You know, there’s a way that you can not only strengthen your family’s future but also save big on taxes. And that’s by hiring your spouse to work as an employee in your business.
If you’re a sole proprietor, or if you happen to run a single-member LLC taxed as a sole proprietorship or as a partnership (as long as your spouse isn’t a partner), this could be particularly rewarding.
Warning: This strategy requires careful consideration. It’s much like anything else in life, isn’t it? We must approach it the right way. So, would you like to explore five key insights, five essential pieces of wisdom, that you should consider about employing your spouse? I believe they might guide you on a path that’s both enriching and prudent.
Take Advantage of Tax-Free Employee Benefits
If you’re considering putting your spouse on the payroll and paying cash wages, you may be wasting your hard earned money. Bluntly, this method will realize no tax savings. Those wages you pay are fully taxable, and both you and your spouse must each pay your share of Social Security and Medicare tax on those wages. Also, as your spouse’s employer, you’ll have to withhold these taxes and pay them to the IRS.
I challenge you to think about it this way: when you pay your spouse wages, you’re essentially moving the income from one place on your tax return to another. It’s a shift, not a saving.
But here’s the rub: Instead of wages, consider paying your spouse entirely, or mostly, with tax-free employee fringe benefits. Things like health insurance, which aren’t taxable income for your spouse-employee, yet remain a deductible expense for you as an employer. Now that, my friends, results in real tax savings.
Here are some examples of tax-free fringe employee benefits:
- Health Insurance: Coverage for medical, dental, and sometimes vision care.
- Note: 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 and don’t operate as an S corporation.
- Dependent Care Assistance: Such as childcare or care for a disabled dependent.
- Flexible Spending Accounts (FSAs): For healthcare or dependent care.
- Health Savings Accounts (HSAs): Contributions may be made pre-tax.
- Cell Phone Provided for Business Use: When used primarily for work-related purposes.
- Professional Development: Such as workshops, training, or conferences related to the job.
And let’s take it a step further. If you pay a spouse only with these tax-free fringe benefits, the burdensome requirements like payroll taxes, employment tax returns, or filing a W-2 for your spouse? Those can be set aside.
The Elephant in the Room: Minimum Wage
Now, I know what you might be thinking: “Don’t I have to pay my spouse at least the minimum wage, consisting of cash wages?”
Well, let me be clear on this. In most states, the answer is no, you don’t. When a sole proprietor business owner hires his or her spouse, the minimum wage laws typically don’t apply. The same holds true for federal and state unemployment taxes.
But here’s where you need to be careful. If your business is structured as a corporation or an LLC, the rules change. In those cases, the minimum wage laws do apply when your business entity, not you as an individual, hires your spouse. And I want to emphasize this: the IRS doesn’t enforce minimum wage laws.
So, you might wonder, “Do I need to pay my spouse any cash wages to deduct those employee fringe benefits?” Well, the answer is, you don’t have to. The key is that your spouse must be your bona fide employee, and the total compensation must be reasonable.
For example, the owner of a daycare 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.
Make Sure Your Spouse Is Your Bona Fide Employee
This all sounds promising but I want to warn you that the IRS often looks closely at these arrangements. They may question deductions for health insurance and other expenses by claiming the spouse is not a bona fide employee.
You see, your spouse won’t just magically become an employee because there’s a signed employment agreement. In fact, if you don’t live up to its terms, that written agreement could backfire on you. It’s often the case that you’re better off without one.
So, what do you need to prove? Let me break it down for you.
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:
- Date of service performed: You’ll want to keep track of the days on which the work is performed. This includes both the start and end dates for the period being recorded.
- Hours: Break down the number of hours worked each day, including the start and end times.
- Task or Project Description: Outline what was done during those hours. Was it administrative work? Was it client-related? This insight helps provide transparency
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 those monies 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.
You may be feeling a strong temptation to overpay. You see, those payments are deductible, and that might lead some to think, “Why not pay a little extra?” But let me be clear: it’s vital to resist that temptation, to act with integrity and fairness.
Consider what similar workers in similar roles are earning. Look at the responsibilities, the skills required, the hours worked, and align the compensation accordingly. You don’t have to go it alone, either. A simple online search will reveal many sources of salary information. You might even consult industry reports or reach out to professional associations in your field.
But here’s the key: document what you find. Keep records of the salaries that similar workers earn, along with a clear rationale for the compensation you’re providing to your spouse.