Hiring Spouse - Effective Tax Strategy or Additional Cost?

Have you ever wondered whether putting your spouse on the payroll of your small business is a good idea? It’s a question many small business owners ask, and it’s not always straightforward. Imagine this decision as a double-edged sword: it can be a fantastic tool if used correctly, but it can also have unintended consequences if not handled carefully. Let's explore why you might want to put your spouse on payroll, why you might not, and how you can do it if you decide it's the right move for your business.

Why Consider Putting Your Spouse on Payroll?

Maximizing retirement savings can be like playing the double team in financial basketball. Think of it as a game where you and your spouse are on the same team, aiming to score as many points as possible to win. In this case, "points" represent contributions to your retirement fund. The IRS sets a limit on how much each player (individual) can contribute to a 401(k) each year—in 2024, that's $22,500 per player under 50, and an extra $7,500 if you're over 50.

By putting your spouse on payroll, you're essentially adding another player to your team who can also score points (make contributions). If you contribute $22,500 and your spouse does the same, you've effectively doubled your team's score, increasing your overall retirement savings. This strategy is particularly beneficial because each contribution reduces your taxable income, meaning you're also saving on taxes while saving for retirement.

Example Scenario:

Imagine you, as the business owner, earn a salary of $50,000. You decide to contribute $22,500 to your 401(k). The business can match an additional amount—let's say $10,000. Now, by adding your spouse to the payroll with a salary of $25,000, they too can contribute up to $22,500, with an additional match of $5,000. This strategy allows your household to funnel over $60,000 into retirement savings—essentially doubling your retirement contributions, much like having a star player scoring double points in a game.

Health Reimbursement Arrangements (HRA) work like coupons for medical expenses. Picture your business as a supermarket, with every expense being an item on the shelf. An HRA allows you to "buy" (deduct) medical expenses at a discount. When you hire your spouse through a separate small business structure (like a sole proprietorship), you can use this "coupon" to reduce your taxable income by the amount spent on eligible medical expenses.

This setup means that expenses like doctor visits, dental work, or even alternative treatments like chiropractic care can be “purchased” at a discount (deducted from your taxes). The actual savings depend on how many “items” (medical expenses) you “buy” (deduct). This strategy can be particularly useful if your family has significant healthcare costs that are not fully covered by insurance.

Real-Life Example:

A small business owner in California set up a sole proprietorship to employ their spouse and utilized an HRA. They treated their out-of-pocket medical expenses like items on sale, “purchasing” $8,000 worth of medical care. By doing so, they saved thousands in taxes, just like a savvy shopper using a coupon to get a better deal on groceries.

Why You Might Think Twice About It

A common misconception about Social Security is that putting your spouse on payroll will enhance their benefits, like adding more coins to a piggy bank. However, think of Social Security more like a fixed-value gift card. Adding more coins (contributions) to the piggy bank doesn’t necessarily increase the value of this gift card—it just costs you more in payroll taxes without a guaranteed return.

In many cases, the spousal benefit from Social Security is more advantageous than trying to “overfill” the piggy bank with extra contributions. The added expense of payroll taxes may not be worth the effort, much like putting more money into a piggy bank that won’t yield a higher return.

Adding your spouse to payroll is also akin to opening an extra bank account. While it might seem beneficial to have another account, each comes with its own fees (payroll taxes) and paperwork (administrative burdens). If there isn’t a clear financial benefit—such as higher retirement contributions or significant medical expense deductions—these extra costs might not justify the effort. It’s like maintaining an unnecessary bank account where the fees outweigh the benefits.

Steps to Put Your Spouse on Payroll

Proper documentation is like building a strong foundation for a house. Just like a house needs a solid foundation to stand firm, your decision to put your spouse on payroll needs thorough documentation. This includes a clear job description and evidence that your spouse is doing real work for the business. If the IRS decides to “inspect your house” (audit your business), they’ll be looking to see if your foundation is solid. If your documentation isn’t in order, you risk penalties and back taxes, much like a house crumbling without a proper foundation.

Choosing the right payroll structure is like navigating a road with different lanes. You don’t need to take the most complicated lane (making your spouse a co-owner) to reach your destination (tax savings). Instead, you can stay in a simpler lane, listing them as an officer or board member. This allows you to avoid the traffic jams (complex legal and tax issues) and still reach your goal efficiently.

Implementing a retirement plan and HRA is like using the right tools in your toolbox. Each tool (strategy) serves a different purpose, and using the right tool for the job makes the work easier and more effective. Work with a tax professional to choose the right “tools” (plans) for your business needs. This way, you can build a strong financial future, just like using the correct tools to construct a sturdy building.

Putting your spouse on payroll can be a powerful strategy, but it’s not a universal solution. Think of it as choosing the right tool from a toolbox or picking the correct lane on a road. The decision should be guided by your business’s unique needs, your financial goals, and a thorough understanding of the tax landscape. Consulting with a knowledgeable tax professional can provide clarity and help you avoid costly mistakes, much like a guide who knows the road ahead.