If you own your own business and operate as a proprietorship or partnership (wherein your spouse is not a partner), one of the smartest tax moves you can make is hiring your spouse to work as your employee.
But the tax savings may be a mirage if you don’t pay your spouse the right way. And the arrangement is subject to attack by the IRS if your spouse is not a bona fide employee.
Here are 5 things you should know before you hire your spouse that will maximize your savings and minimize the audit risk.
1. Pay benefits, not wages. The way to save on taxes is to pay your spouse with tax-free employee benefits, not taxable wages. Benefits such as health insurance are fully deductible by you as a business expense, but not taxable income for your spouse.
Also, if you pay a spouse only with tax-free fringe benefits, you need not pay payroll taxes, file employment tax returns, or file a W-2 for your spouse.
2. Establish a medical reimbursement arrangement. 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 an Individual Coverage Health Reimbursement Account (ICHRA) if you have multiple employees.
3. Provide benefits in addition to health coverage.There are many other tax-free fringe benefits you can provide your spouse in addition to health insurance, including education related to your business, up to $50,000 of life insurance, and de minimis fringes such as gifts.
4. Treat your spouse as a bona fide employee. For your arrangement to withstand IRS scrutiny, you must be able to prove that your spouse is your bona fide employee. You’ll have no problem if:
- you are the sole owner of your business,
- your spouse does real work under your direction and control and keeps a timesheet,
- you regularly pay your spouse’s medical and other reimbursable expenses from your separate business checking account, and
- your spouse’s compensation is reasonable for the work performed.
5. Beware of Certain Tax-Free Benefits. Section 127 education plan. The law prohibits Section 127 benefits to your spouse and dependents under the 5 percent ownership test.
Transportation benefits. If you and your spouse work in an outside office, you can provide him or her tax-free transportation benefits—just as you can for any rank and file employee. For 2020, you may pay up to $270 per month for parking near your business premises or for transit passes.
But as a result of the Tax Cuts and Jobs Act, the tax-free transportation benefits to your employees are not deductible by you, the employer.
Because we are talking about your spouse as an employee, the transportation fringe benefit gives no net benefit to you and your spouse (it’s a wash).
Hiring your spouse can result in substantial tax savings, but only if you pay your spouse solely, or mainly, with tax free employee fringe benefits instead of taxable wages. The IRS doesn’t require you to pay your spouse any W-2 wages.
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.
Tax-free employee fringe benefits are not limited to health benefits—for example, you can provide certain education, life insurance, and working condition fringe benefits.