Choosing a legal structure for your business has significant tax consequences. While both a partnership and a corporation are effective ways to run a business, the decision between the two business formats is often made by factoring in which will offer the best tax treatment based on the needs of the owners involved. Although favorable tax treatment is not the only concern when starting a business, it is a primary concern with long-term consequences for profitability.

Entity-Level Taxation

A corporation is an independent legal entity that exists separately from its shareholders. It is considered a taxpayer by the Internal Revenue Service and must file an annual income tax return under its own name and employer identification number. The corporation pays taxes on net income at the corporate tax rate, unless it meets the requirements to be an S corporation, in which case it can pass through its earnings to shareholders and avoid double taxation. A partnership is not an independent legal entity and is not a taxpayer under IRS rules. Partnerships are business endeavors that operate under the legal names and personal responsibility of the partners. A partnership reports its revenue and expenses to the IRS annually on an informational tax return but does not pay taxes as a business entity.

Pass-Through Taxation

Instead of paying entity-level taxes, a partnership passes its profits and losses through to its partners on a proportional basis. Each partner reports his share of profits and losses on his individual income tax return and pays taxes on the amounts at his individual tax rate. This pass-through taxation is considered one of the primary benefits of operating a business as a partnership.

Double Taxation

Corporations distribute profits to shareholders as dividends. Dividends are disbursed from the corporation's after-tax profits on a per-share basis. Once a shareholder receives his dividend payment, he must report the payment on his personal income tax return and pay taxes on the distribution at the individual tax rate. This double taxation of corporate profits – once at the entity level and again at the shareholder level – is considered one of the major drawbacks of setting up a business as a corporation.

Taxing Owner Payments or Benefits

Corporations and partnerships face different tax treatment relating to owners who work for the company. The IRS considers partners who work for a partnership to be self-employed and not employees of the business. Any compensation a partner takes for services rendered to the partnership is treated as an advance against profits. The partner must pay self-employment taxes on the money. Comparatively, shareholders who work for a corporation are considered employees of the business. They are paid wages from which the corporation deducts the employee's share of payroll withholdings while paying the employer's share. The corporation gets to write off employee salaries and payroll taxes as a business expense. Also, corporations typically cam deduct many types of fringe benefits paid to shareholders who work for a corporation as business expenses, while the IRS prevents partners from deducting many of the same expenses.