For those that are married, this is a very important question and something we often analyze for clients in our office. In fact, many clients rush to put their spouse on payroll, but for the wrong reasons and it could actually be a costly mistake.
Essentially, there are 3 situations when business owners may put their spouse on payroll, rather than just share draws or distributions (typically the best move). Two of these three reasons make sense, and the other is a deceptive ruse I need to warn you about.
The first reason to put your spouse on payroll is for the purpose maximizing your spouse’s 401k contribution. Even if your spouse has a 401k through another job, or simply wants to put more into long-term savings than what an IRA may allow, the 401k plan could be the perfect fit. I actually think this is a great way to increase your tax deductions in the business, AND a very wise and profitable move. In fact, if you can afford it and want to get even more creative you could fund a ROTH 401k and create a tax free account, rather than just deferring taxes until the future.
For example, this year (2018) your spouse could contribute up to $18,500 (or $24,500 if over age 50) and your company gets to take a tax deduction for the W-2, while your spouse doesn’t claim any income on the W-2. Even though you pay some FICA tax on the W-2 amount in order to ‘fund’ the 401k, the ultimate tax benefit is significant due to the ‘time value of money’ and the opportunity of the spouse to create and fund a 401k.
Health care savings is the second why your spouse should go on payroll. If your family has a lot of medical costs, putting your spouse on payroll may allow you to utilize the Health Reimbursement Arrangement (HRA). Many small business owners with operational income use the S-Corporation and they themselves are already on payroll and presume and HRA could work for them. This is not the case.
In order to use the HRA, your spouse becomes the key to the strategy. You typically utilize a Sole-Proprietorship (something I call a ‘family management company’) wherein you actually hire your spouse in a ‘sister company’ and not directly in the S-Corp. The sole-prop then adopts the HRA and ‘back doors’ both you and your spouse into an HRA and way to write-off all your medical expenses. Again, this strategy is impossible directly inside an S-Corporation unless the husband and wife owners utilize this 2nd entity as I just described. Bottom line, if your family has more than 5k in out of pocket medical expenses (over and above health insurance premiums), implementing the plan can create savings far in excess of the costs to implement the plan.
I discuss this strategy more fully in my new book “The Tax and Legal Playbook” and compare the HRA to the Health Savings Account and other health care strategies. The beauty of the HRA (Health Reimbursement Arrangement) is your payroll need only be minimal and this is not a ‘use it or lose it plan’, but a reimbursement plan that can allow a couple/family to deduct almost all of their medical expenses at any age.
The third reason many put their spouse on payroll is to maximize Social Security benefits. However, this is a ruse or misleading objective and generally doesn’t work. On the face of it, this strategy would seem logical, right? Paying into Social Security so that your spouse will at least get some benefit in the future when they turn 59 1/2. However, it’s not true.
Reason being, a “non-working spouse” of a “working spouse” already qualifies for significant Social Security spousal benefits. Thus, they don’t claim Social Security under their own name, but ‘through’ their spouse. Surprisingly, this can net you more income per month.
Speak with a financial advisor that understands Social Security planning to ‘run the numbers’ before rushing to cut another payroll check to your spouse. You can also visit www.ssa.gov and plug in your social security numbers to see what your actual benefits would be. This information will be very revealing helpful to your planning.
In summary, please consider this issue carefully and consult with your tax advisor before blindly choosing payroll levels or any payroll at all for your spouse.
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Mark J. Kohler is a CPA, Attorney, Radio Show host and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street Isn’t Telling You” and “What Your CPA Isn’t Telling You- Life Changing Tax Strategies”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP.