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Tax Saving Benefits for Sole Proprietors – Employ a Spouse

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Many sole proprietors benefit from family members assisting with their business, especially in the start-up phase. While these services are often uncompensated, tax-saving opportunities are available if a formal compensation arrangement is created. However, for wages paid to a spouse to provide tax advantages, the overall compensation arrangement for a spouse must be reasonable. When measuring reasonable compensation, both direct wages and nontaxable fringe benefits must be considered.

As a self-employed individual, a sole proprietor can deduct annual health insurance premiums for income tax purposes. However, a self-employment tax benefit is also available. By creating a formal employee relationship with a spouse and paying the medical insurance premiums and other medical costs of the spouse (and family members, including the proprietor) as a tax-free fringe benefit, 100% of the cost is deductible for both income and self-employment tax purposes.

Generally, it is not economically beneficial to employ a spouse and incur the annual FICA costs associated with compensation solely for the purpose of enhancing his or her social security retirement benefits. Not only is the rate of return on social security contributions relatively low, but a nonworking spouse automatically will receive a retirement benefit equal to 50% of the higher earning spouse’s retirement benefits. However, social security does add disability benefits, as well as monthly survivor benefits for the pre-age 18 children of a deceased worker. For these two reasons, it may be economical to provide a small salary subject to FICA from a family proprietorship for a spouse who is otherwise not employed outside of the home if there are young dependent children in the family.

In some cases, a spousal salary may enhance the ability to fund a contribution to a qualified retirement plan. For example, a sole proprietor who provides a Savings Incentive Match Plan (SIMPLE) for all employees may only have one voluntary reduction contribution for the year (plus, of course, the employer matching contribution). However, if that sole proprietor pays a spouse sufficient annual compensation, a second SIMPLE contribution can occur. While this strategy works well with a SIMPLE because of its low maximum, it is not as effective for many other qualified retirement plan arrangements, such as defined-contribution plans.

Keep in mind that the ability to make an IRA contribution is not a motive for employing a spouse within a sole proprietorship, unless the salary is used to create the only earned income. This is because a nonearning spouse can make an IRA contribution if the other spouse has sufficient earned income.

These are some of the opportunities available when employing a spouse in a sole proprietorship. Employing a child in a sole proprietorship can also be an effective method in reducing the overall family tax burden.

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