Start a Texas S Corp

What is an S corporation?

An S corp is not a business structure. It’s not a separate legal entity like a corporation or LLC. Instead, “S corporation” refers to a tax classification that either an LLC or a corporation can apply for with the IRS if it meets the criteria. Generally speaking, S corp status is geared toward small businesses.

Below, we’ll outline the criteria needed to qualify as an S corporation and list the steps needed to file as an S corp, should you decide that it’s right for your business.

S Corporation Requirements

The Internal Revenue Service (IRS) imposes restrictions on what businesses can file as an S corp. Specifically, to qualify for S corporation election, an entity must:

• Be a domestic corporation or LLC
• Have only one class of stock
• Have no more than 100 shareholders or members (“shareholders” is the term for owners of a corporation, while “members” is the term for owners of an LLC)
• Not be an ineligible corporation, such as certain financial institutions, insurance companies, and domestic international sales corporations
• Have only allowable shareholders or members, which includes individuals, certain trusts, and estates. The shareholders may not be partnerships, corporations, or non-resident aliens. A nonresident alien is an alien who has not passed the green card test or the substantial presence test.

If your business entity meets these requirements, keep reading to learn how to complete a Texas S corp filing.

Filing as an S Corp in Texas

Before you can apply to be a Texas Subchapter S corporation, you’ll need to form either an LLC or a C corporation if you haven’t already done so. Then, you’ll file an election form with the IRS.

If you’re ready to learn about starting an S corp in Texas, we’ll walk you through it. First, we’ll show you how to form an LLC in Texas. If you’d rather form a Texas corporation, follow the instructions on our Texas corporation page. Then, in Step 6, we’ll explain how to file for S corp status as either an LLC or corporation.

Pros and Cons of Filing as an S Corp

While S corp classification does benefit some businesses, making this election isn’t necessarily right for everyone. You and your business partners will need to carefully consider the pros and cons before deciding how to proceed. Consult an experienced tax professional about whether the S corp election would be best for your particular business.

Advantages of S Corp Election for LLCs

The advantages of an S corp tax designation for an LLC differ from the advantages for C corporations. Let’s look at the advantages for LLCs first.

By default, a standard LLC already has pass-through taxation, so the benefits of S corp election for an LLC have to do with self-employment taxes. This takes some explanation, but for certain LLCs, it could save a lot in taxes.

Self-Employment Taxes Explained

In a standard LLC, the members are considered self-employed. They make money by receiving their share of profits from the LLC, but they can’t be employed by the LLC. Being self-employed means paying self-employment taxes (the taxes earmarked for Social Security and Medicare, which add up to about 15.3%) on all profits they receive from the LLC. This percentage is more than the taxes they’d pay when working for someone else because their employer would pay part of them.

Dividing Salary and Profits

However, when the members elect S corporation status, they can be compensated in two ways: by receiving their share of the profits and by being paid as an employee.

Once they do that, they only pay Social Security and Medicare taxes on their salary and not the profits they receive. Depending on factors such as how profitable your company is, the savings could add up to a lot. (Of course, the members will still pay federal income tax and all other applicable taxes on their share of the profits.) Money paid out as salary is a tax-deductible expense for the business. 

Reasonable Compensation

One caveat to being a member employed by your LLC is that the IRS expects you to pay yourself a “reasonable” salary. Otherwise, you could pay yourself an annual salary of $2 and avoid contributing anything to Social Security and Medicare. 

So, what does the IRS consider “reasonable compensation”? The instructions on Form 1120-S read, “Distributions and other payments by an S corporation to a corporate officer must be treated as wages to the extent the amounts are reasonable compensation for services rendered to the corporation.” While the terms aren’t completely defined, the IRS seems to consider “reasonable” to be something similar to what others in your field are earning.

If the IRS determines that your salary isn’t enough, it has the authority to reclassify your non-wage distributions (which are not subject to employment taxes) to wages (which are subject to employment taxes). Several court cases have supported the IRS’s right to do this.

Disadvantages of S Corp Election for LLCs

Having an LLC with S corporation election can have some drawbacks over a normal LLC:

Stricter Requirements 

As we listed earlier, S corps have more limitations for qualifying than a standard LLC or C corporation. An S corp can have no more than 100 members, and none of them can be partnerships, corporations, or non-resident aliens. A standard LLC doesn’t have such limitations.

More IRS Scrutiny

Because of the above restrictions and the requirements about paying yourself a “reasonable salary,” the IRS tends to monitor LLCs more closely when they’re filing as an S corporation. That could mean a greater chance of being audited, even if you follow the law to the letter.

In fact, LLCs filing as an S corporation may want to observe many of the same formalities that C corporations do (such as keeping a corporate records book), even if they’re not legally required to. That way, their paperwork and records are more orderly in the event of an audit.

Additional Accounting and Bookkeeping

Having an LLC that files as an S corporation generally means more paperwork. You’ll have to do payroll for your business (if you aren’t already) so you can pay yourself. Your taxes will be more complex, as well.

These added complications may drive up your administrative costs. You may find that you need an accountant, bookkeeper, and/or a payroll service or software.

Advantages of S Corp Election for C Corporations

If you have a C corporation (which is the default form of corporation), filing as an S corporation does have its advantages:

Pass-Through Taxation

A major disadvantage for traditional corporations is “double taxation.” When a corporation makes money, the IRS taxes those profits on the corporate level. But when those profits are ‌distributed to the individual owners (shareholders) as dividends, they’re taxed a second time on the shareholders’ personal tax returns.

When a C corporation qualifies to be an S corporation, those profits are only taxed at the individual level. The business itself isn’t taxed on them. This is called “pass-through taxation,” and it’s how sole proprietorships and general partnerships are taxed. LLCs are also taxed this way unless they choose to be taxed as a corporation.

We need to add here that, since the 2017 Tax Cuts and Jobs Act, the corporate tax rate has been lowered to a flat 21%. So, the disadvantages of C corporation taxation aren’t as severe now as they were. 

Writing Off Losses

Just as profits pass through to the owners of an S corporation, so do the losses. Unlike the shareholders of a C corporation, S corporation owners can write off the company’s losses on their personal income statements. 

This can help offset their income from other sources and can be helpful if the corporation loses money in its early years. However, make sure you’re aware of ​​the IRS’s shareholder loss limitations.

Qualified Business Income Deduction

Under the aforementioned Tax Cuts and Jobs Act, some S corp owners may be able to deduct up to 20% of their qualified business income. This deduction isn’t available to C corporation shareholders.

Qualified business income (QBI) is basically your share of the company’s profits, or, as the IRS puts it, “QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts.”

The IRS website has a more detailed explanation as to what is and is not included in QBI. There’s an income threshold that, if exceeded, may reduce your QBI (see the IRS’s website for details).  

Disadvantages of S Corp Election for C Corporations

S corporation election also has its downsides:

Limited Number of Shareholders

As we said, an S corporation is limited to 100 shareholders, while a C corporation has no such restriction. That limitation could become an issue if the corporation expands and goes public later.

Limited Types of Shareholders

All S corporation shareholders must be U.S. citizens, or certain trusts or estates. That could limit your ability to expand internationally. In addition, shareholders can’t be partnerships or corporations. C corporations don’t have those limitations.

One Class of Stock

Corporations sometimes attract investors by offering preferred stock, but the IRS doesn’t allow S corporations to offer preferred stock.

More IRS Scrutiny

With the extra restrictions S corporations have, the IRS watches them more closely to see if they’re in compliance. In other words, there’s a greater chance of your corporation being audited.

Once again, we want to stress how important it is to have tax guidance about your specific situation from a qualified tax professional. An accountant with S corp experience should be able to make sure you stay in compliance with the IRS, and they may also be able to help you find additional tax savings.

Texas-Specific Considerations

In an S corp, the business itself doesn’t usually pay federal income taxes. But what about state income taxes?

Most other states treat S corporations the same way the federal government does for income taxes. That is, if the company doesn’t pay federal income taxes on its profits, it doesn’t pay state income taxes, either.

But Texas doesn’t have a corporate income tax or a personal income tax. It gets a lot of its tax revenue from high sales taxes and the Texas Franchise Tax (which accompanies the annual franchise tax report). This is a tax you pay for the “privilege of doing business” in the state.

Not all business entities have to pay the Texas Franchise Tax, but S corps (whether they’re LLCs or corporations) do. The good news is that only businesses above the “No Tax Due Threshold” pay the franchise tax, meaning that if your business’s annualized total revenue for the tax year is less than $1,230,000 (as of 2023), you don’t need to pay it.

However, the state does want you to tell them that you don’t owe anything for this tax by filing a No Tax Due Report (Form 05-163) and a Public Information Report (Form 05-102) every year (due May 15).

Do you think your LLC will be making enough to pay the franchise tax? If so, you’ll still file the Public Information Form, but instead of the No Tax Due Report, you’ll file either the EZ Computation Report or the Long Form, both of which can be found on the Texas Comptroller website.

Determining how to calculate your tax payment gets complex very quickly, so this is another one of those times you’ll want to consult an accountant. You can also seek info on the Texas Comptroller website or call them at 800-252-1381.

How We Can Help

Starting and running a business can be complicated, but we’re here to make it as easy for you as possible.

If you want to form an LLC with S corp status, our S corp service can help you do just that. Plus, we offer other services to help you run and grow your business and stay in compliance with state and federal laws.