Photo by Karolina Grabowska from Pexels

Separate out Husband-Wife Partnership and Hire Your Spouse as an Employee

Consider this strategy for your existing husband-wife partnership if you are not in a community property state and you do not love the S corporation idea.

Step 1. Separate the existing husband-wife partnership or LLC treated as a partnership for federal tax purposes and start running the business as a sole proprietorship operated by one spouse.

Step 2. Hire your spouse as an employee of the new sole proprietorship. Pay him/her a modest salary out of the business account and withhold 7.65 percent from the salary to cover the employee/spouse’s portion of the FICA tax. As the employer, the sole proprietorship must pay the other 7.65% of the employer’s portion of FICA tax. However, since the employee/spouse’s salary is modest, the FICA tax will also be reduced.

Step 3. Set up a medical expense reimbursement plan as a fringe benefit to the employee/spouse. Use this plan to cover the family’s out-of-pocket medical bills, including health insurance premiums, by reimbursing the employee/spouse out of the proprietorship’s business account.

Deduct the reimbursements as a business expense on the sole proprietorship Schedule C when you file your joint tax return. On the employee/spouse’s side, the reimbursements are free of federal income tax, Social Security, and Medicare taxes because the plan is considered a tax-free fringe benefit to the employee.

Step 4. On the proprietorship’s Schedule C, deduct the medical expense reimbursements made under the plan, the employee/spouse’s salary, and the employer’s portion of the FICA tax. These deductions reduce the proprietor’s net income and thus the self-employment tax bill.

Step 5. Include only one Schedule SE for the spouse who is the proprietor on the joint tax return. This will minimize the self-employment tax hit because the maximum 15.3 percent self-employment tax rate applies to no more than $137,700 of net self-employment income for 2020, versus up to $275,400 if your business was being operated as a 50-50 husband-wife partnership.

Warning. The employee/spouse’s modest salary plus the medical expense plan’s reimbursements must add up to reasonable compensation for his/her work in the business.

Following this strategy should substantially reduce the total amount you pay for Social Security and Medicare taxes. Additionally, deducting the medical expense plan reimbursements on the proprietorship’s Schedule C will also reduce your federal income tax bill.