4 nanny tax mistakes to avoid during tax season

4 nanny tax mistakes to avoid this tax season

March 26, 2021 11:28 AM

Household employment has its share of nuances that may catch accountants and families off guard, cause noncompliance, and cost your clients money.

Here are some of the typical tax season mistakes made by accountants and families and how to fix them.

Classifying a worker as an independent contractor

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Nannies, housekeepers, senior caregivers and other household workers are considered employees and not independent contractors. Simply put, the family is in control of when and how the work is performed. You could file Form SS-8 with the IRS to get an official determination, but during tax season you may not have much time to wait for a decision that will most likely establish that the worker is an employee. The IRS has consistently ruled this way over the years. Also, giving a nanny a 1099 and calling them an independent contractor is considered tax evasion.

This means you and your client need to follow tax, wage and labor laws. The family should get a federal employer identification number, register as an employer with their state, and file a new hire report. They will need to pay their share of Social Security and Medicare taxes (7.65 percent of gross wages) and withhold the same amount from their employee’s pay. Your client will also owe federal and state unemployment taxes.

At the end of the year, the employee gets a W-2 while the family submits a copy of the W-2 and Form W-3 with the Social Security Administration and files Schedule H with their personal tax return.

Placing a worker on a company payroll

Household employees should not be paid through your client’s business. Tax deductions on a company payroll require all employees to be “direct contributors to the success of the business.” Including household workers on a business payroll is considered an illegal tax deduction.

A sole proprietor of a business or farm can report household payroll taxes on their company’s Form 941 or Form 943 for ease of filing. That does not mean they can put a household worker on their business payroll. They can just report the taxes with their business filings.

Even with this exception, and to keep it simple, it may be best to keep household payroll taxes separate from business-related taxes.

Business owners with domestic help can remit household employment taxes quarterly using Form 1040-ES and then file Schedule H with their personal tax returns while continuing to report their company taxes on Form 941.

Losing out on tax breaks

A household employer can use a Dependent Care Flexible Spending Account offered through their job to set aside pre-tax money (up to $10,500 in 2021 under the American Rescue Plan) to help pay for childcare and reduce their taxable income. This can save a family anywhere from $3,300 to $4,700 depending on their marginal tax rate, where they live and other factors.

Wages paid to a nanny are considered a reimbursable expense under a Dependent Care FSA.

A nanny’s pay is a qualifying expense for the Child and Dependent Care Tax Credit, which also got a big boost from the latest pandemic relief legislation. The credit has increased to $8,000 for families with one child and to $16,000 for two or more children. The amount of the credit gradually decreases based on a family’s adjusted gross income, from 50 percent of qualifying expenses for households with an AGI of less than $125,000 to 1 percent for households with an AGI of $440,000.

With the American Rescue Plan, a family with an AGI between $185,000 and $400,000 can get a 20 percent credit on qualified expenses and receive $1,600 for one child and $3,200 for two or more children.

Failing to get pandemic tax credits

A worker sprays sanitizer into the hands of a shopper at a supermarket in Johannesburg, South Africa in May.

Waldo Swiegers/Bloomberg

Under last year’s Families First Coronavirus Response Act, household employers were required to provide paid sick and family leave to their workers for qualified reasons due to the pandemic.

Families could take a dollar-for-dollar tax credit to offset the cost of paid leave, which can be reconciled on Schedule H if they had not been remitting taxes on a quarterly basis. Depending on how much paid leave they provided to their employee, families could get up to $7,100 in tax credits.

More recent legislation — including the American Rescue Plan — made paid sick and family leave voluntary but kept the tax credits, which means families can still save on taxes if they decide to provide pandemic-related paid leave to their employees.

Being aware of these tax breaks can shave thousands of dollars off your client’s tax obligation while understanding labor law nuances will save them from fines, penalties, payment of back taxes, and other noncompliance issues.