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Employing Your Spouse: Five Key Points to Keep in Mind
When it comes to your business, hiring your spouse as an employee can lead to significant tax savings, especially if you operate as:
- A sole proprietor
- Single-member LLC taxed as a sole proprietorship
- Partnership (assuming your spouse isn’t a partner)
However, it’s crucial to approach this arrangement correctly to avoid potential pitfalls. Here are five key considerations to keep in mind when employing your spouse.
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1. Opt for Tax-Free Employee Benefits, Not Taxable Wages
Simply putting your spouse on the payroll and paying them cash wages won’t generate any tax savings. Cash wages paid to your spouse are fully taxable, subjecting them to federal and state income taxes.
Both you and your spouse are responsible for covering half of the Social Security and Medicare taxes associated with wages. As the employer, you must withhold and remit these taxes to the IRS.
Paying your spouse’s wages shifts the income from one section of your tax return to another.
Primarily compensate your spouse with tax-free employee fringe benefits to maximize your tax savings. Certain benefits, such as health insurance, aren’t considered taxable income for your spouse-employee but can be deducted as expenses for you as the employer.
This results in tangible tax savings. Moreover, if you pay your spouse exclusively or predominantly through tax-free fringe benefits, you’re exempt from payroll taxes, employment tax filings, and the need to issue a W-2 form for your spouse.
2. Establish a Medical Reimbursement Arrangement
Health benefits typically represent the most substantial tax-free fringe benefit you can offer your spouse as an employee.
Hiring your spouse and implementing an appropriate plan can convert health insurance premiums and medical expenses into deductible business expenses. This applies to yourself, your spouse, and your children (27 years old and under).
Deducting these health expenses reduces your income and Social Security and Medicare taxes.
If your spouse is the sole employee of your business, setting up a spousal health reimbursement arrangement, known as a “105-HRA,” is highly recommended. This arrangement offers the most advantageous way to cover health expenses when you’re a business owner with your spouse as your only employee.
For a 105-HRA, your spouse purchases a health insurance plan to cover the entire family, including you. As the employer, you reimburse your spouse for the premiums paid.
You can reimburse your spouse for health-related costs not covered by insurance, encompassing deductibles, copayments, and prescription expenses for the entire family. Virtually, you can reimburse all deductible medical expenses to your spouse.
The IRS doesn’t limit the amount you can reimburse a spouse-employee through a 105-HRA. However, the total reimbursement should be reasonable based on the work performed by your spouse.
For your spouse, the entire cost of the family plan becomes a tax-free employee fringe benefit. Meanwhile, as the employer, you can deduct the total amount for your employee benefits program as an ordinary business expense.
For example, let’s consider the case of Milo Shellito, who owned a 2,300-acre farm in Kansas. He hired his wife, Sharlyn, as his sole employee to assist with various farm chores. Mr. Shellito established a 105-HRA and paid Mrs. Shellito $20,897 in medical expenses and insurance premium reimbursements in one year.
On their joint Form 1040 tax return, Mr. and Mrs. Shellito reported the entire sum as a deduction on Schedule F (Profit or Loss from Farming), considering it an ordinary business expense within their employee benefits program. The result turned into tax savings of $6,947. The Tax Court upheld this arrangement.
It’s worth noting that the 105-HRA generates these tax savings every year and can be applied to various types of businesses, including:
- LLCs taxed as sole proprietorships or partnerships
- Real estate rental businesses
- Farm businesses
For the sake of adhering to regulations and ensuring appropriate execution, both you and your spouse need to sign a formal plan document. Additionally, your spouse should provide supporting evidence for all expenses eligible for reimbursement.
For comprehensive details on establishing a 105-HRA, refer to the Blueprint for Employee-Spouse 105-HRA (Health Reimbursement Arrangement).
What if You Have Additional Employees?
If you employ individuals other than your spouse, a 105-HRA isn’t suitable due to restrictions imposed by the Affordable Care Act (ACA). In this case, you can establish an Individual Coverage Health Reimbursement Arrangement (ICHRA) to cover your spouse and other employees.
Introduced on January 1, 2020, ICHRAs offer many of the same advantages as 105-HRAs. Under an ICHRA, your spouse and other employees can obtain health coverage or Medicare. The plan your spouse selects should include you and other family members. Employees must provide annual proof of coverage.
As the employer, you determine a monthly allowance of tax-free funds that your spouse and other employees can utilize to pay for health insurance premiums and other uninsured healthcare expenses.
The IRS doesn’t impose any caps on the allowance amount—it can be as large or small as you specify. You also have the flexibility to differentiate among your employees, providing better benefits to certain classes of employees than others. For instance, you may reimburse full-time employees more than part-timers.
These reimbursements are tax-free for employees and tax-deductible for you as the employer.
Please note that 105-HRAs and ICHRAs do not apply to S corporations. If you possess more than 2% ownership in an S corporation, your spouse is not regarded as an employee and, as a result, cannot partake in employee health plans.
3. Leverage Other Tax-Free Fringe Benefits
Aside from health benefits, you can provide various other tax-free fringe benefits to your spouse as an employee. Consider the following options:
- Education: Expenses related to job-related education undertaken by your spouse-employee are tax-deductible for you and not considered taxable income for your spouse.
- Life insurance: Employers can offer tax-free group term life insurance coverage of up to $50,000.
- Working condition fringe benefits: The entire cost of items that assist your spouse in performing their job, such as a smartphone used for business purposes, can be deducted.
- De minimis fringe benefits: Low-cost occasional employee benefits like occasional meals, snacks, gifts (e.g., small birthday gifts), event tickets, or flowers for special occasions are tax-free and deductible for the employer.
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4. Be cautious of specific tax-free benefits
- Section 127 education plan: Spouses and dependents under the 5 percent ownership test are ineligible for Section 127 benefits.
- Transportation benefits: If you and your spouse work in an external office, you can provide tax-free transportation benefits like other employees. In 2023, the maximum allowed is $300 per month for parking or transit passes near your business premises. However, due to the Tax Cuts and Jobs Act, these transportation benefits are not tax-deductible for employers. As a result, providing transportation benefits to your spouse as an employee offers no net benefit (it’s a wash).
5. Ensure Your Spouse Qualifies as a Legitimate Employee
The IRS often scrutinizes deductions related to health insurance and other expenses for spouse-employees, frequently challenging the legitimacy of the employment. To substantiate your spouse’s status as a bona fide employee and defend against potential IRS disputes, consider the following factors:
- Your spouse should not be a co-owner of your business, as co-ownership implies a partnership rather than an employer-employee relationship. Ensure that all business assets are solely owned by you, maintain a separate business bank account under your control, and have contracts and government filings exclusively in your name.
- Your spouse must perform actual work for your business, either full- or part-time. The work performed doesn’t have to be indispensable but should be commonly accepted, helpful, and appropriate for your business.
- Maintain records of the work performed by your spouse and the corresponding hours. Weekly time sheets help document the date, services rendered, and time spent.
- Your spouse should be compensated for their work through medical and other expenses reimbursement. Separate bank accounts should be used for managing these expenses, with your spouse submitting claims for reimbursement regularly.
- The relationship between you and your spouse should reflect employer-employee dynamics, with you making managerial decisions and providing direction and control over their work.
- Compensation provided to your spouse should be reasonable and comparable to what similar workers earn for similar tasks. Keep records of salary information to support the reasonableness of the compensation.
Complying with state requirements for employers is also crucial, as some states may necessitate employer registration and workers’ compensation coverage for your spouse, even if they are your sole employee. Certain states may necessitate you to withhold and remit premiums for state disability or family and medical leave programs.
By understanding these key aspects and adhering to the guidelines, employing your spouse can result in substantial tax savings while ensuring compliance with relevant regulations and avoiding potential issues.
Frequently Asked Questions about employing your spouse
Employing your spouse can result in significant tax savings through various fringe benefits and deductions, providing opportunities to optimize your tax situation.
Paying your spouse primarily with tax-free fringe benefits is generally more advantageous than taxable wages. Doing so can maximize tax savings and reduce the overall tax burden for you and your spouse.
In most states, the minimum wage laws do not apply when a sole proprietor business owner hires their spouse as an employee. However, minimum wage laws may apply if your business is a corporation or an LLC.
You can deduct health insurance premiums and certain medical expenses for your spouse by establishing a medical reimbursement arrangement, such as a 105-HRA or ICHRA. These arrangements allow you to convert these expenses into fully deductible business expenses, resulting in tax savings.
While there are certain limitations, you can provide various tax-free fringe benefits to your spouse. These may include education-related expenses, group term life insurance coverage, working condition fringe benefits, and de minimis fringe benefits like occasional meals and gifts.
It is important to maintain proper documentation to establish that your spouse is a bona fide employee. This includes keeping time sheets to track the work performed, having separate bank accounts for business and personal finances, and ensuring that your spouse works under your direction and control.
If you own more than 2% ownership in an S corporation, your spouse is not considered an employee and, as a result, cannot partake in employee health plans.
Depending on your state, additional requirements may exist to comply with when employing your spouse. This could include registering as an employer, providing workers’ compensation coverage, and withholding and paying premiums for family and medical leave programs or state disability.
To ensure compliance and mitigate any potential issues, it is advisable to consult with tax professionals who can provide guidance specific to your situation. Following guidelines for genuine employment, reasonable compensation, and adhering to state requirements will help you maintain compliance with IRS regulations.
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