Proprietorships often struggle to maximize tax advantages because the complexities of the tax code can make it difficult for proprietors to identify all the avenues available for reducing tax burdens. In addition, proprietorships often lack the staff to manage the recordkeeping needed to track and document business expenses for tax purposes.
However, there is one step proprietors can take to lower their tax exposure that is easy to understand and orchestrate: hiring your spouse as an employee. By adding your spouse to your staff, you add to your business deductions and create a pathway for reducing self-employment tax.
“If you own your own business and operate as a proprietorship, hiring your spouse to work as your employee is one of the smartest tax moves you can make,” says Arron Bennett, founder of Bennett Financials. “While there are some important considerations to work through — the IRS is known to closely scrutinize situations in which a spouse is brought on as staff — hiring a spouse can take a lot of financial pressure off small business owners by facilitating tax savings in some key areas.”
Bennett started his financial career working for large corporate accounting firms as a 401(k) compliance officer. In that role, he witnessed firsthand how small business owners often get overlooked and burdened with unnecessary tax payments, with the accounting firms they hire usually offering minimal support. Motivated to provide better solutions, he founded his venture with the mission of helping businesses save substantial amounts on taxes through advanced tax planning strategies that are typically reserved for ultra-high-net-worth individuals.
As Bennett’s company has grown, he has expanded its business tax planning services to include fractional CFO roles, guiding clients on reinvesting tax savings into strategies that skyrocket their profitability and accelerate business growth. By providing strategic financial guidance, expert tax planning, and long-term financial growth strategies, he has helped clients save more than $15 million in taxes.
“To optimize the impact of hiring a spouse, proprietors need to look beyond the common forms of compensation,” Bennett explains. “The goal should be leveraging strategies that reduce tax burdens for the company and ensure the spouse benefits in a meaningful way.”
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Pay benefits, not wages
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A traditional relationship in which employees receive financial compensation for their work is not the path to maximum tax savings, as it leaves the proprietor responsible for paying payroll taxes on the wages. By paying in benefits instead of wages, however, proprietors gain tax benefits without taking on the payroll tax responsibilities.
“The way to save on taxes is to pay your spouse with tax-free employee benefits, not taxable wages,” Bennett explains. “Benefits such as health insurance are fully deductible by you as a business expense, but not taxable income for your spouse.”
Health benefits play a huge role in helping companies attract employees. In fact, recent polls show that 89 percent of workers describe employer-sponsored health insurance as “extremely important to them.” Because they recognize their value, the US government makes it easier for companies to provide those benefits by offering tax incentives to those who do.
Health insurance premiums a company pays on behalf of its employees are generally considered ordinary business expenses, which can be deducted from the company’s income for tax purposes. Additionally, companies have some flexibility in deciding what percentage of the premium they will cover. When a proprietor hires a spouse, they could choose to maximize the tax deduction by paying 100 percent of the premium.
Focusing compensation on benefits also removes some of the administrative burden associated with taxes, which can save proprietorships on tax prep fees. “If you pay a spouse only with tax-free fringe benefits, you don’t need to file employment tax returns or a W-2 for your spouse,” Bennett adds, “both of which add more paperwork for proprietors who are often already overburdened with administrative work.”
Establish a Health Reimbursement Arrangement
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A Health Reimbursement Arrangement (HRA) is an employer-funded account that reimburses employees for qualified medical expenses. HRAs offer proprietors tax benefits because their contributions to the accounts are generally tax-deductible. When extended to a spouse, HRAs provide further benefits because the employee reimbursements they provide are typically tax-free.
Bennett considers HRAs to be the most valuable fringe benefit a proprietor can give to a spouse-employee. They provide more flexibility to employees, allowing them to choose their own plan from the marketplace or use the funds for treatments not typically covered by insurance. HRAs also provide for portability should a spouse-employee eventually take a job with another company.
Provide benefits in addition to health coverage
Health coverage will most likely be the most impactful benefit proprietors can provide to a spouse-employee when securing some tax benefits, but it doesn’t need to be the only one. “There are many other tax-free fringe benefits you can provide your spouse in addition to health insurance,” Bennett says. “Some examples include education and certifications related to your business, up to $50,000 of life insurance, and de minimis fringes such as gifts.”
Each of the benefits Bennett mentions has the potential to be claimed as a tax deduction by the company. Educational expenses can be claimed if they fulfill a business purpose, such as providing bookkeeping skills or methodologies that can improve the efficiency or productivity of business processes. Group term life insurance an employer offers is also generally considered a tax-deductible business expense.
The “de minimis” gifts Bennett mentions can be considered tax-deductible expenses if they are small, infrequent gifts of minimal value. These can also include achievement awards or access to employee assistance programs that provide counseling or guidance.
Treat the spouse as a bona fide employee
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All the advantages gained by hiring a spouse will be lost if the IRS determines he or she is not a bona fide employee. Consequently, proprietors must ensure their spouse is doing work that can be shown to add value to the company.
To avoid problems at tax time, proprietors should prepare and keep documentation that defines the spouse’s work, schedule, benefits, and how those benefits are provided. Documenting the relationship with a signed and certified employee agreement can add legitimacy to it.
Tax optimization is critical for proprietorships, especially as they seek to secure the financial resources needed for business growth. Hiring a spouse can contribute to optimization, provided it involves the right strategy. By focusing on benefits instead of wages, proprietors can orchestrate a hire that serves everyone involved, providing ample compensation for the spouse-employee while also maximizing the company’s tax advantages.
