Should an S corporation employ the owner's spouse or children?

S corporation owners often wonder about putting their spouse on the payroll. Or about giving a job to a son or daughter.

At one level, this seems to make sense because the wages paid to a spouse or child will create a tax deduction on the business income tax return.

The General Rule: Don't Hire Family

As a general rule, however, you don't actually want to do this. Yes, the money you pay a spouse or child will be a deduction on the business tax return. But the money you pay will also be taxable on the spouse's and child's tax returns. So there's often not any "net" income tax savings.

What's more, adding a spouse or child to the payroll may increase the payroll taxes the business and the family members pay. The S corporation and the employee will typically pay at least a 15.3% payroll tax on the wages for Social Security and Medicare taxes. And probably other hidden payroll taxes will get levied, too. The 6% Federal Unemployment Tax (aka FUTA), which applies to the first $7,000 of most employee's wages, may have to be paid. In most states, unemployment insurance may need to be paid, too.

If you start thinking about these payroll taxes, you pretty quickly come to the idea that the S corporation could simply increase the size of its distribution to the shareholder... and then the shareholder could give the money to his or her spouse or children. In this situation, bingo--no payroll taxes get paid on the amounts given to the spouse or child.

For the preceding reasons, then, you probably don't want to put your spouse or children on the payroll. That, as I've said, is the general rule...

Every general rule has exceptions, of course. And the rule about not paying the owner's spouse or children has exceptions, too. So let me discuss those here...

Exception #1: Consider the Fringe Benefit Factor

Here's the first exception to the general rule: By paying wages to a shareholder spouse, the shareholder spouse may gain fringe benefits.

For example, if the shareholder's spouse receives wages from the S corporation, he or she will gain Social Security earnings credits.

Further, a spouse may also be eligible for tax-free fringe benefits from the S corporation. For example, by adding a shareholder spouse to the company payroll, the spouse might be able to contribute to something like a 401(k) plan and the shareholder's family might be able, as a result, to increase its family-level retirement savings.

Let me issue a caution about putting a spouse on the payroll just to gain fringe benefits, however.

Often, the payroll taxes you pay to get the fringe benefit eat up any of the fringe benefits' tax saving. So you need to really diligent in your accounting for the costs and benefits.

For example, putting someone on the payroll only to get social security benefits rarely makes sense. (The big exception to this would be when a spouse only needs a few quarters of additional work to qualify and that's what the S corporation will do: provide those few additional quarters.)

And just to say this: Putting a spouse on the payroll just to qualify for a pension often doesn't make sense either. Again, the payroll taxes you incur by doing this usually eats up the tax savings created by the, say, 401(k). (See this article for more about this odd, counter-intuitive situation.)

However, what can make sense is when you can offer a spouse other tax free fringe benefits by virtue of being an S corporation employee including things like college classes, business travel, and other stuff like that. (This works better because the fringe benefit amounts aren't subject to payroll taxes.)

And this maybe too obvious comment: If employing your spouse means you get to cover him or her with a pension AND qualify for future social security benefits that otherwise wouldn't be there AND put some educational, travel and other expenses onto the business tax return in a totally legitimate way, well, this situation probably does make sense.

Yes, you've got those heavy payroll taxes to shoulder. But you're getting multiple benefits by employing a spouse.

Exception #2: Consider Income Splitting for Kids

Here's a second exception to the general rule: Paying children wages out of an S corporation--even with the extra payroll taxes such wages are likely to trigger--may sometimes save enough in family income taxes to make the idea worthwhile.

These savings occur when the shareholder's children pay no or very low income taxes on their wages but the parent pays a high marginal rate like 40%. In this special exception case, routing money through to the shareholder's children as wages may save the family overall taxes.

If your marginal tax rate is, say, 40% but your son or daughter pays 0%, your family (if not you) saves the 40% income tax. You will pay possibly a 15%-ish payroll tax. So you're not coming out ahead the full 40%. But you're ahead by 25%. Which is pretty dang good.

A final caution: Amounts paid to a shareholder's family member would need to be reasonable. The S corporation can't simply make up a fake job.

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