Today, many families operate their own business, and both husband and wife work the business to achieve success. Of the many questions that can arise in such a situation, an important one may be, “If one spouse is technically considered the ‘owner’ of the business, and the other spouse either already works in the business, or could work in the business, is there any advantage to actually hiring the ‘non-owner’ spouse as a bona fide employee”? Potential advantages generally flow from the ability of the spouse to receive tax-favored fringe benefits in his or her capacity as an employee. Some disadvantages may also flow, principally from added employment tax and other liabilities that may be generated, especially when a related person is an employee.
One word of caution up front: most closely-held S corporations are prevented from realizing the benefits of hiring the spouse as an employee. The spouse of a more than 2-percent S corporation stockholder is automatically treated as a more than 2-percent owner, which forecloses most employee fringe benefit deductions.
Further, the term “bona fide employee” is key to this discussion. Merely calling your spouse an employee when no, or very little, actual services are performed, or not physically establishing a true employer-employee relationship with such evidence as time records and pay checks with taxes withheld, is to invite the scrutiny of the IRS or other taxing agencies.
Health insurance: A spouse who is hired as a bona fide employee generally can be given health insurance coverage that includes coverage for all family members, including the principal owner spouse, thereby effectively converting all family health insurance premiums into business expenses.
Self-employment tax: At 15.3% of earnings, the self-employment tax should play a role in deciding whether to have medical premiums and other fringe benefits written off as a trade or business deduction through a spouse-employee. Even starting in 2003, when health insurance costs will be 100% income-tax deductible for the self-employed, there will still be benefits to setting up a medical plan which is deductible as a business expense since the deduction will continue to reduce, dollar for dollar, the profits on which self-employment tax is computed.
Running the numbers usually reveals the continuing benefit of having a spouse as an employee covered under a health plan in which the rest of the family, including the owner-spouse, are covered as dependents. And although the wages of the spouse are subject to FICA, the spouse is able to build up Social Security and Medicare credits.
Section 105 reimbursement plan: Setting up a "section 105" medical reimbursement plan under which the spouse-as-employee is covered creates benefits in addition to a business expense deduction for health insurance premiums. The spouse can also use the plan to deduct insurance co-pays, noncovered prescriptions, eye glasses, dental care, orthodontics, and other medical expenses that would otherwise be confined to an itemized "Schedule A" deduction subject to the difficult-to-reach 7.5% floor. In addition, an employee spouse would be entitled to $50,000 of group-term life insurance premiums and disability premiums as nontaxable fringe benefits.
Retirement plan impact: The key term here is “attribution”. For these purposes, attribution means: are the assets or earnings of one spouse automatically ‘attributed’, under the tax code, to the other spouse simply because they are married persons? The answer is of course, as with most things under the tax laws, it depends. Fortunately, in one important respect, the answer is no. The earnings/wages of each spouse are considered independently in determining the amount that can be contributed to the retirement plan on each spouse’s behalf. This was not always the case, and can significantly increase the amount of retirement savings a couple can accumulate.
However, having a spouse count as an employee is a double-edged sword in several other respects. For example, “ownership” attribution (as opposed to “earnings” attribution) for tax purposes can be a problem. The basic definition of a highly compensated employee is one either earning above the threshold level (generally $85,000) or a 5 percent owner. As a result, a spouse who is deemed to be a highly compensated employee or even a key employee may limit a small business owner's ability to use certain age-related or cross-testing elements of the retirement plan.
On the other hand, in certain instances having a spouse as an employee can help direct more retirement benefits to the owner. This apparent paradox works because of the testing rules for "highly compensated." For example, when a spouse is on the payroll as a lower paid employee such as an office manager, choosing to exclude the spouse from participation in a retirement plan can have a positive effect on cross-testing, since the percentage of highly compensated employees covered under the plan is reduced dramatically. Because of the attribution rules, there would then be two highly compensated employees. By excluding the spouse from participation in the plan, only 50% of highly compensated employees are covered, thereby reducing the percentage of non-highly compensated employees that need to participate in the plan to avoid top heavy rules, or creating a favorable computation for the average benefits test.
Confused yet? If so, consider discussing this issue with your plan administrator, or a tax or plan professional. The potential benefits are well worth the effort.
Other employee perks: Often small business owners will want to hire their spouses to get them onto the travel and entertainment budget more easily. Unfortunately, even if one of the spouses uses a maiden name, the similar address of the taxpayers, as well as disclosures if a retirement plan is in operation, will guarantee closer IRS scrutiny during any travel and entertainment audit. These expenses may be recharacterized as gifts or disguised dividends. In addition, certain provisions of the Internal Revenue Code specifically address the expenses of a spouse, whether as a spouse or an employee. Under Treasury Department regulations, a taxpayer may not deduct travel expenses paid or incurred for a spouse (or dependent) unless the spouse or other individual is a bona-fide employee of the employer, the travel is for a bona-fide business purpose, and the expenses of the spouse or other person are otherwise deductible.
This article is intended to provide general information only, and does not represent any specific tax advice regarding any individual or company’s unique tax situation. In no way does this article represent financial advice. For assistance in your own situation, please seek the counsel of your tax and/or financial advisor.
George Graziano, CPA/ABV is the tax manager for the Grass Valley Public Accounting and Financial Planning firm of Scinto Graziano, LLP. He can be reached at 273-3200 or george@sgcpa.biz
