Tax Consquences of Hiring Spouse as Employee

By | February 24, 2015

For many small business owners, it may make sense to hire a spouse as an employee. However, the small business owner must be certain that the spouse is in fact an employee or they may face trouble from IRS for claiming deductions for things that they should not have. The following article highlights upon several items that taxpayers must consider when hiring their spouse as an employee. Further, this article may be useful for any business owner when they are hiring a member of their family.


Health Insurance in Small Business

A spouse who is hired as a bona fide employee generally can be given health insurance coverage that includes coverage for all family members, including the principal owner spouse, thereby effectively converting all family health insurance premiums into business expenses. Even though health insurance costs are 100 percent deductible for the self-employed, there are still benefits to setting up a medical plan which is deductible as a business expense since the deduction reduces, dollar for dollar, the profits on which self-employment tax is computed.


Section 105 medical reimbursement plan

Setting up a “section 105” medical reimbursement plan under which the spouse-as-employee is covered creates benefits in addition to a business expense deduction for health insurance premiums. The spouse can also use the plan to deduct insurance co-pays, noncovered prescriptions, eye glasses, dental care, orthodontics, and other medical expenses that would otherwise be confined to an itemized “Schedule A” deduction subject to the difficult-to-reach 10-percent floor (7.5 percent for taxpayers age 65 or older).


Retirement Plans for Spouse

Having a spouse count as an employee is a double-edged sword in several respects. For example, ownership attribution for tax purposes is a problem. The basic definition of a highly compensated employee is one either earning above the inflation-adjusted threshold level of $115,000 for 2012-2014 ($120,000 for 2015) or a 5 percent owner. As a result, a spouse who is deemed to be a highly compensated employee or even a key employee will limit a small business owner’s ability to use an age-related or cross-testing of the retirement plan.


Having a spouse as an employee

Nevertheless, in certain instances having a spouse as an employee can help direct more retirement benefits to the owner. This apparent paradox works because of the testing rules for “highly compensated.” For example, when a spouse is on the payroll as a lower paid employee such as an office manager, choosing to exclude the spouse from participation in a retirement plan can have a positive effect on cross testing, since the percentage of highly compensated employees covered under the plan is reduced dramatically.


Benefits of Spouse as Employee of Small Business

Because of the attribution rules, there would then be two highly compensated employees. By excluding the spouse from participation in the plan, only 50 percent of highly compensated employees are covered, thereby reducing the percentage of non-highly compensated employees that need to participate in the plan to avoid top heavy rules, or creating a favorable computation for the average benefits test.