Spouse-Employee Health Insurance Deduction

Business insurance for the small family business can be a source of great health insurance benefits for the small business owner and her family. This is especially the case when it comes to the "Spouse-Employee."

What is a Spouse-Employee?

A spouse-employee is a spouse of a business owner who works as an employee at the business and is not an "owner" or professional in the business. Also, the spouse cannot be an "independent contractor." The IRS, in addressing the issue states:

The Service now looks at facts in the following categories when determining worker classification: behavioral control, financial control and relationship of the parties.

In simple terms, the spouse should be a traditional employee subject to the direction of the boss or managers, the spouse should not be in a position to influence profit and loss in the business or have significant financial investment in the business, and the relationship should be that of employer-employee in order to be considered as an employee.

There are a number of considerations the IRS uses in determining whether a spouse qualifies for an employee. For example, the IRS issued a (somewhat arbitrary) ruling that a spouse with more than a 2% interest in a sub-chapter S corporation cannot be considered an employee. Rather, they are owners.

What is the Benefit?

The benefit to having an employee-spouse is as follows:

1. The cost of the accident and health coverage is deductible by the employer-spouse if he provides such coverage to his spouse as an employee.
2. Both the cost of the coverage and the medical reimbursements are excludable from the gross income of the employee-spouse.

Generally, health or accident insurance provided to a self-employed owner of a business is chargeable as income to the owner and taxable. But, we all live in the real world. We know that a self-employed owner and their spouse reside in the same household. So, by making the spouse an employee of the business, the business owner can deduct the cost of the health insurance premiums and the spouse does not have to declare the premiums as income. In effect, free health insurance for the spouse. Yes, I know the business is still paying the premium so it is not "free" in that sense, but would be free to the household. Taken to a logical conclusion, a family business owner with a spouse and children actively and legitimately employed by the business would have health care insurance provided by the business for their household.

Also, consider that the wages earned by the spouse and children are also business expenses and deductible. Spouses typically contribute jointly to household expenses and children can use wages to help pay for college. Combine these benefits with the provision of health insurance and you can see why the family business is sometimes referred to as the poor mans tax shelter.

What is the Catch?

Consult with your tax adviser and look at your state laws before taking this deduction. Depending on the business format there may be restrictions or limitations on the deduction. Also, the IRS will want evidence of actual work performed by the spouse or other family employees. The work must have value to the business and be marketable in the community and it must actually be done.

The biggest "catch" is the non-discriminatory provisions of section 105 of the IRS Code. In order for such benefits to be excluded as income the benefit must be uniformly applied and offered to all employees. That is, health insurance must be available to all employees and not just family members. Non-family employees must be offered the same benefits in the same fashion. For example, if there is a one-year waiting period for benefits, than the spouse must wait one year as well.