Income Tax: Corporations, Trusts, and Passthrough Entities

Now that you understand how individuals are taxed on investment income, the next step is understanding how different entity types are taxed. Many clients invest through or alongside business entities, trusts, and estates, and the tax treatment varies significantly by entity type.

How Are C-Corporations Taxed?

A C-corporation is a separate legal entity that files its own tax return and pays taxes at the corporate level.

• Taxed at a flat 21% corporate rate
• When the corporation distributes profits as dividends, shareholders pay tax on those dividends on their personal returns
• This creates double taxation: income is taxed once at the corporate level and again when distributed to shareholders

Double taxation illustrated:

Exam Tip: Gotchas

• Double taxation is the defining disadvantage of a C-corporation. If a question asks why an owner might prefer an S-corp or partnership over a C-corp, double taxation is almost always the answer.

How Do S-Corporations and Partnerships (Passthrough Entities) Avoid Double Taxation?

S-corporations and partnerships (including LLCs taxed as partnerships) are passthrough entities: they generally do not pay entity-level federal income tax (an S-corp can owe tax in limited situations, such as certain built-in gains). Instead, income and losses "pass through" to the owners' personal tax returns.

• S-corporations: Limited to 100 shareholders, generally individuals who are U.S. citizens or residents (certain trusts and estates may also qualify); only one class of stock allowed
• Partnerships: No limit on the number of partners; can have both general and limited partners
• Limited Liability Companies (LLCs): Most commonly taxed as partnerships (or as S-corps by election)

How passthrough taxation works:

• The entity files an informational return (Form 1065 for partnerships, Form 1120-S for S-corps)
• Each owner receives a Schedule K-1 showing their share of income, deductions, and credits
• Owners report their share on their personal returns and pay tax at their individual rates
• Income is taxable to the owners whether or not it is actually distributed

Think of it this way: If a partnership earns $200,000 but reinvests all of it back into the business, each partner still owes tax on their share of that $200,000. The IRS does not care whether the money landed in the partner's bank account.

Exam Tip: Gotchas

• Passthrough income is taxable even if not distributed. An S-corp owner who receives no distribution still owes tax on their share of the company's income.
• Only C-corporations face double taxation. S-corps and partnerships avoid it by passing income through to owners.

Why Do Trusts Hit the Top Tax Bracket So Quickly?

Trust taxation has unique characteristics that advisers must understand, particularly the highly compressed tax brackets.

• A trust is a separate taxpaying entity that files Form 1041
• Income retained by the trust is taxed at trust tax rates
• Income distributed to beneficiaries is taxed at the beneficiary's individual rate (the trust gets a deduction for the distribution). The trust reports each beneficiary's share on a Schedule K-1, which the beneficiary uses to report the income on their own return.

Compressed trust tax brackets (2026):

• Trusts reach the highest marginal rate (37%) on taxable income over $16,000
• By comparison, a married couple filing jointly does not hit 37% until income exceeds $768,700
• This rapid escalation creates a strong incentive for trustees to distribute income to beneficiaries who are in lower tax brackets

Think of it this way: A trust earning $20,000 already owes tax at the 37% rate on the top portion. If that same income were distributed to a beneficiary in the 12% bracket, the family saves thousands in taxes. That is why most trusts distribute income rather than retain it.

Types of trusts for tax purposes:

• Grantor trust: Income is taxed to the grantor (the person who created the trust), not the trust itself
• Simple trust: Must distribute all income annually; beneficiaries pay the tax
• Complex trust: Can accumulate income, make charitable contributions, and distribute principal

Exam Tip: Gotchas

• Trust brackets are the most compressed in the tax code. The 37% rate kicks in above $16,000 for trusts versus $768,700 for married couples filing jointly. This is a frequently tested comparison.
• Distributing income to beneficiaries shifts the tax burden from the trust's compressed brackets to the beneficiary's (usually lower) individual brackets.

How Is an Estate Taxed During Administration?

An estate is a temporary entity that exists during the administration of a deceased person's affairs. Its tax treatment is similar to trusts.

• Income earned by the estate during the administration period is taxable
• The estate files Form 1041 (same as trusts)
• Uses the same compressed tax brackets as trusts
• The estate can deduct income distributed to beneficiaries
• Once all assets are distributed and debts settled, the estate terminates

The key distinction: estate taxation here refers to income earned by the estate during administration (interest, dividends, rent on estate assets), not the estate tax on the transfer of wealth at death (covered in the next section).

Exam Tip: Gotchas

• Estate income tax and estate tax are two different things. Income tax applies to earnings (dividends, interest, rent) the estate generates while being settled. The estate tax applies to the value of assets transferred at death. A question about "estate taxation" could mean either one, so read carefully.

What Should You Check on Exam Day?

• C-corporations pay a flat 21% rate, then shareholders are taxed again on dividends: double taxation
• S-corporations are limited to 100 shareholders (generally individuals who are U.S. citizens or residents; certain trusts and estates may also qualify) and one class of stock; partnerships have no owner limit
• Passthrough income (S-corps, partnerships) is taxable to owners whether or not it is actually distributed, reported on a Schedule K-1
• Trusts and estates both file Form 1041 and share the same compressed brackets, reaching 37% on taxable income over $16,000 (2026)
• A grantor trust taxes income to the grantor; a simple trust must distribute all income annually; a complex trust may accumulate income
• Estate income tax (earnings during administration) is distinct from estate tax (tax on the value transferred at death): do not confuse the two on the exam