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
• Reports its income on Form 1120 (U.S. Corporation Income Tax Return)

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; individual shareholders must be U.S. citizens or resident aliens (certain trusts, estates, and qualifying tax-exempt organizations may also qualify); one class of stock only
• Reports its income on Form 1120-S, with each shareholder's share passed through on Schedule K-1

Exam Tip: Gotchas

• S-corp limitations are frequently tested. 100 shareholders max, one class of stock, individual shareholders generally limited to U.S. citizens or resident aliens (certain trusts and estates may also qualify).

How Are Partnerships and LLCs Taxed?

• Pass-through entities: income and losses flow to partners/members on Schedule K-1
• The entity files Form 1065, an informational return; the partnership or partnership-taxed limited liability company (LLC) itself pays no income tax
• 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)
• An LLC has no tax form of its own. Its default federal tax treatment depends on how many owners it has, and it can elect a different one:
  • Single-member LLC: a disregarded entity by default. The owner reports the income directly on the owner's own return (for an individual, usually on Schedule C). There is no Form 1065 and no K-1.
  • Multi-member LLC: taxed as a partnership by default, so it files Form 1065 and issues K-1s.
  • Election: either kind can elect to be taxed as a corporation instead.

How Are Trusts and Estates Taxed?

• Trusts and estates are separate taxable entities with their own compressed tax brackets
• A trust or estate files Form 1041 (U.S. Income Tax Return for Estates and Trusts) to report its income
• 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 retain REIT status
• Generally deducts dividends paid, reducing entity-level tax on distributed income; retained taxable income may still be taxed at the REIT level
• Does not pass operating losses through to shareholders
• 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.
• A REIT is not a pass-through entity. It is taxed like a corporation, and the dividends-paid deduction only reduces its own tax. That deduction does not send income items or losses to shareholders. A REIT loss stays at the REIT level, and shareholders receive Form 1099-DIV, not Schedule K-1. Pass-through losses belong to S corporations, partnerships, and MLPs.

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 and file Form 1120; dividends are taxed again to shareholders (double taxation)
• S-corporations file Form 1120-S and pass through to shareholders' individual returns, avoiding double taxation; capped at 100 shareholders, individual shareholders generally U.S. citizens or resident aliens (certain trusts and estates may also qualify), one class of stock
• Partnerships and multi-member LLCs taxed as partnerships file Form 1065 and pass income to members on Schedule K-1; a single-member LLC is disregarded by default (owner reports directly), and any LLC can elect corporate tax
• Trusts and estates file Form 1041; distributed income is taxed to the beneficiary, retained income is taxed to the trust at highly compressed brackets (top 37% rate near $16,000 of income)
• Simple trusts must distribute all income annually and cannot distribute principal or make charitable contributions; complex trusts are any trust that does not meet those rules, classified annually by actual conduct