working spouses in the family business

With the changes in EGTRRA increasing the maximum contribution that can be contributed in a qualified plan to the lesser of 100 percent of pay or $40,000, a large number of small family business owners are reconsidering a prior decision to not pay a working spouse. The general consensus among such owners has previously been that the additional FICA taxes paid on the wages paid to a spouse outweigh any benefit to including a spouse on the payroll. Where the family business maintained a profit sharing plan, including a spouse on the payroll also led to being covered under the profit sharing plan and receiving a contribution of not more than 15 percent of the spouse's compensation, and frequently even less. Thus, the benefits from participating in the plan could easily be outweighed by the increased FICA taxes.

Now with the change in tax laws and the ability to receive a contribution of up to 100 percent of pay, a small employer such as a physician earning $200,000 with a spouse being paid $40,000 can each receive an allocation of $40,000 if the practice maintains a 401(k) plan. The $80,000 is within the current deductible limits and does not exceed any other limitations. Of course, if there is staff, then the amount of actual contribution will be subject to nondiscrimination testing. That testing could affect the actual amount allocated to the physician and spouse. Note that in order to allocate a $40,000 contribution to the spouse, wages of at least $40,000 must be paid. The question in some professionals' minds still remains, "Is the increase in FICA tax now overweighed by the increased retirement benefits received by the family?"

The first step in addressing this question is to consider the impact of Social Security taxes. Basically, an individual receiving $40,000 and subject to Social Security taxes will be required to pay a total of about $5,200 in Social Security taxes (Medicare taxes on the $40,000 would have been paid by the physician). In addition, federal unemployment taxes generally add an additional $300 to $400 in expenses per year. The FUTA taxes and employer's share of the FICA taxes are deductible, reducing the impact of more taxes. The total income tax liability for the family generally does not change because the spouse's salary merely comes from a reallocation of the compensation paid to the physician. Of course, where a spouse performs no services, the payment of $40,000 could be ruled on IRS audit as a constructive dividend to the physician, and such inclusion would not be recommended.

What are the benefits?

The immediate benefit is that the total family contribution increases from $40,000 to $80,000. Had that physician not contributed the $40,000, that amount would have teen paid as a bonus. Where the physician is in the 35 percent tax bracket, then the taxes on the bonus would be $14,000. The $40,000 contribution to the spouse produces a tax savings of $14,000 and after-tax cost for FICA and FUTA of about $ 5,500. Thus, when you compare the after-tax cost for including an individual in the plan versus the benefits of additional contributions, the plan is a clear choice.

The next question that generally comes to the owner's mind is, "Does the spouse actually receive any additional Social Security benefits for the payment of those FICA taxes?" Assuming that a spouse is not fully insured for Social Security purposes, which generally requires 40 quarter credits, payment of this compensation may permit the spouse to receive additional Social Security benefits

Basically, at age 65 a spouse with no Social Security credits is entitled to 50 percent of the Social Security benefit available to the working spouse at age 65. Where a spouse is entitled to both spousal benefits and his or her own benefits, the greater of the spousal or individual credits is paid, not both. Basically, in measuring the pluses and minuses of adding a spouse to the payroll, you really have to discount the value of the additional Social Security benefit for the spouse.

Remember, many current restrictions can reduce the amount of Social Security benefits that are actually retained. To determine the amount of Social Security benefits paid at all ages that are subject to federal income taxes, one must first calculate the "provisional" income. A taxpayer's provisional income is the sum of the taxpayer's adjusted gross income, the taxpayer's tax-exempt interest for the year and one-half the Social Security benefit for the year. If the provisional income is less than the Social Security base amount ($25,000 (2002) for single taxpayers and $32,000 (2002) or less for a married taxpayer filing jointly), the Social Security benefits are not taxed. If the provisional income is between the base amount of $34,000 (2002) and $44,000 (2002) for a married taxpayer filing jointly, up to 50 percent of the Social Security benefit will be included in taxable income. If the provisional amount exceeds $34,000 (2002) or $44,000 (2002) for a married couple filing jointly, up to 85 percent of the Social Security benefit will be included in taxable income.

As discussed above, married couples filing a joint return have a single combined base amount of $32,000 and a single combined adjusted base amount of $44,000. But the threshold for including Social Security benefits in gross income is reduced to zero if the spouses live together at any time during the tax year, and the entire amount of benefits is subject to inclusion at the higher 85-percent level. They include the lesser of 85 percent of their Social Security or 85 percent of their provisional income in gross income, regardless of income. To find out whether any of your benefits are taxable, compare the base amount (explained later) for your filing status with the total of: (1) one-half of your benefits, plus (2) all your other income, including tax-exempt interest.

For example, if you and your spouse (both over 65) file a joint return and both receive Social Security benefits during the year of $ 9,000 and a taxable pension of $17,000 and interest income of $500, your benefits are not taxable because your income is not more than your base amount ($32,000) for married filing jointly.

In 2002, an individual who retires between 62 and 65 would have a reduction in Social Security benefits of one dollar for each two dollars earned above this threshold. And, the amount of the benefits that are received becomes subject to federal income taxes when the individual's tax-free and taxable income exceeds certain annual thresholds.

Taking all factors into account, including the creditor protection in an ERISA plan and the compounding of earnings on a tax-deferred basis, most small families will want to include a working spouse on the payroll when the plan contribution can be maximized.

Gregory E. Matthews, CPA,
Matthews Benefit Group, Inc.
St. Petersburg, Florida
gmat@eerisa.com

© SBCA 2006
Neither SBCA Inc., nor any individual member of this association assumes any liability for any action taken based on any articles contained herein.