THE UNPAID (AND OVERWORKED?) SPOUSE
When family members are called in to help with the business it's more likely in response to a crisis than a planned decision. As the business continues to flourish, they can quickly become indispensable. That's the time to stop and think about their role in the business, how they will be paid, and how your decisions may affect your family's tax situation.
You may decide to have them keep working but do not plan to pay them for the work. Alternatively you may decide to increase the family's "Personal Draw" because it seems like all the same money anyway. If the helping spouse is also working elsewhere and has earned income to report, you won't be missing a lot of tax breaks. (But see "Employee Travel" below.) However, if they aren't being paid for working somewhere else, you may be missing out on a couple of tax credits.
EARNED INCOME TAX CREDIT (EIC)
If the family's total income is low (under $28,495 with two or more children, $25,078 with one child or $9,500 with no child) you could be eligible for this refundable credit. At this income level you may have only a small income tax but still have some Self-Employment tax. The EIC will enable you to significantly reduce those taxes or even get a refund. The hitch is, if you are married, both spouses need to be showing earned income. This could be from their own business profit or wages from working for someone. If either spouse shows no earned income, there will be no credit. This could be a reason to "create" some earned income.
CHILD CARE CREDIT
If you have a child under age 13 in the household and you have any child care expenses, you may be eligible for this credit. It is not a refundable credit like the EIC, but it is helpful in offsetting your regular income tax. It won't help against your Self-Employment tax. Again, for this credit, both spouses need to be able to show earned income in order to be eligible. The credit available for one child's expenses ranges between $480 and $720 depending on the level of the family's income. A second child's expenses could double thie credit amount. This credit, too, could be helpful and worth planning for.
BUSINESS TRAVEL EXPENSES
You are used to deducting the appropriate amounts of business travel expenses you incur while going to shows or visiting customers, etc. After a while, you probably yearn to have someone accompany you. Isn't it wonderful to have someone share the booth-sitting with you? In recent years, though, the tax laws have been tightened and now state that you cannot deduct legitimate travel expenses for your spouse or your dependent (or anyone else!) unless they are an employee of your business. Now this could be a big problem worth fixing!
RETIREMENT PLAN CONTRIBUTIONS: IRA, SEP, KEOGH & SIMPLE PLANS
We can't get into the intricacies of these plans here, but I remind you that for all except the IRA, contributions to these retirement plans are based on the business owner's business profit. Beginning in 1997, couples who are eligible for deductible IRA contributions will be allowed to put up to $2,000 in each person's IRA, for a total maximum of $4,000, even if one has no earned income. (You used to be limited to a total of $2,250 if one spouse had no earned income.) Your decision about how to treat (for tax purposes) your "unpaid spouse helper" will not, therefore, effect your IRA eligibility.
The business owner will be able to put their maximum percentage of the profit into their SEP or KEOGH or SIMPLE plans. However, you don't, as a couple, have any flexibility as to whose retirement account the funds accumulate in. Only the business owner can make these contributions to their own or their employee's account, so the retirement funds may accumulate only in their names. If this does not meet your family's needs, you may want to consider adopting a different status for your spouse's work.
SOCIAL SECURITY CREDITS
Another thing to keep in mind is that through our work we earn our right to participate in the Social Security System and receive retirement benefits eventually. When you work for someone else, the FICA that is withheld and also matched by your employer is credited to your own Social Security account. Likewise, when you report business profit and file the Schedule SE, Self-Employment Tax, your earnings and FICA tax are recorded in your Social Security account. If you don't work (and report the earnings as taxable to you) a certain number of credits in your lifetime, you won't be eligible for benefits when you retire. Also, the amount you will receive in benefits is somewhat related to the amount of earned income you have reported over the years.
Regardless of some natural skepticism about whether or not there will be any money left in the Social Security system when you retire, it is still prudent to assure your right to receive benefits. If you want to know where you or your spouse stand in your accumulation of Social Security credits (or quarters), call the Social Security Administration at 1-800-772-1213 and ask to be sent a Statement of Earnings and Benefits. Depending on the situation, "creating earned income" may again be helpful.
FAMILY HEALTH INSURANCE COVERAGE
If your family's health insurance isn't being provided through your or your spouse's employer, you hopefully have arranged coverage as a small group through your business. The premiums you pay for yourself as the owner are not deductible business expenses. They are eligible for the "Self-employed health insurance deduction" as an adjustment to income on the first page of Form 1040. For 1997, 40% of your premiums are deductible on that line.
The only health insurance premiums that are allowed as a business deduction (also reducing the business profit subject to the Self-Employment tax) are those paid for your employees. Consider this. If your spouse were your employee and the business agreed to pay the entire amount of family health insurance premiums for its employees, all those premiums would be deductible business expenses! That could be a significant tax savings!
CREATING EARNED INCOME BY HIRING YOUR SPOUSE
Perhaps the best way to create earned income for your spouse is to put them on the payroll and pay them for all the work they have been doing for the business. Their wages will be subject to the FICA and Medicare taxes, but are not subject to Federal and state unemployment taxes. Getting into the payroll routine can be troublesome, so I usually recommend using a local payroll tax service. It is well worth the small charge for the service!
The spouse's wages and payroll taxes will be a deductible business expense and their W-2 earnings will be reported on your joint tax return as their own earned income. This opens up the possibilities discussed above for the Earned Income Credit and Child Care Credit. You will be able to deduct their travel expenses (as long as they otherwise qualify) and have them participate in the business' retirement plan and health insurance plan. Social Security credits will be added, too. The tax savings could be significant!
CREATING EARNED INCOME BY OWNING THE BUSINESS JOINTLY
If your spouse is actually running the business equally with you, it may be more appropriate to show them as a joint owner and file a "joint Schedule C". This approach is a bit unusual and some tax preparers are reluctant to file this way. However, my experience with it has been good, having taken several through audits with IRS without any question about the joint Schedule C.
The way it works in your tax return is to show the entire year's business activity on one Schedule C, as before, but put both names on the form. Then divide the net profit in half and carry each person's half to their own Schedule SE for calculating their Self-Employment Tax. Those separate earned incomes will also be used in calculating the Earned Income Credit, Child Care Credit and retirement plan contributions. Qualifying business travel expenses are deductible for each owner, as well.
Although this method avoids the complications of payroll taxes, there are a couple of drawbacks to this method. If the business earns more than the FICA limit ($65,400 for 1997), Self-Employment taxes will have to be paid by each of you on your share of the profit (up to $65,400 each). Also, since neither of you would be an employee, the health insurance premiums will not be deductible business expenses in this scenario.
CREATING EARNED INCOME BY PAYING YOUR SPOUSE AS A SUBCONTRACTOR
In some circumstances, it may be logical and reasonable to pay your spouse as a subcontractor. This achieves about the same results as the joint Schedule C. It is best used when the spouse already has their own business doing similar work for other businesses as a subcontractor. Perhaps the nature of their business activity can be characterized broadly enough to encompass a variety of work they may be doing. It is important, here, for the subcontracting spouse to carefully maintain a separate business identity and present regular billings for their work.
SPREAD THE TAX BENEFITS EVEN FURTHER
If your children are able to work with you, too, putting them on the payroll brings further benefits. Their wages are not subject to any payroll taxes (up to age 18) and they can earn up to $4150 without paying any tax at all. Still, their wages will be a business deduction for you. This results in an even greater family tax savings.
Even if they earn enough to pay some taxes, their tax bracket will likely be lower than yours. The concept of shifting income to lower tax brackets can be extended in some situations to include other family members or close friends. A business deduction for you saves both the Self-Employment tax and the income tax in possibly the 28% tax bracket. Wages paid to another person might be taxed at only 15%. Looking at the larger picture in this way often points to these other tax-saving opportunities.
