One of the fundamental differences between corporations and partnership business entities is that the former faces “two tiers” of taxation – once at the corporation level, and again when profits are distributed as dividends to the shareholder – while the latter are only taxed once to their owners as “pass-through” entities. Of course, the reality is that there are a lot of factors that go into determining the right kind of business entity, beyond just the pass-through taxation treatment or not, though in practice it is often a material factor.
A hybrid mid-point between the two is an S corporation, which is recognized as a corporation for legal purposes – including for liability protection, and transferability of stock shares – but still taxed as a pass-through business, similar to a partnership.
However, in practice the pass-through tax treatment of an S corporation isn’t exactly identical to a partnership, because with a partnership all pass-through income is subject to self-employment FICA taxes (as high as 15.3%), while an S corporation only pays FICA taxes on salary compensation to its owners, and not the remaining profits paid out as nontaxable dividend distributions.
To prevent everyone from just converting partnerships into S corporations that all pay their owners $0 in salary – to completely avoid FICA taxes – the IRS still requires that S corporation owner-employees be paid “reasonable compensation” for the services they render to the business.
Nonetheless, the reality is that for highly profitable businesses, especially with multiple owners and/or multiple employees, there is clearly a portion of profits, over and above just reasonable salary compensation, that can be distributed as a dividend to the S corporation owners, saving FICA self-employment taxes in the process. For profitable businesses, the tax savings can be thousands or even a few tens of thousands of dollars in savings.
Ultimately, not all small businesses can take advantage of these rules. Some don’t meet the ownership requirements of an S corporation, and others are so small and dependent on their owners that realistically, “reasonable” compensation would be 100% of the business profits anyway. Nonetheless, there are many high-income partnerships (or LLCs taxed as such) that might benefit by switching to an S corporation (or making an election for the LLC to be taxed as an S corporation), specifically to split the business profits into FICA-taxable wages and FICA-exempt S corporation dividend distributions. At least, until or unless Congress shuts down this perceived “loophole” and reunifies the taxation of S corporation dividend distributions with the pass-through income of partnerships!