The 12 Tax Days of Christmas: Day 4
Rather than your true love sending you a partridge in a pear tree, wouldn’t you appreciate some money-saving tax tips? For my year-ending 12 Tax Days of Christmas series, I’ll dig back into the archives of previous topical columns to reiterate understandable, realistic and legitimate tax strategies that you need to implement now in order to have a much smaller tax bill come April 15.
For this fourth tax day of Christmas, let's address the fact that many small-business owners rush to put their spouse on payroll before year-end, but it could actually be for the wrong reasons and be a costly mistake. First, entrepreneurs think that if their spouse is helping with the business, the only way they can pay them is to put them on payroll. Wrong. The spouse can simply be compensated through the draws you are taking as the owner. By putting them on payroll, you could actually be unnecessarily paying thousands in FICA (payroll taxes).
Next, business owners think they are doing themselves a favor by creating "earned income" for their spouse so they can contribute to an IRA. Wrong. A non-working spouse does not have to have a paycheck in order to contribute to a traditional or Roth IRA. The non-working spouse can create what's called a Spousal IRA. There are really only two requirements: One, the working spouse has eligible compensation that's at least as much as the total contribution to the both IRAs; and two, they file a joint income-tax return. Bottom line, don't cut a paycheck to simply fund an IRA or Roth IRA.
Third, the entrepreneur wants to generate a social-security benefit for the non-working spouse, and they think putting them on payroll is the only way to do it. Wrong. On the face of it, this would seem logical, right? Paying into Social Security so that your spouse will at least get some benefit in the future when they turn 59 1/2. However, this is very misleading. For example, a "non-working spouse" of a "working spouse" already qualifies for spousal benefits. Speak with a financial advisor that understands Social Security and plan to run the numbers before rushing to cut another payroll check. I also cover this topic in depth and dedicate an entire chapter to this strategy in my book, The Business Owner's Guide to Financial Freedom: What Wall Street Isn't Telling You.
Related: The 12 Tax Days of Christmas: Day 2
Although there are some serious misconceptions on when to put a spouse on payroll, I actually believe there are two really good reasons to do so before year-end. Both of the below strategies create excellent tax deductions and are a good use of money.
1. Maximize the spouse's 401(k) contribution.
There is no such thing as a spousal 401(k) contribution like there exists for the IRA. Thus, in order to put away the big dollars, the business owner and their spouse need to consider the 401(k) and create an actual payroll for the non-working spouse.
Now, as a preliminary matter, I always believe the spouse is truly not deemed "non-working." The spouse would certainly be serving on the Board of Advisors or Directors for the company, and they would presumably be constantly involved in the operations of the company. Thus, the salary would be justified and appropriate.
Also, it's important to note that this strategy most typically involves a Solo 401(k) (but can also be used with a group 401(k) with other employees, but to not to as great an effect). A Solo 401(k) is designed for a company with no outside employees but the owner and their family.
In 2019, the primary business owner and their spouse could each contribute up to $19,000 (or $25,000 if over 50), and the company can take a tax deduction for the W-2, while the spouse doesn't claim any income on the W-2. Even though you pay some FICA or payroll tax on the W-2 amount in order to fund the 401(k), the ultimate tax benefit is significant due to the "time value of money" and the opportunity of the spouse to create and fund a 401(k). Typically, we would "gross up" the payroll amount to cover the FICA taxes and then "zero out" the rest of the contribution. For example, if your spouse is under 50, the payroll amount would be approximately $22,350, with a net pay of $19,000. Then, with the $19,000 deferral, the W-2 nets out at zero.
In addition to the deferral the spouse could make from their paycheck, the company can also do a match on the total payroll. This would further be a deduction for the company and add to its 401(k) balance. In the example above, in a Solo 401(k) this would equate to 25 percent of the payroll amount of $22,350, or approximately $5,500. Just for 2019 alone, the company would have a tax write-off of more than $27,850 and the spouse would have a balance of more than $24,500 in their 401(k) and no taxable income to boot.
In fact, if you can afford it and want to get even more creative with both the business owner and/or the spouse, they could fund a Roth 401(k) and create a tax-free account, rather than just deferring taxes until the future.
2. Adopt an HRA for the spouse.
Most Americans don't get a tax deduction for extra medical expenses. They can't itemize (it's usually not worth the effort with AGI limits), or they don't qualify for a Health Savings Account (HSA). However, if you own a small business, the Health Reimbursement Arrangement (HRA) could be the perfect fit. Just imagine if you could deduct 100 percent of these medical costs. It could be life-changing.
Essentially, putting your spouse on payroll may allow you to utilize the HRA. However, keep in mind that you would have to utilize a Sole Proprietorship (something I call a "family management company" and discuss in the coming fifth Tax Day of Christmas entry). The strategy is to create this same "support" or "management" company that would hire the spouse (and/or children) for services provided to the main company, and under this employment provide for an HRA.
If you are single, it’s required to use a C corporation. (See Chapter 11 of The Tax and Legal Playbook: 2nd Edition for more information on seven different tax- and money-saving strategies when it comes to medical insurance and health-care expenses.)
On the face of it, the HRA may sound complicated or expense, but it is quite simple and affordable. It is self-administered, without the need for an insurance company or bank's involvement, and the cost is under $500 at KKOS Lawyers. However, we always want to consider a cost-benefit analysis, and we typically see it make sense for a family with more than $5,000 in out-of-pocket medical expenses (over and above insurance premiums). You can learn more by reading my breakdown, "How an HRA can Save you Thousands when facing extra Health Care Costs".
Related: The 12 Tax Days of Christmas: Day 3
The beauty of the HRA is the spouse’s payroll is essentially the HRA amount. No need to issue a W-2. Also, this is not a "use it or lose it" plan, but a reimbursement plan that can allow a couple/family to deduct almost all of their medical expenses at any age. Look ahead to my sixth Tax Day of Christmas entry for more information on the HRA.
Bottom line, whether it’s a 401(k) or an HRA, it’s important to understand and explain why you are specifically putting your spouse on payroll. Don’t do it just because it feels good or sounds good. This can be a wonderful wealth-building and tax-saving strategy, or a nightmare that could cost you thousands in taxes. Whatever the case may be, this is something that must be decided on before year-end.