for limited partners who actively work in the business.

For owner-operators, S corp wins on SE tax. For pure investors or limited partners with capital-source income, partnership may equal or beat S corp.

Source: 26 U.S.C. Section 1402(a)(13)

Profits-interest grants (Rev Proc 93-27)

Partnerships may grant a new partner a "profits interest" (right to share in future profits and appreciation) without immediate income tax under Rev Proc 93-27, provided the interest has zero current liquidation value. This is the partnership-equivalent of an option grant, without the option mechanics.

S corps cannot grant profits interests. S corp equity must be common stock, taxable at fair market value when issued (or 83(b) at grant value, vesting over time per the issuance terms).

Property contribution and distribution

Under IRC Section 721, contributions of property to a partnership in exchange for partnership interest are tax-free. Under IRC Section 731, distributions of property from a partnership to a partner are generally tax-free (with exceptions for hot assets, disguised sales, and mixing bowl transactions).

S corps use IRC Section 351 for contributions (tax-free if 80 percent control test met) but trigger gain on property distributions under IRC Section 311(b). For businesses that contribute and distribute property regularly (real estate especially), partnership wins on these transactions.