What changes tax-wise when my spouse works in the business?

Employing a spouse for real work opens a second retirement plan contribution, can support a medical reimbursement arrangement under the one-employee exception to the Affordable Care Act market reforms, and adds ordinary deductible wages. The work must be real and the pay reasonable for it. Inside an S-corporation the spouse is treated as a more-than-two-percent shareholder for certain benefits, which changes how health coverage is deducted.

Key points

A spouse on the business payroll must perform genuine work and receive a wage that is reasonable for the duties actually performed.
A spouse who earns wages can contribute to the company retirement plan, adding a second contributor to the household's tax-advantaged savings.
A sole proprietorship whose only employee is the owner's spouse can reimburse family medical costs under a written section 105 plan.
In an S-corporation, attribution rules treat a spouse as a more-than-two-percent shareholder, so health premiums go through wages and are deducted on the personal return.
Spouse wages are deductible to the business but taxable to the household, so the retirement and medical benefits, not the wage itself, create the tax advantage.

What does employing a spouse unlock?

Bringing a spouse onto the payroll changes the tax picture only when the employment is real. The spouse must do genuine work, and the pay must be reasonable for what they actually do, measured against what an unrelated person would be paid for the same duties. With that foundation, three doors open.

The first is retirement savings. A spouse earning wages can participate in the company plan, whether a solo 401(k), a SEP, or a SIMPLE, make their own elective deferrals, and receive employer contributions, subject to the plan document and the annual limits. The second is a medical reimbursement arrangement, described below. The third is that the spouse's wages are an ordinary, deductible business expense under section 162. The wages are taxable to the household, and when the employer is the other spouse's sole proprietorship they are subject to Social Security and Medicare withholding but exempt from federal unemployment tax.

How does a medical reimbursement plan work with a spouse employee?

A business with a single employee can adopt a written medical reimbursement plan under section 105 and reimburse that employee's family medical costs, including the owner's, as a deductible business expense. The reimbursements are excluded from the employee's income under section 105(b). The Affordable Care Act market reforms, which otherwise restrict standalone reimbursement arrangements, do not apply to a plan covering only one employee, which is what makes the design possible.

The fit is a sole proprietorship or a partnership in which the spouse is a bona fide employee rather than an owner. The plan must be in writing, the spouse must be a genuine employee, and the reimbursements must be for qualifying medical expenses that are documented with receipts. Adding a second employee ends the one-employee exception and brings the market reforms and nondiscrimination rules into play.

What is different in an S-corporation?

The S-corporation is the important exception. Under section 1372 and the attribution rules of section 318, the spouse of a more-than-two-percent shareholder is treated as a more-than-two-percent shareholder, even if the shares are held only by the other spouse. That status changes how fringe benefits are handled.

Health coverage for such a person is not an excludable fringe benefit. The premiums are added to the shareholder's Form W-2 wages, exempt from Social Security and Medicare tax but subject to income tax, and then deducted as self-employed health insurance on the personal return using Form 7206. A section 105 plan does not produce an exclusion for a more-than-two-percent shareholder, so the medical reimbursement design that works in a sole proprietorship does not work the same way inside an S-corporation.

What documentation is required, and when is it not worth it?

An examiner looks first at whether the employment is genuine. Keep a written job description, a wage tied to the duties, time or task records, payroll processed through the payroll system with a Form W-2 issued, and deposits into the spouse's own accounts. Any medical reimbursement plan needs its written plan document and receipts for each reimbursed expense.

It is not worth it when the wage is set higher than the work justifies, when the business already has other employees so the one-employee exception fails, or when the added payroll tax and administration cost more than the retirement and medical benefits deliver. Because the answer depends heavily on entity type, have a CPA model the options for your structure before putting a spouse on payroll.