Trying to choose between a sole proprietorship and a partnership? Discover the key tax differences, benefits, and which structure can help you save more on taxes in this in-depth guide.
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When starting a new business, one of the most important decisions you’ll face is choosing the right business structure. For many small business owners, the decision often comes down to two popular options: sole proprietorship or partnership. Each has its own advantages, but if your primary goal is maximizing tax savings, you’ll need to dive deeper into how each structure affects your tax liability.
In this blog, we’ll break down the key differences between a sole proprietorship and a partnership, how taxes are handled in each, and which structure might offer better tax-saving opportunities based on your unique situation.
A sole proprietorship is the simplest and most common business structure. It’s an unincorporated business owned and operated by a single individual. There’s no legal distinction between the owner and the business, which means the owner receives all profits—and is personally responsible for all debts and liabilities.
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A partnership is an unincorporated business with two or more owners. Partnerships come in several forms (general partnerships, limited partnerships, limited liability partnerships), but at the core, they allow multiple people to share ownership, profits, and responsibilities.
Sole Proprietorship:
Partnership:
Self-employment taxes (covering Social Security and Medicare) are a significant consideration.
💡 Tax Tip: A limited partner in a limited partnership may not be subject to self-employment tax on their distributive share of income if they are not actively involved in the business.
Sole proprietors may qualify for a 20% deduction on qualified business income under Section 199A, reducing taxable income significantly.
All ordinary and necessary business expenses—home office, mileage, supplies, etc.—can be deducted directly from income on Schedule C.
No need to file a separate business tax return saves on accounting costs and complexity.
Sole proprietors can deduct 100% of health insurance premiums (including for family) if not eligible for coverage through a spouse.
Eligible to contribute to a SEP IRA, Solo 401(k), or traditional IRA to lower taxable income.
Partners can divide income in a tax-efficient way, especially if one partner is in a lower tax bracket. Also, useful for married couples or family-run businesses.
Like sole proprietors, partners may qualify for the 20% QBI deduction, based on their share of qualified business income.
The partnership can deduct ordinary and necessary business expenses before distributing profits.
Partners can receive guaranteed payments (similar to a salary) that are deductible by the partnership, reducing the business’s taxable income. However, guaranteed payments are subject to self-employment tax.
Partnerships can allocate profits and losses disproportionately (based on a partnership agreement), which may help manage tax liability across partners.
Like sole proprietors, partners can set up retirement accounts and deduct health insurance premiums.
Drawbacks:
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Let’s look at a basic example to compare the tax impact for a sole proprietor and a two-person partnership.
Scenario:
Sole Proprietor:
Partnership (50/50 Split):
In this example, the partnership allows income to be split between two people, potentially lowering the tax burden if one or both are in lower brackets. However, total self-employment tax remains the same ($14,130), just split in half.
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The answer depends on your business income, long-term goals, and personal financial situation. Here's a general breakdown:
Regardless of structure, here are a few extra ways to lower your tax bill:
When it comes to partnership vs. sole proprietorship, there’s no one-size-fits-all answer. While both offer pass-through taxation and the QBI deduction, partnerships allow for more income-splitting and flexibility—making them potentially more tax-efficient in certain scenarios. On the other hand, sole proprietorships are ideal for solo entrepreneurs looking for ease and control.
If you’re trying to decide, ask yourself:
💡 Tip: Consider starting as a sole proprietorship and later converting to a partnership or LLC as the business grows and becomes more complex.
Every business is unique, and the tax code is full of hidden pitfalls and opportunities. If you want to make sure you're set up for maximum tax savings, working with a tax advisor or accountant is the best step forward.
It depends on your specific situation. Sole proprietorships are simpler and may be more tax-efficient for individuals with modest income and no partners. Partnerships, however, offer income-splitting and more flexible profit allocation, which can reduce the overall tax burden when partners are in different tax brackets. Both structures qualify for the QBI deduction, but partnerships offer more flexibility in tax planning.
Yes, both sole proprietors and partners may qualify for the Qualified Business Income (QBI) deduction under Section 199A, allowing them to deduct up to 20% of qualified business income. Eligibility and the amount of the deduction depend on factors like total taxable income, the type of business, and whether the owner is active in the business.
Sole proprietors pay self-employment tax (15.3%) on their net business income reported on Schedule C. Partners in a general partnership also pay self-employment tax on their share of ordinary income reported on Schedule K-1. Limited partners, however, may be exempt from self-employment tax on their distributive share if they are not actively involved in the business.
Yes, you can transition from a sole proprietorship to a partnership at any time by bringing on one or more partners and drafting a partnership agreement. You’ll need to register the new partnership with the IRS and local authorities, obtain a new EIN, and file taxes accordingly starting that tax year.
Sole proprietors file Schedule C with their personal tax return (Form 1040). They may also need to file Schedule SE for self-employment tax.
Partnerships must file Form 1065 (U.S. Return of Partnership Income) and issue Schedule K-1 to each partner, who then reports that income on their individual tax return.
Being audited is comparable to being struck by lightning. You don't want to practice pole vaulting in a thunderstorm just because it's unlikely. Making sure your books are accurate and your taxes are filed on time is one of the best ways to keep your head down during tax season. Check out Vincere's take on tax season!
This post is just for informational purposes and is not meant to be legal, business, or tax advice. Regarding the matters discussed in this post, each individual should consult his or her own attorney, business advisor, or tax advisor. Vincere accepts no responsibility for actions taken in reliance on the information contained in this document.
For business tax planning articles, our tax resources provides valuable insights into how you can reduce your tax liability now, and in the future.
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