Adding Your Spouse to Payroll
Posted August 30, 2018
We get a lot of calls and emails from business owners who ask about adding their spouse to payroll. There are several reasons where this might make sense, but there are also some pitfalls and things you need to be aware of. Don’t be that business owner that just goes out there and does something without consideration or consultation with a small business CPA like us. You would never do that, right? Right.
Problems with Adding Spouse to Payroll
The biggest problem to adding your spouse to payroll is the additional payroll taxes. Before we jump too far into that, let’s talk about how we would determine reasonable salary if we were adding your spouse to payroll. One of the ways we determine reasonable shareholder salary is by the value of the tasks and duties being performed by the shareholder. This is similar to a market approach analysis that RCReports performs.
So, we take some of those tasks and duties, split them up between spouses and then we maintain the same total officer compensation between two people. Huh? Ok, let’s say Susan is being paid $100,000 by her S Corp. Her husband comes along and does some of Susan’s tasks like bookkeeping and licking stamps. Stamp licking is high-end work. We would then pay Susan $80,000 and her husband would be paid $20,000 for a total of $100,000. Let’s call her husband Mark, the stamp licker.
Think of officer compensation or reasonable S Corp salary like a pie, and we are just chopping it up into different pieces, some small, some large.
In this example, Social Security and Medicare taxes would be same between paying just Susan, and paying Susan and Mark together. However, if Susan is being paid $150,000 and we now allocate $20,000 of that to Mark, we just generated an extra 6.2% x $20,000 in Social Security taxes on Mark because Susan’s original salary already exceed the Social Security cap in 2019 of $132,900. Therefore, this would create unnecessary Social Security taxes… that is bad in case you were wondering.
Also, unemployment is determined on each employee. So, Susan’s unemployment tax is unavoidable and might amount to $350 to $500 depending on her state. Unemployment is similar to Social Security since it has a wage limit, and several states are very low such as $11,000 or so. By adding Mark to the payroll, we suddenly add $350 to $500 in unemployment insurance tax. That too is bad… but not too bad as compared to the possible benefits.
To make things worse, some states have a state disability insurance like California. This piles on to the unemployment insurance tax problem explained above.
Don’t forget that if your spouse is already working somewhere else and receiving a W-2, he or she will be contributing to unemployment all over again by being added to the family business. However, there might be some tax arbitrage explained below.
Ok Jason, we get it. What are some of the reasons adding your spouse to payroll makes sense? Wonderful question… let’s jump in.
Maximizing 401k Deferral
If you have piles of money laying around, and you think your accountant is underpaid you can increase your fee payment. If that isn’t enough, and piles of money are just getting in the way of your walk to the bathroom, then perhaps you need to dump it into a 401k.
Currently, employees can defer $18,500 plus another $6,000 if they are 50 or older. So, using our example before and assuming Susan is 50, she can defer $24,500 into her 401k. The company could also add another $25,000 (25% of $100,000) as a profit sharing discretionary contribution for a total of $49,500. Not bad.
If we add Mark to the mix, this $49,500 becomes $74,000 ($49,500 plus $24,500) and it only “cost” you about $300 to $500 in additional payroll taxes. Said in another way, Mark could defer $24,500 at a 33% marginal tax rate, and defer over $8,000 in taxes and it cost him $300 to $500 in insidious payroll taxes to do so. Not bad.
How would the salaries look in the scenario? We would pay Susan $70,000 and Mark $30,000. They each defer $24,500. The company adds another 25% of the combined salaries into the 401k (so, that doesn’t change in either scenario). Table time!
|Option A||Option B|
Also recall that solo 401k plans often allow spouses to pool their assets (some even allow separate accounts). If you need help with this, let us know. Contrary to some belief, you do not need two solo 401k plans and you don’t need the full version company sponsored 401k plan unless you hire a person besides the spouses.
Meals and Entertainment, and Travel
Adding your spouse to payroll suddenly makes him or her an employee, and if your employee tags along on business travel, suddenly those expenses become deductible business expenses. This rule hasn’t been butchered by the new Tax Cuts and Jobs Act of 2017. Business travel away from your tax home is safe- airline tickets and hotels are deducted at 100%, and meals are deducted at 50%.
So if the next conference is in Las Vegas, and your spouse is on the payroll, you could turn business into business and pleasure pretty easily, and the whole shootin’ match is a deduction to the business. Winner winner, chicken dinner.
You were going to spend the money anyway… you were always going to tag along (it’s Vegas baby, no one goes alone) and now it’s a small business tax deduction. That is the secret sauce in life- finding a way to take dollars already budgeted to leave your body, and make them into tax deductions. Ssshh! Don’ tell anyone else…
Meals with business associates has finally been updated by the IRS with Notice 2018-76 where essentially the old school rules of deducting meals expense at 50% is restored. This includes your spouse! So, provided you and your spouse are a) talking business which is common among small business owners and b) it is not lavish or extravagant (like dinners in Fiji), then you are good to go deducting your business meals with your employee spouse. Here is our blog-
Some states require businesses to have a “plus 1” on payroll to be compliant on health insurance. Last time we checked on this, Texas was still one of them. As far as we understand the rule, as an S Corp you need to have “you plus 1 other” on payroll to be compliant with the state’s health insurance rules. Adding your spouse satisfies this.
You might also find that having separate health insurance policies is the way to go… better coverage, lower premiums, or both. But only the health insurance on those who are greater than 2% shareholders can be deducted as an adjustment to income (dollar for dollar) versus a crummy limited deduction on Schedule A. Therefore, in this case, your spouse not only needs to be added to payroll but he or she must also be added as a member or shareholder to get the full deduction of the health insurance premium.
Perhaps that third vehicle can be considered a business asset for the spouse. You have three automobiles, one is dedicated as personal use and the other two are dedicated as business use since you have two people on payroll who need automobiles. Here is questionnaire on the automobile decision tree (business versus personal)-
There is also a reason that is less quantitative and more qualitative. Let’s be frank here. A lot of spouses support the business owner spouse, but are never paid. We thought Lincoln did away with involuntary servitude but it still exists in a marriage. As such, you can either pay an additional $300 to $500 in insidious payroll taxes or pay $300 to $500 to the marriage counselor. Easy choice.
Adding Social Security Credits
If your spouse wants to continue adding credits to Social Security, then adding your spouse to payroll might be a good idea. The first bend point in Social Security credit calculation is right around $60,000. This means that a $60,000 salary offers the most Social Security bang for payroll buck. It tapers off to around $95,000 and the tapers again (severely) such that very little credit is given above $95,000. These amounts are adjusted each year for inflation.
How would this work? Let’s say we are paying Susan (from our previous example) $120,000. We could easily pay Susan $60,000 and Mark $60,000 which would get the most credits to Social Security without much additional cost. Before you think this is a great idea, you must be in a spot where adding credits makes sense. If your spouse is 55 years old, his or her Social Security benefit is fairly rigid because of the historical contributions. If your spouse is 30 years old, then perhaps.
Social Security Arbitrage
There might be a situation where a bit of tax arbitrage can be taken advantage of. Let’s say Susan is being paid $120,000 by her S Corp. Her husband, Mark, makes $150,000 elsewhere. If Susan’s salary is reduced to $80,000 and Mark is added to payroll at $40,000 there will be a $2,480 savings in Social Security taxes. How? Magic.
As an employee, your wage limit for Social Security taxes is $128,400 for 2018. If for some reason (like two jobs) you have wages that were taxed for Social Security taxes in excess of $128,400, you get that refunded on your individual tax return. Only the employee gets the refund, not the employer(s).
So, throughout the year Mark will have $40,000 in wages that were taxed for Social Security taxes by the S Corp. Susan will have $40,000 less in wages being taxed for Social Security taxes. In other words, we essentially take the Social Security taxes that Susan was going to pay and we make Mark pay them, but he has other W-2 income that exceeds the wage limit, so these taxes are refunded.
$40,000 x 6.2% is $2,480. Boom!
Yes, Mark would need to actually do work and be valuable (a stretch, we know), and all those things, but you get the idea.
Jason Watson, CPA is the Managing Partner of the Watson CPA Group, a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.