Entity and Trust Taxation

How a business entity or trust is taxed determines how income, losses, and deductions reach the investor's tax return. Understanding these structures helps you make suitable recommendations.

How Are C-Corporations Taxed?

• Taxed as a separate entity at the corporate tax rate (flat 21%)
• Subject to double taxation - corporation pays tax on earnings, then shareholders pay tax on dividends received
• Dividends paid to shareholders are not deductible by the corporation

Exam Tip: Gotchas

• The defining feature of C-corporations is double taxation. The corporation pays 21% on earnings, then shareholders pay dividend tax on distributions.

How Are S-Corporations Taxed?

• Pass-through entity - income, losses, deductions, and credits flow through to shareholders' individual tax returns
• The entity itself generally pays no federal income tax
• Avoids double taxation
• Limited to 100 shareholders, must be U.S. residents, one class of stock only

Exam Tip: Gotchas

• S-corp limitations are frequently tested. 100 shareholders max, one class of stock, U.S. citizens/residents only.

How Are Partnerships and LLCs Taxed?

• Pass-through entities - income and losses flow to partners/members on Schedule K-1
• Partners are taxed at their individual rates on their allocable share of income
• Limited partnerships - limited partners receive passive income (relevant for passive loss rules)

How Are Trusts and Estates Taxed?

• Trusts and estates are separate taxable entities with their own compressed tax brackets
• Trust income distributed to beneficiaries is taxed on the beneficiary's return (passed through on K-1)
• Trust income retained by the trust is taxed at the trust's rates
• Trust tax brackets are highly compressed - the top rate (37%) applies at just ~$16,000 of income (vs. ~$640,600 for individuals)
• Grantor trusts - the grantor (creator) is treated as the owner for tax purposes; income is taxed on the grantor's return
• Simple trusts - must distribute all income to beneficiaries annually, cannot distribute principal, and cannot make charitable contributions
• Complex trusts - any trust that does not meet the simple trust rules; may accumulate income, distribute principal, and make charitable contributions

Exam Tip: Gotchas

• Trust tax brackets are severely compressed. A trust hits the 37% rate at a very low income level (~$16,000). This makes it tax-inefficient to accumulate income inside a trust; advisers should generally recommend distributing income to beneficiaries in lower brackets.
• Simple vs. complex is determined by the year's actual distributions, not by a label in the trust document. A trust that accumulates income in one year and distributes it all the next can be complex, then simple, from year to year.

How Are REITs (Real Estate Investment Trusts) Taxed?

• Must distribute at least 90% of taxable income to shareholders
• The entity avoids corporate-level taxation if distribution requirements are met
• Distributions generally taxed as ordinary income (not qualified dividends)

Exam Tip: Gotchas

• REIT dividends are ordinary income, not qualified dividends. This is a common exam trap.

How Are MLPs (Master Limited Partnerships) Taxed?

• Publicly traded partnerships (typically energy/natural resources)
• Pass-through taxation with K-1 reporting
• Distributions are often return of capital (reduce basis, not immediately taxable)

How Do the Entity Types Compare?

What Should You Check on Exam Day?

• C-corporations pay a flat 21% at the entity level; dividends are taxed again to shareholders (double taxation)
• S-corporations pass through to shareholders' returns, avoid double taxation, and are capped at 100 shareholders, U.S. residents only, one class of stock
• Partnerships and LLCs pass income and losses to partners/members on Schedule K-1, taxed at individual rates
• Trust brackets are highly compressed: the top 37% rate applies at roughly $16,000 of trust income, versus about $640,600 for individuals
• Distributed trust income is taxed to the beneficiary; retained trust income is taxed to the trust
• Simple trusts must distribute all income annually, cannot distribute principal, and cannot make charitable contributions; complex trusts are any trust that does not meet those rules, classified annually by actual conduct
• REITs must distribute at least 90% of taxable income to avoid entity-level tax; REIT dividends are ordinary income, not qualified dividends
• MLP distributions are pass-through K-1 income, often treated as return of capital rather than immediately taxable