S-Corp Election and Reasonable Salary: What Texas Small Business Owners Need to Know

One of the most common tax planning conversations we have with small business owners in Texas goes something like this: "I heard I can save money by becoming an S-corp. Is that true?"

The short answer is yes — but only under the right conditions, and only if you do it correctly. Done wrong, an S-corp election creates more compliance burden than it saves in taxes. Done right, it can reduce your self-employment tax bill by thousands of dollars a year.

Here's what you actually need to know.

By default, a single-member LLC is taxed as a sole proprietor. All of your net business income flows to your personal return on Schedule C, and you pay self-employment tax (15.3%) on every dollar of profit — up to the Social Security wage base ($168,600 for 2024), then 2.9% above that.

When you elect S-corp status (by filing Form 2553 with the IRS), the business becomes a pass-through entity with a different structure. Instead of all profit being subject to self-employment tax, you split your income into two buckets:

1. W-2 salary — you pay yourself a reasonable salary as an employee of your own company. Payroll taxes (Social Security + Medicare) apply to this amount.
2. Distributions — profit above your salary passes through to you as a distribution. Distributions are NOT subject to self-employment tax.

The tax savings come from that second bucket. If your business earns $150,000 in profit and you pay yourself a $75,000 salary, you only pay payroll taxes on $75,000 instead of $150,000. At 15.3%, that's roughly $11,475 in savings — minus the added cost of running payroll and filing an S-corp return.

Here's where most people get tripped up. The IRS requires S-corp owner-employees to pay themselves a "reasonable salary" for the work they perform. You cannot pay yourself $1 in salary and take $149,999 in distributions to avoid payroll taxes. The IRS watches for this aggressively.

What counts as reasonable? The IRS looks at:

• What you would pay someone else to do your job
• Your industry and geographic market (Abilene/West Texas rates matter here)
• Your qualifications and experience
• The time you actually spend working in the business
• What comparable businesses pay for similar roles

There's no single formula, but a common benchmark is paying yourself 40–60% of net profit as salary, with the remainder taken as distributions. For a bookkeeper or accountant in West Texas, reasonable salary might be $45,000–$70,000 depending on hours and scope.

If the IRS audits your S-corp and determines your salary was unreasonably low, they can reclassify your distributions as wages — and you'll owe back payroll taxes, penalties, and interest on the difference.

The S-corp election adds compliance costs: you need to run payroll, file quarterly 941s, file a separate S-corp tax return (Form 1120-S), and issue yourself a W-2. Those costs typically run $1,500–$3,000/year in additional accounting fees.

That means the election only makes financial sense when your tax savings exceed those costs. As a rough rule:

• Under $40,000 net profit: S-corp election rarely makes sense. The savings don't cover the added costs.
• $40,000–$80,000 net profit: It depends. Run the numbers with your tax advisor.
• Over $80,000 net profit: The election almost always makes sense. Savings typically exceed costs by a meaningful margin.

For a Texas business owner earning $120,000 in net profit, the S-corp election might save $8,000–$12,000 in self-employment taxes annually — well above the added compliance cost.

To elect S-corp status for a given tax year, you must file Form 2553 by March 15 of that year (for calendar-year businesses). If you miss the deadline, you can request late election relief — the IRS grants it in most cases if you have a valid reason — but it's easier to file on time.

If you're forming a new LLC and want S-corp status from day one, file Form 2553 within 75 days of formation.

Once you're an S-corp, your bookkeeping and tax situation changes in several ways:

You must run payroll. You're now an employee of your own company. That means setting up payroll, withholding federal income tax and FICA from your paychecks, making payroll tax deposits, and filing quarterly 941s. This is not optional.

You file a separate business return. Form 1120-S is due March 15 (or September 15 with an extension). This is in addition to your personal Form 1040.

Distributions must be documented. Distributions from an S-corp should be documented with board resolutions or distribution records. Your bookkeeper should track these separately from salary.

Your basis matters. S-corp losses can only be deducted to the extent of your basis in the company. This gets complicated if you have multiple years of losses or have loaned money to the business.

Health insurance is handled differently. S-corp owners who own more than 2% of the company must include health insurance premiums in W-2 wages — but can then deduct them on their personal return. This requires specific payroll handling to get right.

Not running payroll at all. Some business owners elect S-corp status and then forget to actually set up payroll. Taking only distributions with no salary is a red flag the IRS looks for specifically.

Setting salary too low. A $12,000/year salary for a business generating $200,000 in profit will not survive IRS scrutiny. Document your salary decision and be prepared to defend it.

Missing the 1120-S deadline. The S-corp return is due March 15, not April 15. Many business owners miss this because they're used to the individual return deadline.

Commingling distributions and salary. Keep your payroll deposits and distribution transfers clearly separated in your bookkeeping. Mixing them creates confusion and audit risk.

If your Texas LLC is generating consistent profit above $80,000 and you haven't evaluated the S-corp election, it's worth a conversation. The savings are real — but so is the added complexity.

At The Gap ProAdvisors, we handle S-corp elections, payroll setup, quarterly filings, and Form 1120-S preparation for small business owners across Abilene and West Texas. We can run the numbers for your specific situation and tell you whether the election makes sense — and if it does, handle the entire transition.

Schedule a free 30-minute consultation to get started. We work fully remotely, so there's no office visit required.