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Hiring
Your Spouse as an Employee
This
is intended to answer questions about some of the federal income
tax pros and cons of hiring a spouse as an employee in a family
business. The advantages generally flow from the ability of the
spouse to receive tax-favored fringe benefits in his or her capacity
as an employee. The disadvantages principally flow from the added
employment tax and other liabilities that are generated, especially
when a related person is an employee.
One word of caution up front: most closely-held S corporations are
prevented from realizing any benefits from 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.
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% 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: Having a spouse count as an employee
is a double-edged sword in several respects. For example, ownership
attribution for tax purposes is a problem. The basic definition
of a highly compensated employee is one either earning above the
threshold level (generally $80,000) or a 5 percent owner. As a result,
a spouse who is deemed to be a highly compensated employee or even
a key employee will limit a small business owner's ability to use
an age-related or cross-testing of the retirement plan.
Nevertheless, in certain instances having a spouse as an employee
can help direct more retirement benefits to the owner. This 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.
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.
Be sure to consult with a tax advisor for proper planning and implementation
of tax saving ideas to be sure they are right for you.
C.
David Pitzer, CPA, PC
118
Two Mile Pike
Goodlettsville, TN 37072
(615) 851-2727
Fax: (615) 851-8711
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2002, 2003
C. David Pitzer, CPA, PC
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