Most Texas owners switch to an S corp to save on self-employment tax. It works. But only if the salary you pay yourself is one the IRS will accept as reasonable.

Go too low, and the IRS can treat part of your distributions as wages and send the company a bill for the payroll tax it skipped, with penalties and interest on top. Go too high, and you’ve given back the savings that made the S corp worth setting up in the first place.

Nobody can hand you a universal number. You can get to a defensible one, though, if you know how the IRS looks at it.

Why your S corp salary matters

When you own an S corp and work in it, money reaches you two ways. Salary goes through payroll, so Social Security and Medicare come out of it. Distributions are whatever profit is left, and they don’t get hit with either.

In 2026, Social Security is 6.2% from you and another 6.2% from the company, on wages up to $184,500. Medicare is 1.45% from each side with no cap, and once your wages pass $200,000, you pay an extra 0.9%. So a dollar moved from salary to distributions can dodge up to 15.3% in tax.

The IRS knows this. Its guidance on S corp compensation says you have to pay yourself reasonable compensation before you take distributions, and that it can reclassify distributions as wages when you don’t.

The CPA who paid himself $24,000

Ask a tax professional about this, and they’ll bring up David E. Watson, P.C. v. United States. Watson was a CPA in Iowa with about 20 years of experience, working full-time at a busy firm. His S corp paid him a $24,000 salary in 2002 and 2003. It also paid him around $200,000 a year in distributions.

The IRS hired an expert who put the value of Watson’s work at $91,044 a year. The district court went with that number and treated the $67,044 gap as wages for both years, so the company owed the back payroll tax plus penalties and interest. The Eighth Circuit upheld it in 2012.

Watson’s main argument was that no law sets a minimum salary. The court didn’t buy it. Nobody said there was a minimum. The issue was whether $24,000 was a fair price for what he actually did, and it wasn’t close.

How the IRS decides what’s reasonable

You won’t find a formula in the tax code or the regulations. Courts go case by case. The IRS has published a list of the factors courts have leaned on:

  • Your training and experience
  • Your duties and responsibilities
  • How much time you put into the business
  • What you pay employees who aren’t owners
  • Your history of dividends and distributions
  • What similar businesses pay for similar work
  • Any compensation agreements or formulas you use

In plain terms, the IRS wants to know what it would cost you to hire someone to do your job.

How to actually set the number

The most common method is to look at the market. The Bureau of Labor Statistics publishes pay by occupation for the Dallas-Fort Worth-Arlington area, and you should use it instead of national averages. Pay in Southlake isn’t pay in Lubbock. The IRS is well aware of that.

Most small business owners don’t do one job, though. You might spend 25 hours a week in the field as the licensed tech and another 10 writing estimates, then squeeze bookkeeping in on Sunday night. So price each of those roles at its own market rate and add them up. That usually lands closer to reality than pricing yourself as a full-time CEO, and it’s often lower, since you aren’t doing executive work all week.

There’s also an income-based method that looks at what an outside investor would expect to earn from the business and treats the rest as your pay. Valuation firms use it. Most owner-run businesses in North Texas don’t need it.

There’s no 60/40 rule

Plenty of articles say to split profit 60% salary and 40% distributions, or some other ratio. No law, regulation, or court decision says that. It’s a rule of thumb that ignores the one thing the IRS cares about, which is the work you do.

Take a solo attorney and a landscaping company owner who both clear the same profit. Almost all of the attorney’s profit comes from the attorney’s own hours. A good chunk of the landscaper’s comes from crews and equipment. Their reasonable salaries won’t be the same, and a ratio can’t tell you that.

A worked example

Say you own an HVAC company in Keller that clears $180,000 before paying you. You work full time, mostly on service calls and estimates. You price out your roles with DFW wage data and land on $80,000 as your reasonable salary.

As a sole proprietor or single-member LLC, you’d owe about $25,400 in self-employment tax on that $180,000.

As an S corp paying you $80,000, the payroll tax on your salary (both halves) is about $12,240. The rest of the profit comes out as distributions, with no payroll tax on it.

That’s a difference of roughly $13,000 a year. You’ll give some of that back in payroll service fees, a separate Form 1120-S return, and Texas unemployment tax. And income tax and the QBI deduction move around too, so the real number takes a full projection. Still, you can see the tradeoff.

Could you cut the salary to $40,000 and save more on paper? Sure. That’s also pretty much what Watson did.

Texas payroll and franchise tax for S corps

Texas doesn’t have a state income tax, so there’s nothing to withhold for the state from your paycheck. That makes the S corp math here mostly a federal question.

Once you’re on payroll, though, a couple of Texas items show up:

  • Unemployment tax. Your S corp pays Texas Workforce Commission unemployment tax on the first $9,000 of each employee’s wages, and that includes you. New employers usually start at 2.7%, or about $243 a year per person, filed quarterly. Federal unemployment tax (FUTA) applies too, but the credit for paying the Texas tax on time knocks it down to a small amount.
  • Franchise tax. For 2026 and 2027 reports, an S corp with annualized revenue at or below $2.65 million owes no franchise tax. You still have to file a Public Information Report by May 15 every year. If you’re over the threshold, officer pay can count toward the compensation deduction, which tops out at $480,000 per person.

 

Mistakes we see with S corp salaries

Taking distributions all year with no payroll. Once cash is coming out of the business to you, a salary needs to run through real payroll, with withholding and quarterly Form 941 filings. One big paycheck in December looks bad and throws off your withholding.

Thinking a zero salary is always a problem. It isn’t always. The IRS says reasonable compensation never has to be more than what you actually take out. If it’s your first year and you’re putting every dollar back into the business, no salary can hold up. It becomes an issue when you start pulling cash.

Getting health insurance wrong. If you own more than 2% of the S corp and the company pays your health insurance, those premiums go on your W-2 as wages. Social Security and Medicare generally don’t apply to them. Set it up correctly, and you can deduct the premiums on your personal return. Get it wrong, and that deduction can disappear.

Setting it once and forgetting it. If your role or the profit changes, your salary should too. Look at it every year before December.

No documentation. In an audit, “my old accountant said $50,000 was fine” won’t get you far. A one-page memo showing your duties, your hours, and the wage data you used will.

How your salary affects the QBI deduction

The qualified business income deduction lets a lot of S corp owners deduct up to 20% of their business income, and it’s permanent now. Your salary doesn’t count as QBI. So, in general, the lower your salary, the bigger the deduction.

For 2026, if your taxable income is under $201,750 (single) or $403,500 (married filing jointly), that’s all you need to know. Above those amounts, the deduction can be capped at 50% of the W-2 wages your business pays. That flips things. A salary that’s too low can actually shrink the deduction. Higher earners and owners of service businesses like law firms and accounting practices should run it both ways before picking a number.

Common questions about S corp owner salary

Is there a minimum salary for an S corp owner? There’s no set dollar amount. The test is whether your pay is reasonable for the work you do in your local market.

What percentage of profit should my salary be? None is required. Base it on what your job is worth, not a ratio.

Can I lower my salary in a slow year? Yes, if the business is earning less and your role hasn’t grown. Write down why you changed it.

Do I need payroll if I’m the only employee? Yes. You still need federal withholding, a W-2, and quarterly filings, even if you’re the only one on payroll.

What happens if the IRS decides my salary was too low? It can reclassify part of your distributions as wages. The company then owes both halves of Social Security and Medicare on that amount, plus penalties and interest, and it’s often for more than one year.

Getting help with your S corp salary in North DFW

Books By Bonnie is run by Bonnie Huggins, a licensed tax attorney, enrolled agent, and bookkeeper in Colleyville. She works with business owners in Southlake, Keller, Grapevine, Roanoke, Trophy Club, Westlake, North Richland Hills, Hurst, and around DFW.

If you’re not sure your salary would survive an IRS review, or you’re still deciding whether an S corp is worth it, talk to her before year-end.

Schedule a free consultation.

 

General information, not legal or tax advice for your specific situation. Reasonable compensation depends on the facts of your business.