How LLCs Are Actually Taxed: A Breakdown for New Business Owners

Most new LLC owners assume that forming an LLC changes how they are taxed. It does not, at least not by default. An LLC is a legal structure, not a tax structure, and the IRS taxes it based on elections you make or fail to make. Understanding this distinction is the difference between paying exactly what you owe and quietly overpaying every year.

 

The default tax status of an LLC

By default, the IRS does not recognize an LLC as its own tax entity. Instead, it looks at how many members the LLC has and taxes it accordingly. A single-member LLC is treated as a disregarded entity, meaning the business's profit and loss flow directly onto the owner's personal tax return. A multi-member LLC defaults to partnership taxation. Neither of these defaults change unless you file paperwork with the IRS to elect a different structure, such as S Corp status.

 

How single-member LLCs are taxed

If you are the only owner, your LLC's profit is reported on Schedule C of your personal tax return. That profit is taxed twice: once as ordinary income at your regular tax bracket, and again as self-employment tax, which covers Social Security and Medicare at a combined rate of 15.3%. This self-employment tax applies to the entire net profit of the business, not just a portion of it, which is the single biggest tax surprise for new LLC owners.

 

How multi-member LLCs are taxed

A multi-member LLC defaults to partnership taxation. The LLC itself files an informational return, Form 1065, but does not pay tax directly. Instead, each member receives a Schedule K-1 reporting their share of the profit, which they then report on their own personal tax return. Each member still owes self-employment tax on their share of the profit, proportional to their ownership percentage, unless the LLC has elected S Corp status.

 

Electing S Corp status to lower self-employment tax

An LLC, whether single or multi-member, can elect to be taxed as an S Corporation by filing Form 2553. This does not change the LLC's legal structure, only how it is taxed. Under an S Corp election, the owner becomes an employee of the business and must be paid a reasonable salary, which is subject to payroll tax. Any remaining profit can be distributed to the owner as a distribution, which is not subject to self-employment tax. This is where the real savings come from, since only the salary portion, not the full profit, gets hit with the 15.3% tax.

 

When the S Corp election actually pays off

S Corp elections come with real costs: payroll processing, a separate tax filing, and more bookkeeping. Below roughly $40,000 to $60,000 in net profit, those costs usually outweigh the self-employment tax savings. Above that range, the math typically starts to favor the S Corp election, though the exact break-even point depends on your state, your reasonable salary requirement, and your accountant's fees.

 

Common mistakes that lead to overpaying

Assuming the LLC itself lowers your tax rate. Waiting years to consider an S Corp election even after profit has grown well past the break-even point. Failing to make quarterly estimated tax payments, which leads to penalties on top of the tax owed. Not tracking deductible business expenses throughout the year, which inflates taxable profit unnecessarily. Mixing personal and business expenses in a way that makes it harder to claim legitimate deductions.

 

How to choose the right structure for your LLC

Start with your realistic net profit for the year, not your revenue. If it's under $40,000, the default LLC taxation is usually simplest and cheapest to maintain. As profit grows past that point, sit down with an accountant and run the actual numbers for an S Corp election, since the benefit depends heavily on your specific salary and state taxes. Reviewing this every year as your business grows, rather than setting it once and forgetting it, is what actually keeps your tax bill as low as it can legally be.