How LLC taxes work—and why they’re not as simple as you think

If you’ve ever started a side hustle, freelanced full-time, or dreamt of launching a startup, you’ve probably Googled this at least once: “Should I start an LLC?” And if you made it past the legal setup videos and Canva logo designs, you hit the tax wall. Because even though LLCs look clean on paper, their tax treatment is anything but plug-and-play.

Let’s unpack how LLC taxes actually work—what changes if you're the only member, how things shift when you add a cofounder, and what happens if you elect to be taxed like a corporation. Spoiler: LLCs are flexible, but that flexibility comes with choices you need to get right.

At its core, a Limited Liability Company (LLC) is a legal structure that blends the flexibility of a partnership with the liability protection of a corporation. The “limited liability” part means you (and your personal bank account) are shielded from lawsuits and debts tied to your business.

But the real flex? LLCs don’t have a default tax structure locked in. You can choose how the IRS sees you—sole proprietor, partnership, S corporation, or even a C corporation. That’s where the confusion (and opportunity) kicks in.

Say you’re a one-person LLC. By default, the IRS considers you a “disregarded entity.” Sounds brutal, but it just means they treat your LLC the same way they’d treat a sole proprietorship. You’ll file a Schedule C as part of your regular Form 1040, reporting all income and expenses from your business. No separate business tax return required.

But don’t get too cozy. Even without a formal payroll, you’ll owe self-employment taxes—covering both the employer and employee share of Social Security and Medicare (yup, that’s 15.3% off the top). So your earnings might be protected legally under an LLC, but financially, it’s still a one-person show.

Bring in a second member and the IRS upgrades your LLC from sole proprietor to partnership. That comes with a new tax form—Form 1065—and Schedule K-1s that go out to every member.

The big difference? Now you’re not just reporting income. You’re allocating it. The LLC itself doesn’t pay tax, but it’s required to break down the profits (or losses) and assign them to each member based on their ownership percentage or custom agreement.

That means even if you don’t take a distribution (i.e. you leave the money in the business), the IRS still expects you to report and pay tax on your share. This is called phantom income, and it hits founders harder than you think.

Here’s the part no one talks about enough: whether you’re solo or in a multi-member LLC, if you’re operating under default tax treatment (sole prop or partnership), you're on the hook for self-employment tax.

Unlike a regular W-2 employee who splits their FICA taxes with an employer, you foot the full bill. That 15.3% rate gets applied to your net earnings—after expenses, but before you’ve had a chance to breathe. And because there's no paycheck withholding, you're also responsible for estimated quarterly taxes to avoid penalties. Fun.

This is where the LLC gets strategic. You can elect to have your LLC taxed as an S corp or even a C corp. (Yes, even if you’re still just one person.) With an S corp election, you can split your income into “salary” and “distributions.” The salary portion is subject to payroll taxes, but the distributions are not. This can reduce your total self-employment tax bill—but only if you pay yourself a “reasonable” salary and run proper payroll.

It’s not a loophole. It’s a tradeoff. Because now you’re also filing more complex returns, running payroll, and complying with corporate rules. For some founders, that overhead is worth the tax savings. For others, it’s a trap dressed up as a tax hack.

Elect to be taxed as a C corporation, and you’re playing in a different league. Your LLC becomes a separate taxable entity. It pays corporate income tax on profits (21% federal as of 2025), and if you distribute dividends to members, they pay personal income tax again.

This is the infamous “double taxation” structure. And while it sounds bad, it’s not always a deal-breaker. If your startup plans to reinvest profits and eventually raise venture capital, this setup might actually align better with investor expectations.

The catch? You need to file Form 8832 to formally elect corporate treatment. And you’ll need to know when that election takes effect—or you’ll miss the planning window.

If your LLC is taxed as a partnership, every member gets a Schedule K-1. This isn’t just a tax receipt. It tells each member how much of the company’s profit (or loss) they’re responsible for—and how much tax they’ll owe on it personally.

K-1s include income, deductions, and tax credits. They also track capital accounts (basically your investment in the LLC). So if you’re bootstrapping with a friend and one of you puts in more cash or time, that imbalance can show up on the K-1 and change your tax bill. It’s not a DIY document. You’ll probably want a CPA—or at least solid tax software—to handle it.

LLCs don’t issue shares like corporations. Instead, they offer “membership interests,” which can be structured as full ownership stakes, profit-only units, or synthetic equity like phantom shares or unit appreciation rights (UARs).

Here’s the kicker: most of this equity is taxed when value is realized—not when it’s granted. So if your company sells and you cash out your equity, that’s when the IRS shows up with a tax bill. But how it’s structured—especially for founders vs. employees—can impact how it’s taxed: income, capital gains, or even ordinary compensation.

Designing equity in an LLC is harder than in a startup C corp. But if you’re running a service business or plan to stay private, it can be more flexible.

So, why pick an LLC if it’s this complicated? Because it can be efficient—if you understand your growth trajectory. LLCs let you keep things simple at the start (as a sole proprietor or partnership) and scale into more complex tax structures later. You get liability protection from day one, without having to navigate corporate formalities or shareholder bylaws.

If you’re running a bootstrapped freelance business or a small team with no outside capital, the pass-through setup keeps things lean. If you’re eyeing investor funding or stock-based compensation, you might eventually migrate to C corp status—or elect S corp treatment in the meantime. Just know that each decision opens a different playbook.

Quick recap:

• Single-member LLCs default to sole proprietorship taxation and file Schedule C.
• Multi-member LLCs default to partnerships and issue K-1s to members.
• Self-employment taxes apply unless you elect S corp or C corp treatment.
• LLCs can opt into corporate taxation via IRS Form 8832.
• Equity isn’t stock—it’s more flexible, but harder to standardize.
• Double taxation only applies if you elect C corp status.

LLCs offer a choose-your-own-tax-adventure model. But the IRS isn’t forgiving when you pick wrong.

Here’s the honest take: LLCs are chill until you hit year two. Then the tax choices start compounding.

If you're just freelancing or side hustling, default taxation works fine—but don’t forget about self-employment tax. If you’re scaling a real business with partners or profit-sharing, get a CPA early. And if you’re building for acquisition or venture funding? Your LLC might be a temporary stop on the way to C corp territory. In the end, the flexibility is real. So is the complexity. Just don’t let the word “limited” fool you—because taxes? Not so much.