When to determine whether to hire your spouse
Your spouse may spend a considerable amount of time helping out at the office. Sooner or later, you will probably ask yourself the question, “Are there any tax advantages to making my spouse a formal employee?” While the answer depends on your individual circumstances and the structure of your business, there are a few important areas to consider before putting your spouse on the payroll.
Probably the major drawback to making your spouse an employee involves payroll taxes and workers’ compensation insurance. As with any employee, your business must pay employment taxes and workers’ comp on any wages paid to your spouse. And it must withhold Federal Insurance Contributions Act (FICA) and pay Federal Unemployment Tax Act (FUTA) taxes on all wages paid — including Social Security and Medicare taxes.
For example, if your spouse is an employee in 2006, your company and your spouse must each pay a 1.45 percent Medicare tax on all of your spouse’s wages and a 6.2 percent Social Security tax on the first $94,200 of wages (up from $90,000 in 2005). The silver lining to this scenario is that typically the payment of these taxes will be a deductible business expense.
If the combined income of both spouses exceeds the Social Security maximums ($94,200 for 2006), then you may want to have the income on only one family member, so you can reach the maximum sooner. It also can make sense to have the spouse receive even a small salary, even a few thousand per year, to maximize Social Security benefits, since benefits are normally based on the higher of the two incomes or equal to one half of the spouse’s income.
Another benefit of being on the payroll is that the couple has access to the child and dependent tax credit, which requires that both spouses work to qualify.
If you’re a sole proprietor or you and your spouse are partners in a limited liability company, you may not need to pay FUTA and SUTA, but must withhold for FICA and Medicare. Corporations are not allowed these tax breaks, so consider your options carefully and see if what you pay your spouse in salary will outweigh the potential tax repercussions.
Assuming your company is a C corporation, any compensation paid to your spouse would normally be left in the corporation. In other words, if your corporation is in a higher tax bracket than you and your spouse, you may save tax overall by paying your spouse a salary. Otherwise, there is no benefit (and possibly a detriment).
On the other hand, if you operate your business as an S corporation or a sole proprietorship, you do not have to worry about corporate taxes. The income from your business is reported on your personal return, whether or not your spouse is paid a salary. Result: In this case, there is no income tax advantage to putting your spouse on the payroll, although this should be reviewed carefully, since states like New Hampshire do not recognize the S corporation.
Also note that the IRS is very specific about a reasonable salary. If they believe that you are paying your spouse an excessive salary for the position or title they hold, they will scrutinize both the salary and your tax statements.
If you operate your business as a C corporation, paying a salary to your spouse allows you to take earnings out of the corporation without paying a double tax. For example, if you take money out of a C corporation as a dividend, you’ll pay a tax on the original earnings by the C corporation and then another tax on the shareholder’s return when you receive the dividend. Money you take out of a C corporation for salary is taxed only once – to the employee.
If your spouse was not working or earning a salary in the business previously, adding him or her to your payroll will increase the Social Security benefit upon retirement. Additionally, if your business has a qualified retirement plan in place, it may provide retirement benefits to your spouse as an employee.
For example, if you have a 401(k) plan, your spouse can contribute a portion of his or her salary to the plan on a tax-deferred basis. Or the business may make contributions on behalf of your spouse to a pension or profit-sharing plan. A plan like this can be very useful when a business owner wants to put more into his or her retirement plan, but is hitting the maximums with an existing retirement plan.
If your business is a sole proprietorship putting your spouse on the payroll will allow you to deduct fully your medical insurance benefits as a business expense to save both social security taxes and income taxes. Typically, self-employed individuals can deduct 100 percent of the cost of health insurance, but only as an adjustment to income, still leaving Social Security to be paid. The cost of the medical insurance is a deduction for the business and by setting up health insurance for all employees (e.g. your spouse and yourself) you’re able to maximize your deduction to 100 percent of the costs.
Another reason to add your spouse to the payroll is the ability to deduct business travel expenses. Under current law, you may deduct your spouse’s travel expenses only if he or she is a formal employee of the business. By putting your spouse on the payroll, you may be able to claim extra travel deductions if your spouse accompanies you on a business trip or makes separate business travel arrangements.
There are other factors that can affect whether or not you pay your spouse a salary. Be sure to look at the “big picture” with an accounting or business tax professional in order to see all your options.
Steven A. Feinberg of Appletree Business Services LLC can be reached at 603-434-2775 or AppletreeBusiness.com.