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Adding Your Spouse to Payroll
By Jason Watson, CPA
Posted Sunday, October 10, 2021
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. Here is a quick list of benefits we will get into, and right after this we’ll discuss the problems.
- Expenses such as meals, business travel, mileage, cell phones, etc. have more deduction capability.
- Leverage the minority owned small business benefits (usually with government contracts).
- Increase 401k plan or SEP IRA contributions as a household.
- Reduce income base for operating spouse and subsequent reasonable salary testing (huh? Don’t worry… we’ll explore this more).
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 a 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 (see our chapter dedicated to reasonable shareholder salaries).
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 chief stamp licker. There are worse things to be, Mark.
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 the same between paying just Susan, and paying Susan and Mark together. However, if Susan is being paid $160,000 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 for the 2021 tax year of $142,800. Therefore, this would create unnecessary Social Security taxes… that is bad in case you were wondering seeing how reducing Social Security is one of the pillars of our book.
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 (be patient, we are getting there).
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.
Business Tax Deductions and Fringe Benefits
Dinners with your spouse could be booked as a business meeting making your meals expense 50% deductible (but 100% for the 2021 and 2022 tax years). Business travel to conferences or other business-related trips can be 100% deductible when your spouse is also an employee. Business trips to Fiji? Probably not. There are rules on extravagance.
Please refer to our chapter on tax deductions and fringe benefits.
401k Plans, SEP IRAs and Social Security
401k plan contributions and other benefits could be extended to your spouse. Currently, employees can defer $19,500 (for the 2021 tax year) plus another $6,500 if they are 50 or older. So, using our example before and assuming Susan is 50, she can defer $26,000 into her 401k. The business could also add another $25,000 (25% of $100,000) as a profit-sharing discretionary contribution for a total of $51,000. Not bad.
If we add Mark to the mix, this $51,000 becomes $77,000 ($51,000 plus $26,000) and it only “cost” you about $300 to $500 in additional payroll taxes. Said in another way, Mark could contribute $26,000 at a 32% marginal tax rate and defer over $8,300 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 $26,000. The business 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.
We sometimes consider solo 401k contributions and retirement planning as more qualitative than quantitative. Remember, pre-tax retirement contributions are only tax deferrals- IOU’s to the IRS that they patiently wait to collect when you retire. Therefore, when you withdraw retirement money you have to pay taxes. As such, the six-million-dollar question is what are marginal tax rates today versus marginal tax rates in retirement.
The theory is that you take these interest-free IOU’s and parlay them into building wealth. Don’t forget the benefit of deferring state taxes that you might not ever pay back if you relocate for retirement (Pennsylvania has caught on to this trick, and does not give you a tax deferral for 401k plans… no wonder the Eagles stink).
Each spouse can be contributing to his and her respective Social Security basis and obtain Medicare coverage independently. Some people especially in their 50s and perhaps 60s want to contribute to their Social Security basis. Sounds crazy, but each situation is unique and requires careful planning. So, perhaps this benefit is more of a qualified benefit.
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 might satisfy 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.
Dependent Care Credit
To qualify for dependent care (like a childcare facility) tax credits, both parents must be working, looking for work or be full-time students, or a combination. Therefore, creating a viable job description and having your spouse receive a paycheck allows you to be eligible for dependent care tax credits.
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 $142,800 (for the 2021 tax year). If for some reason (like two jobs) you have wages that were taxed for Social Security taxes in excess of $142,800, 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.
Spouse As Independent Contractor
Paying your spouse or your children for that matter as contractors can open a can of worms. First, they probably aren’t truly a contractor. Generally, a contractor is someone who holds themselves out to the public as a person in that particular line of work or trade. Second, in the case of an S Corp you are now converting some income that was otherwise not subjected to Social Security and Medicare taxes, and making it so. In other words, you are changing the color of the money but in the wrong way.
Jason Watson, CPA, is a Senior Partner of WCG, Inc., a boutique yet progressive tax and
consultation firm located in Colorado and South Dakota serving clients worldwide.
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