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): taxed according to their election, not their legal form. By default a single-member LLC is disregarded (the owner reports the activity on their own return, and the LLC files no separate federal income tax return) and a multi-member LLC is taxed as a partnership. Either one may instead elect corporate treatment

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.
• An LLC has no tax form of its own. Its treatment follows the default rule or its election, so "LLC" alone never answers a taxation question.

How Are REITs and MLPs Taxed?

Both are marketed as high-payout vehicles, and they are taxed by completely different mechanics. This contrast is a common test point.

REITs (real estate investment trusts):

• A REIT is not a passthrough in the partnership sense. It is a corporation that avoids entity-level tax on what it distributes, provided it meets the qualification and distribution tests
• The shareholder receives dividends, not a share of the entity's income
• REIT dividends are generally taxed as ordinary income rather than at the preferential qualified-dividend rates

MLPs (master limited partnerships):

• An MLP is a true passthrough. The investor is a partner, not a shareholder
• The partner receives a Schedule K-1, not a Form 1099
• Income is taxed to the partner whether or not cash is distributed, the same rule as any partnership
• Cash distributions are generally treated as a return of capital that reduces basis, rather than as a taxable dividend

Exam Tip: Gotchas

• A REIT dividend is ordinary income, not a qualified dividend. Investors who assume the preferential rate applies are making the error the exam tests.
• An MLP distribution is usually not taxed on receipt. It reduces the partner's basis instead. The partner is nonetheless taxed on their share of MLP income even in a year with no distribution.

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 and one class of stock; partnerships have no owner limit
• Passthrough income is taxable to owners whether or not it is distributed, on a Schedule K-1; a single-member LLC is disregarded, a multi-member LLC is a partnership, and either may elect corporate treatment
• A REIT shareholder receives a dividend taxed as ordinary income; an MLP partner receives a Schedule K-1, is taxed whether or not distributed, and sees distributions reduce basis instead
• Trusts and estates file Form 1041 on compressed brackets, hitting 37% over $16,000 (2026); a grantor trust taxes the grantor, a simple trust distributes all income, a complex trust may accumulate it
• 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