Texas Franchise Tax law allows a deduction for compensation paid to employees , but it’s capped. For 2025, the maximum deduction per person is $370,000. For founders and key employees, smart planning around this cap can reduce your Texas Franchise Tax without triggering IRS or state-level scrutiny.
What Is the Compensation Deduction Cap?
Under Texas Tax Code §171.1013, entities using the compensation deduction method can deduct:
- Wages & salaries paid to natural persons
- Up to $370,000 per employee for the 2025 report year
- Includes 401(k) contributions, stock options, and health benefits paid by the employer
This cap is adjusted annually for inflation by the Texas Comptroller.
Who Should Use the Compensation Method?
Eligible for any entity that:
- Does not qualify for the No Tax Due threshold
- Is not in retail or wholesale (which typically uses the COGS method)
- Wants to maximize deductions through payroll planning
Entities can choose either:
- Cost of Goods Sold (COGS)
- Compensation
- 70% standard deduction
Choose only one for each report year.
Example: How the Cap Affects a Founder’s Payroll
Company: Buildlytics Inc.
Tax Year: 2024 (for 2025 filing)
Revenue: $3.5 million
Payroll to Founder (CEO): $500,000
Other Payroll (4 engineers): $120,000 each
Compensation Deduction Calculation:
- Founder cap: $370,000 (only deductible up to cap)
- Engineers: $120,000 × 4 = $480,000
- Total deductible compensation = $370,000 + $480,000 = $850,000
This amount is deducted from total revenue to calculate margin for franchise tax.
Step-by-Step: Founder Payroll Strategy for 2025
- Forecast your total revenue for the 2024 calendar year
- Compare compensation vs COGS deduction potential
- If using compensation method:
- Cap any single employee’s W-2 at $370,000
- Use remaining payroll budget for team expansion
- File franchise tax return using:
- Form 05-158-A (Long Form)
- Include compensation breakdown if audited
When Overpaying Hurts: Pitfalls to Avoid
- Paying founders more than $370,000 doesn’t increase deduction
- IRS may question unreasonably high compensation if S-Corp
- No deduction allowed for contractors or LLC owners without W-2s
Conclusion
Texas’s $370,000 cap on compensation deductions means payroll planning is key. Paying a founder $500K may look impressive, but only $370K counts toward tax relief. To reduce Texas Franchise Tax, structure W-2 wages carefully, explore employee hiring, and choose the right deduction method.
Call to Action
Book a payroll strategy consultation with Anshul Goyal, CPA, EA, FCA to determine the best way to reduce your Texas Franchise Tax liability through compliant founder compensation planning.
Disclaimer:
This blog is for informational purposes only. Compensation deduction caps are enforced annually and must align with state rules and federal wage classifications. Consult a tax advisor before adjusting payroll structures.
Top 5 High-Searched FAQs
1. What is the 2025 compensation deduction cap in Texas?
$370,000 per person.
2. Does the cap include bonuses and benefits?
Yes. Wages, bonuses, 401(k), and health benefits are all included.
3. Can I deduct contractor payments?
No. Only W-2 employee wages count.
4. Can C-Corps and S-Corps both use the compensation method?
Yes. Any margin-taxed entity can elect this method if eligible.
5. Should I pay myself more than the cap?
You can, but the excess amount won’t be deductible for Texas Franchise Tax purposes.
About Our CPA
Anshul Goyal, CPA, EA, FCA advises Texas business owners on how to structure compensation for tax efficiency. He specializes in founder payroll, franchise tax optimization, and cross-border compensation compliance for startups and tech firms.