Can a Husband and Wife Both Be S-Corp Shareholders?
Operating an S corporation as a married couple involves distinct financial and legal rules that impact payroll, distributions, and the structure of your ownership.
A married couple can jointly own and operate a business structured as an S corporation. This business structure provides liability protection and allows profits and losses to be passed directly to the shareholders’ personal tax returns, avoiding corporate-level income tax. Specific tax and legal rules govern how spouses are treated as shareholders, how they are paid, and how ownership is legally viewed.
S Corporation Shareholder Rules for Spouses
An S corporation must adhere to strict eligibility requirements, one of which is a limit on the number of shareholders. The Internal Revenue Code caps the number of permissible shareholders at 100. For married business owners, a special provision simplifies compliance with this cap.
The tax code provides a specific rule that treats a husband and wife as a single shareholder for the 100-shareholder limit. This applies whether the stock is owned jointly or individually by each spouse. This aggregation rule means a married couple only counts as one person toward the limit, which is beneficial for family-owned businesses.
When a corporation elects to be taxed under Subchapter S, it must file Form 2553, Election by a Small Business Corporation. A condition for a valid election is that all shareholders must consent by signing the form. If both spouses own stock, they must both sign Form 2553 to provide consent, even though they are counted as a single shareholder for the limit.
Compensation and Distributions for Spouses
When spouses are both shareholders and employees of their S corporation, the Internal Revenue Service (IRS) requires them to be paid reasonable compensation for their services. This must occur before any non-wage distributions are made. This compensation is paid as a salary, reported on a Form W-2, and is subject to employment taxes like Social Security and Medicare.
The concept of “reasonable compensation” is a point of IRS scrutiny. The compensation should be what a similar business would pay for comparable services, considering factors like the employee’s experience, duties, and time devoted to the business. If both spouses are active in the business, each should receive a reasonable salary reflecting their contributions. The IRS can reclassify distributions as wages if compensation was unreasonably low, which can result in back taxes and penalties.
After paying reasonable salaries, the remaining profits can be paid to shareholders as distributions. Unlike salaries, distributions are not subject to employment taxes. A primary rule is that distributions must be made on a pro-rata basis, in direct proportion to each shareholder’s stock ownership. Paying distributions in a different ratio than ownership percentages could be seen as creating a second class of stock, which would terminate the S corporation status.
Health Insurance and Fringe Benefit Considerations
The tax treatment of health insurance premiums in an S corporation has specific rules for shareholders who own more than 2% of the company’s stock. Due to family attribution rules, where one spouse’s ownership is attributed to the other, a married couple will almost always meet this threshold. These rules mean they cannot receive health insurance as a tax-free benefit in the same way a non-owner employee can.
For a shareholder-employee owning more than 2% of the stock, any health insurance premiums paid by the S corporation are considered additional compensation. The corporation must include the full amount of these premiums in the shareholder’s wages on their Form W-2. This amount is subject to federal income tax withholding but not to Social Security, Medicare (FICA), or federal unemployment (FUTA) taxes.
Although the premiums are included in taxable wages on the W-2, the shareholder-employee may be able to deduct the full amount on their personal tax return. This is done through the self-employed health insurance deduction on Schedule 1 of Form 1040. This process requires careful coordination between the corporation’s payroll reporting and the shareholder’s personal tax filing, as failure to properly report the premiums can jeopardize the deduction.
Stock Ownership and State Law Considerations
Spouses who co-own an S corporation can structure their ownership in any way they choose, such as a 50/50 or 60/40 split. This ownership percentage is documented in the corporation’s records. The legal framework governing marital property, which varies by state, can have significant implications for S corporation stock.
State laws on marital property are divided into two systems: common law and community property. In common law states, assets acquired during a marriage belong to the spouse whose name is on the title. For an S corporation in these states, stock ownership follows the names on the stock certificates.
In community property states, most assets acquired during the marriage are considered to be owned equally by both spouses, regardless of whose name is on the title. This means if S corporation stock is acquired during the marriage, it may be community property, giving the non-titled spouse a 50% interest. The spouse with a community property interest must also consent to the S corporation election on Form 2553, even if they are not listed as a shareholder.