Five Things to Know About Employing Your SpouseTax Planning
Five Things to Know About Employing Your Spouse
Hiring your spouse to work as an employee in your business can save you big on taxes. The savings can be particularly great if you are a sole proprietor or have a single-member LLC taxed as a sole proprietorship or as a partnership (as long as your spouse is not a partner).
But this arrangement can backfire if you don’t do it the right way. Here are five key things to know about employing your spouse.
1. Pay Your Spouse Tax-Free Employee Benefits, Not Taxable Wages
You’ll realize no tax savings if you put your spouse on the payroll and pay him or her cash wages.
Employee wages you pay your spouse are fully taxable. Your spouse-employee must pay federal and state income tax on wages. And you and your spouse must each pay half of the Social Security and Medicare tax on wages. As your spouse’s employer, you must withhold these taxes and pay them to the IRS.
In effect, when you pay your spouse wages, you’re simply moving the income from one place on your tax return to another.
Instead of wages, you should pay your spouse entirely, or mostly, with tax-free employee fringe benefits. Certain types of employee benefits, such as health insurance, are not taxable income for your spouse-employee, yet they are a deductible expense for you as your spouse’s employer. This results in a real tax savings.
Also, if you pay a spouse only with tax-free fringe benefits, you need not pay payroll taxes, file employment tax returns, or file a W-2 for your spouse.
But don’t you have to pay your spouse at least the minimum wage, which must consist of cash wages? No, you don’t. In most states, the minimum wage laws don’t apply when a sole proprietor business owner hires his or her spouse as an employee. The same holds true for federal and state unemployment taxes.
If your business is a corporation or an LLC, the minimum wage laws do apply when your business entity, not you as an individual business owner, hires your spouse. Minimum wage laws are not enforced by the IRS.
You need not pay your spouse any cash wages to deduct employee fringe benefits you pay him or her. The only requirements are that your spouse is your bona fide employee and that the total compensation you pay is reasonable.
For example, the owner of a day care business was allowed to deduct medical reimbursement benefits she paid her husband-employee even though she paid him no cash wages or other remuneration. She provided the Tax Court with convincing evidence that she was the sole owner of the day care business, that her husband regularly performed simple assigned tasks under her direction, and that he was paid a reasonable amount for the work.
Some business owners pay their spouse a nominal amount of wages in addition to fringe benefits—for example, $1,000 per year or $100 per month—and file a W-2. But if your spouse is not your bona fide employee, paying such a small amount of wages won’t be much help.
2. Establish a Medical Reimbursement Arrangement
Health benefits are normally the largest tax-free employee fringe benefit you can provide your spouse.
By hiring your spouse and adopting the right type of plan, you convert health insurance premiums and other medical expenses for your spouse, yourself, and your children under age 27 into fully deductible business expenses.
Deducting these health expenses as a business deduction reduces your taxable income not only for income taxes, but for Social Security and Medicare taxes as well.
If your spouse is the only employee of your business, you should establish a spousal health reimbursement arrangement, what we call a “105-HRA.” This is the best possible way to pay for health expenses when you own your own business. With only one employee, your 105-HRA is not subject to Affordable Care Act (ACA) restrictions, which prohibit stand-alone HRAs.
Here’s how it works:
- Your spouse purchases his or her own health insurance plan in the spouse’s name to cover the entire family (including you). You, as the employer, reimburse your spouse for the premiums.
- You also reimburse your spouse for health expenses not covered by insurance, including deductibles, copays, and prescriptions, for your entire family. You can reimburse your spouse for virtually all deductible medical expenses.
The IRS imposes no limit on the amount you can reimburse a spouse-employee with a 105-HRA. But the total amount should be reasonable for the work your spouse performs. The entire cost is a tax-free employee fringe benefit for your spouse.6 Meanwhile, you (the employer) get to deduct the full amount as an ordinary business expense for an employee benefit program.
Example. Milo Shelitto owned a 2,300-acre farm in Kansas and hired his wife, Sharlyn, as his sole employee to assist with all types of farm chores. Mr. Shelitto established a 105-HRA and paid Mrs. Shelitto $20,897 in medical expense and insurance premium reimbursements one year. Mr. and Mrs. Shelitto deducted the full amount of Schedule F (Profit or Loss from Farming) of their joint Form 1040 tax return as an ordinary business expense for an employee benefit program. This resulted in a tax savings of $6,947. The arrangement was upheld by the Tax Court.
This arrangement works whether you operate your business as:
- a sole proprietorship reporting on Schedule C of IRS Form 1040;
- a partnership filing IRS Form 1065;
- an LLC taxed as a sole proprietorship or partnership;
- a real estate rental business reporting on Schedule E of Form 1040; or
- a farm business reporting on Schedule F of Form 1040.
You and your spouse should sign a formal plan document, and your spouse should substantiate all reimbursed expenses.
If you have employees other than your spouse, you cannot use a 105-HRA due to restrictions imposed by the Affordable Care Act. Instead, you may establish an Individual Coverage Health Reimbursement Account (ICHRA) to cover your spouse and other employees.
ICHRAs are new—they began on January 1, 2020. They offer many of the same advantages as 105-HRAs. With an ICHRA, your spouse and other employees obtain their own individual health coverage or Medicare. Your spouse’s plan should include you and other family members. Your employees must prove they have coverage each year.
You, as the employer, set a monthly allowance of tax-free money your spouse and other employees can use to pay for their health insurance premiums and other uninsured health care expenses.
The IRS imposes no caps on the allowance—it can be as big or small as you specify. You are even allowed to discriminate among your employees, and to provide some classes of employees with better benefits than others. For example, you may provide larger reimbursements for full-time employees than for part-timers.
The reimbursements are tax-free to the employees and tax-deductible for you, the employer.
Neither the 105-HRA nor the ICHRA works if your business is an S corporation. When you own more than 2 percent of an S corporation, your spouse is not considered your employee and therefore cannot participate in employee health plans.
3. Take Advantage of Certain Other Fringe Benefits
There are other tax-free employee fringe benefits you can provide your spouse, as follows.
Education. Job-related education for your spouse-employee is deductible by you and not income to your spouse employee. (But beware of Section 127 education programs, as you’ll see below.)
Life insurance. Employers may provide employees up to $50,000 in group term life insurance coverage tax-free.
Working condition fringe benefits. These are expenses for items that help your spouse do his or her job. For example, you can deduct the cost of a smartphone your spouse uses for business purposes. Your spouse doesn’t have to keep records of the business use of the smartphone.
De minimis fringes. Certain types of relatively low-cost occasional employee benefits are tax-free and deductible by the employer. These include occasional meals and snacks, gifts (such as a small birthday gift), sporting event or theater tickets, and flowers or fruit for special occasions.14
4. Beware of Certain Tax-Free Benefits
Section 127 education plan. The law prohibits Section 127 benefits to your spouse and dependents under the 5 percent ownership test.
Transportation benefits. If you and your spouse work in an outside office, you can provide him or her tax-free transportation benefits—just as you can for any rank and file employee. For 2020, you may pay up to $270 per month for parking near your business premises or for transit passes.
But as a result of the Tax Cuts and Jobs Act, the tax-free transportation benefits to your employees are not deductible by you, the employer.16 Because we are talking about your spouse as an employee, the transportation fringe benefit gives no net benefit to you and your spouse (it’s a wash).
5. Make Sure Your Spouse Is Your Bona Fide Employee
The IRS usually attacks spouse-employee deductions for health insurance and other expenses by claiming the spouse is not a bona fide employee.
Your spouse won’t magically become an employee because he or she signs an employment agreement saying he or she is one. Indeed, a written agreement can backfire if you and your spouse don’t live up to its terms. You’re usually better off without one.
Instead, you need to be able to prove the following.
Your spouse is not a co-owner of your business. Spouses who co-own a business are engaged in a partnership, not an employer-employee relationship. Your spouse should not share title in any business assets. You should have a separate business bank account under your sole control. And all contracts and government filings should be in your name alone.
Your spouse does real work. Your spouse must perform real work for your business, whether full or part time. The services don’t have to be indispensable—only common, accepted, helpful, and appropriate for your business.
Keep track of the work your spouse performs and the related hours, by having him or her fill out weekly time sheets. The time sheet should list the date, the services performed, and the time spent performing the services. The time sheet is the key to proving your spouse is a real employee.
Your spouse gets paid. Your spouse should pay all medical and other reimbursable expenses from his or her separate checking account and then submit a claim for reimbursement—ideally, each month. You then pay the reimbursement from your business account, and your spouse deposits it in his or her checking account.
Your spouse works under your direction and control. The IRS uses the common-law “right of control” test to determine whether your spouse, or any other worker, is your employee. You should make the management
decisions, and your spouse should work under your direction and control.
Your spouse’s compensation is reasonable. Your spouse’s compensation (which, to achieve tax savings, will be primarily from fringe benefits) must be reasonable to be deductible.
There is a strong temptation to overpay your spouse when he or she is your employee, because the payments are deductible. Resist the temptation, and pay no more than similar workers earn for similar work. Furthermore, document what similar workers earn; a simple online search will reveal many sources of salary information.
Key point. Comply with state requirements for employers. Depending on your state, you may need to register as an employer and provide your spouse with workers’ compensation coverage even if he or she is your only employee. In a few states, you may also have to withhold and pay premiums for state disability or family and medical leave programs.
Hiring your spouse can result in substantial tax savings, but only if you pay your spouse solely, or mainly, with taxfree employee fringe benefits instead of taxable wages. The IRS doesn’t require you to pay your spouse any W-2 wages.
The most valuable fringe benefit you can provide your spouse-employee is reimbursement for health insurance and uninsured medical expenses. You can accomplish this through a 105-HRA plan if your spouse is your sole employee, or through an ICHRA if you have multiple employees.
Tax-free employee fringe benefits are not limited to health benefits—for example, you can provide certain education, life insurance, and working condition fringe benefits.
For your spouse-employee deductions to withstand attack by the IRS, you must be able to show that your spouse is a bona fide employee. To do so, your spouse should:
- use a time sheet to keep track of the work performed and submit that time sheet to you on a regular basis;
- be regularly paid a reasonable amount;
- work under your direction and control;
- and not be a co-owner of your business.