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.

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 6.2% Federal Unemployment Tax (aka FUTA), which applies to the first $7,000 of most employee's wages, may have to paid.

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...

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. And he or she 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.

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.

A final caution: Amounts paid to a shareholder spouse and or children would need to be reasonable. The S corporation can’t simply make up a fake job.

Back to list of frequently asked questions