S-corp election vs partnerships: how different structures impact your taxes

Most professional service firms start as partnerships. The logic is sound: partnerships are simple to form, easy to maintain, and partners split profits without much fuss.

Then your firm grows. Revenue crosses $200,000 per partner. Suddenly, you are writing quarterly estimated tax checks that make you wince. Your CPA mentions self-employment tax: 15.3% on every dollar of profit. Meanwhile, your friend, running a similar firm as an S-corp, casually mentions their tax bill is thousands of dollars lower.

What changed? Should you elect S-corp status? And what exactly makes S-corp taxation different enough to matter?

Here is what matters: S-corps let you split your income into salary (taxed like payroll) and distributions (exempt from self-employment tax). This can save you $8,000 to $15,000 per owner annually. But this tax advantage requires stricter compliance and more careful salary decisions, which partnerships skip entirely.

Three differences drive the real-world impact of how each structure treats your income. How do you actually pay yourself? What compliance obligations do you face every month?

Partnerships tax all your income as self-employment earnings, while S-corps split it strategically

The difference starts with the self-employment tax.

Partnerships keep it inexpensive and straightforward

Your partnership earns $500,000 this year. You own half. Your K-1 shows $250,000 in income. The IRS immediately calculates 15.3% self-employment tax: $38,250. This happens whether you withdraw the money or leave it in the business account.

Every dollar passes through to your personal return as self-employment income, all of it. No exceptions. No strategies to reduce it. That is the partnership tax deal.

The self-employment tax rate covers Social Security (12.4% on the first $160,200) and Medicare (2.9% on everything, plus an extra 0.9% on high earners). It adds up fast.

S-corps create savings through the salary and distribution split

S-Corp taxation changes the game. You still pay yourself for the work you do. But the IRS only requires a reasonable salary subject to payroll tax. Everything above that flows through as distributions with zero self-employment tax.

Back to that $250,000 in income. Determine that $100,000 is fair compensation for your role. Pay payroll tax on that: roughly $15,300. The remaining $150,000? Passes through as a distribution. No self-employment tax. Your savings: $22,950 each year.

Watch how this scales. Sarah runs a consulting firm generating $400,000 in profit. Partnership route: $61,200 in self-employment tax. S-corp route with a $120,000 salary: $18,360 in payroll tax. The $280,000 distribution avoids self-employment tax entirely. She saved $42,840 this year. Next year. The year after. Over five years, that is $214,200 kept rather than sent to the IRS.

But a reasonable salary is not optional. The IRS expects market rates. If you claim a $30,000 salary while comparable professionals in your field earn $150,000, expect an audit letter. And penalties.

Getting paid works completely differently under each structure

Tax rates matter. But so does the daily reality of moving money from your business to your personal account.

Partnership draws stay simple, but demand discipline

Take money whenever you need it. That is partnership life. The draw itself triggers no tax because you already owe tax on your full profit share. Withdrew $50,000 this quarter? Taxes stay the same. Left it in the business? Taxes remain the same.

The end of year arrives. Your CPA hands you a K-1. You report it on your personal return, calculate self-employment tax on Schedule SE, and pay up. The tricky part: since nothing was withheld from your draws, you need to make quarterly estimated payments. Miss those, and penalties arrive.

Many partners struggle here. The cash feels free coming out. Then, in April, a shocking tax bill arrives.

S-corp owners run actual payroll

S-Corp compensation is structured like a real job. You process your own payroll. Withhold income tax, Social Security, and Medicare. Send deposits to the IRS bi-weekly or monthly. File Form 941 every quarter. Issue yourself a W-2 at year's end.

Most owners outsource this to payroll providers or integrated payroll and bookkeeping services rather than managing it themselves

You also pay federal and state unemployment insurance. Maintain payroll records. Handle state withholding requirements. Most owners outsource this to Gusto, ADP, or Rippling for $500 to $2,000 a year. Worth it.

After you handle salary through proper payroll, distributions become easy. Take them quarterly after reviewing your financials. No withholding. No special reporting. Just track them in your books.

The administrative reality: partnerships require one annual tax return plus quarterly estimated payments. S-corps require payroll every pay period, quarterly payroll returns, annual W-2s, the corporate return, and K-1s for shareholders. Accounting and payroll costs typically run $2,000 to $5,000 more per year than partnerships. Factor that into your decision. When you factor in payroll, filings, and compliance, the real cost of bookkeeping becomes an important part of the S-Corp decision.

S-Corps face stricter compliance and closer IRS attention

Tax savings only matter if you maintain compliance without sleepless nights.

Partnership requirements stay manageable

File Form 1065 each year. Issue K-1s to partners. Done. States usually follow the federal approach. The IRS audit rate for small partnerships hovers around 0.4%. Lower scrutiny reflects fewer opportunities for aggressive moves.

S-corps require detailed documentation

S-Corp compliance expands significantly. File Form 1120-S annually. Issue K-1s. Maintain payroll records. File Form 941 quarterly. File Form 940 for unemployment tax. Issue W-2s. If you operate in multiple states, add state payroll returns to the list. This distinction matters even more when deciding how owners and contractors are paid, especially when choosing between payroll and 1099 reporting (1099-NEC vs 1099-MISC)

Beyond the forms, you need to justify your salary decision. Document how you compared your compensation to industry benchmarks. Keep job descriptions. Save board minutes discussing salary. If the IRS audits, they want evidence that your salary reflects market reality and that you actually processed proper payroll.

State rules vary wildly. California hits S-corps with franchise taxes: a minimum of $800, rising to $11,790 for receipts over $5 million. Some states require separate S-Corp elections beyond the federal filing. A few states ignore S-corp status entirely and tax you like a regular corporation.

The IRS watches S-corp salaries closely

The agency knows the game. Owners reduce salaries to minimize payroll taxes and inflate distributions to avoid them. This costs the government billions. So they scrutinize S-corp salaries.

During audits, they examine your duties, hours worked, qualifications, local compensation levels, and firm profitability. If they determine your salary is too low, they reclassify distributions as wages. You owe back payroll taxes. Plus interest. Plus penalties that can hit 25% of the unpaid amount.

Protection comes from documentation. Industry salary surveys for your role. Detailed job descriptions. Board meeting minutes. Evidence of consistent payroll processing. Build the file before the audit letter arrives.

Deciding what works for your firm

S-corp election makes sense when tax savings beat the compliance costs and hassle. For most professional service firms, this break-even point sits around $60,000 to $80,000 in annual profit per owner.

Below that threshold, self-employment tax savings are modest. Maybe $5,000 per owner. That barely covers the extra accounting fees, payroll service costs, and time spent managing compliance. Above $100,000 per owner, the savings grow substantial enough to justify the additional complexity.

Your situation matters more than generic thresholds. Already outsourcing bookkeeping? Already running clean financials? Adding S-corp compliance is manageable. Still tracking everything in spreadsheets? Still struggling to file partnership returns on time? Adding S-corp requirements will create more stress than the tax savings justify.

Some firms thrive with the structure S-corp payroll imposes. Regular salary. Consistent withholding. Quarterly distribution reviews are tied to financial performance. Others prefer the flexibility of partnership draws and accept slightly higher taxes in exchange for a reduced administrative burden.

The structure you choose should provide peace of mind, not constant worry about missed deadlines and potential audits. Both partnerships and S-Corps can work beautifully when they match your operational style and growth stage.

Talk with a CPA who works with professional service firms in your state. They can model your actual savings based on your profit levels, factor in state-specific costs and requirements, and explain what the day-to-day reality looks like. The proper entity structure minimizes both your tax bill and your compliance headaches while supporting how you want to run your business.