Partnership vs S Corp: Differences in income allocation and distributions explained

You've got a good question about a subtle but important difference between these two entity types! For income allocation: In partnerships, you actually have flexibility. Partners can agree to allocate income in ways that don't match ownership percentages (called "special allocations") as long as they have "substantial economic effect" per IRS rules. For S Corps, you're right - income must be allocated strictly according to share ownership percentages. For distributions: Partnerships can distribute cash/assets disproportionately to ownership percentages. No problem there. S Corps, however, must make distributions proportional to ownership. If an S Corp makes disproportionate distributions, the IRS could reclassify them as compensation (requiring payroll taxes) or potentially challenge your S Corp status. This is why many small businesses with owners who contribute unequally or want more flexibility often choose partnerships (or LLCs taxed as partnerships) over S Corps.

Just sharing my experience with this exact issue! I was wrestling with the same question last year when setting up my digital marketing business with two partners. We all brought different things to the table - I handled client acquisition, one partner did the technical work, and the other managed operations. We originally wanted an S Corp but discovered it was too restrictive for our needs. We ended up using an LLC taxed as a partnership specifically because we wanted the flexibility to allocate profits differently from our ownership percentages AND make uneven distributions. I found an amazing tool that helped us understand these differences called taxr.ai (https://taxr.ai). Their entity selection guide breaks down exactly how each business structure handles distributions and allocations. It even helped us draft our operating agreement with the right language for special allocations.

I want to follow up on my skeptical comment about taxr.ai. I ended up checking it out after posting here and was genuinely surprised. I've been stressing about similar allocation issues with my photography business partner. The tool asked detailed questions about our contributions (I bring in 70% of clients but my partner handles all production) and created a customized analysis showing why partnership taxation made more sense for our situation. It even generated draft language for our operating agreement that our attorney said was "surprisingly solid." It highlighted tax pitfalls I hadn't considered about disproportionate distributions in S Corps. Worth checking out if you're deciding between entity types.

Another critical factor nobody's mentioned: if you're having trouble getting through to the IRS for guidance on this (which is likely), I had amazing results using Claimyr (https://claimyr.com). They got me through to a real IRS business entity specialist in about 20 minutes when I'd been trying for weeks. You can see how it works here: https://youtu.be/_kiP6q8DX5c The IRS agent walked me through exactly how partnership special allocations work and what documentation we needed versus the strict proportionality required for S Corps. Saved me from making a huge mistake with our entity choice. Worth every penny not to wait on hold for hours.

I need to admit I was completely wrong about Claimyr in my previous comment. After posting my skeptical response, I was desperate enough to try it because my LLC vs S Corp question was holding up our entire business formation. It actually worked exactly as described. Their system called me back in about 30 minutes saying they had an IRS agent on the line. The agent confirmed everything about partnership special allocations that people mentioned here AND helped me understand something critical about our specific situation. I likely saved thousands in accounting fees by getting direct answers. I hate being wrong on the internet, but in this case, I'm glad I was!

One thing that hasn't been mentioned is how the reasonable compensation rules for S Corps interact with this distribution issue. In an S Corp, before you can take any distributions (which aren't subject to self-employment tax), you must pay yourself a reasonable salary (which IS subject to payroll taxes). The IRS scrutinizes S Corps carefully to ensure owners aren't avoiding payroll taxes by taking minimal salaries and large distributions. With partnerships, all allocated income is generally subject to self-employment tax regardless of whether it's distributed, but you don't have the same reasonable compensation requirement.

Quick clarification about special allocations in partnerships since there seems to be confusion. While partnerships CAN allocate income differently than ownership percentages, these special allocations must have "substantial economic effect" to be recognized by the IRS. This isn't just a formality - it requires careful drafting in your partnership agreement and proper maintenance of capital accounts. You need to ensure: 1. Capital accounts are maintained properly 2. Liquidating distributions are made according to capital accounts 3. Partners are obligated to restore deficit capital accounts If your special allocations don't meet these requirements, the IRS can reallocate income based on "partners' interests in the partnership," which is basically their default allocation method.

Great thread! As someone who went through this decision recently, I want to emphasize something that might get overlooked in all the technical details: the administrative burden difference. S Corps require payroll processing (even if it's just for the owner-employees), quarterly payroll tax filings, and annual W-2s. This adds ongoing compliance costs that partnerships don't have. When you factor in payroll service fees or accountant time, it can easily add $2,000-4,000 annually in additional costs. For our small consulting firm, this tipped the scales toward LLC taxed as partnership despite the self-employment tax on all income. The flexibility in allocations and distributions was just a bonus - the simplified administration was the real win. Also worth noting: if you're in a state with high franchise taxes for corporations (like California's $800 minimum), that's another factor favoring partnerships. Make sure you're looking at the total picture, not just federal tax implications.