Avoid nanny tax headaches during tax season
When your client employs someone to work in their home like a nanny, housekeeper or senior caregiver, they may owe household employment taxes or “nanny taxes.” It can be straightforward to prepare and file all the year-end forms associated with household employment. However, a lack of preparation, knowledge and/or communication can cause unneeded stress during busy season. Here’s what can happen and best practices to avoid these hassles.
Classifying the employee as an independent contractor
The IRS considers household workers to be employees and not independent contractors. This is a big distinction because misclassification is considered felony tax evasion. The difference between the two comes down to who has control of the employment. When a family hires a nanny, they set the caregiver’s schedule, tell the worker how they want their children cared for (what their child can eat, when they should nap, etc.), and provide the tools and equipment (kitchen appliances and utensils, strollers, etc.) to do the job. The family is in control, so the worker is their employee. An independent contractor, on the other hand, determines when they will work, how they will do the work, and supplies their own tools and equipment to do the job.
Your client’s employee should get a W-2 and your client will owe Social Security, Medicare and unemployment taxes, which should be reported on Schedule H and filed with their personal tax return.
Best practice: Consider every household worker an employee. If there is any doubt, file Form SS-8 (Determination of Worker Status) with the IRS.
Catching up on wages and hours worked
Household employees are hourly workers who must also be paid the highest applicable minimum wage rate and receive overtime pay for hours worked over 40 in a seven-day workweek. If your client hasn’t been keeping track of pay rates and hours or has been paying their employee a flat salary, you have calculations to perform to make sure their employee has been paid legally.
It can be time-consuming to go back through pay stubs and timesheets (if your client has even kept these records) to ensure everything is above board.
It’s also important to get it right. When you see a disgruntled household employee suing their employer, it’s typically over back wages. The family failed to account for all hours worked and/or didn’t pay a legal overtime rate.
Best practice: Keep timesheets on file and make sure they’re accurate. An employee’s pay stub should include regular hours and pay rate, overtime hours and pay rate, any withholdings, and paid time off and other accruals. This will help you avoid surprises when you need to complete the employee’s W-2.
Also, revisit the employee’s pay rate at least once a year to make sure it’s still above minimum wage. Some states and cities have minimum wage rates that are double the federal rate. Usually, minimum wage rates increase on July 1 or Jan. 1 with some exceptions.
Failing to withhold and remit taxes during the year
As employees ourselves, we’re used to having Social Security, Medicare and income taxes withheld from our pay. When it comes time to file our personal returns, most, if not all or maybe even more, of our tax obligation has already been fulfilled. There are usually no surprises come tax time.
But imagine if that wasn’t the case. What if we had to pay our entire tax responsibility all at once when we filed our return?
If you or your client hasn’t been withholding taxes each pay period, then your client and their employee will be stuck with a considerable tax bill due April 15. That could come as a shock to the employee who may ask your client to help cover all or part of their obligation.
Best practice: Household employment taxes can be remitted quarterly using Form 1040-ES. These would include both the employer and employee’s share of Social Security and Medicare taxes and federal unemployment taxes, which is paid by the employer only. Household employment is one of the rare industries where federal income tax does not need to be withheld from the employee’s pay. However, it’s a good idea to withhold income taxes so the employee doesn’t have to pay them all at once. State unemployment taxes can also be paid quarterly.
An alternate method to account for this extra tax responsibility is for your client to have additional federal income tax withheld from their pay. Since household employment taxes are included on Form 1040 (or Form 1040-SR), the increased withholding could cover the added household employment taxes.
Forgetting to apply caregiver wages to the Child and Dependent Care Tax Credit
One way your client can reduce their tax obligation when they’ve hired a nanny or in-home caregiver is through the Child and Dependent Care Tax Credit.
They may be able to claim a portion of their employee’s wages if the person being cared for is a dependent who is under 13 years old or a spouse or dependent who is physically or mentally incapable of self-care. There is no age limitation for spouses and other dependents. However, they must have lived with you for more than half the year. To qualify, your client must have incurred these expenses so they could work or look for work. Clients with household help will likely qualify for 20 percent of the total expenses allowed to be claimed. That means the potential maximum credit is $600 for the care of one person and $1,200 for two or more children or dependents. Your client can’t claim the credit if the caregiver was their spouse, a parent of the dependent child, a dependent listed on their tax return or their child who is age 18 or younger. Some states may also offer a similar credit for child and/or dependent care.
Best practice: File Form 2441 (Child and Dependent Care Expenses) with your client’s personal tax return. If your client used a Dependent Care FSA through their own employer to claim child and/or dependent care expenses, it may reduce the Child and Dependent Care Credit they receive.
Leaving it all to the end
Household employment taxes can easily be forgotten in the rush to complete forms and file returns. Without the proper preparation, they can turn into a big hassle when you have much better things to do then track down an employee’s hours and wages.
Best practice: Get started early so there are no last-minute surprises. Make 2020 the year of tracking wages and timesheets and filing quarterly taxes. You’ll be happy you did come January 2021.