The Unexpected Costs of Household Employees

Most tax advisers are already aware of the need to file payroll reports for household employees. However, some clients may not fully understand the risks of not reporting wages paid to household workers.

Background

In spite of all the publicity in recent years on the nanny tax (which includes Social Security, Medicare and Federal unemployment tax), many household employers still pay cash to babysitters, housekeepers, health aides and lawn-care workers without withholding taxes or filing the appropriate returns. Often, an employee specifically requests to be paid in cash and the employer wants to avoid paperwork. In addition, employers (1) sometimes assume that a worker is not required to file a return, due to low income (and, thus, does not need a Form W-2) or (2) want to save employment taxes by paying the compensation under the table.

A taxpayer who paid a household employee cash wages totaling more than $1,400 in 2003 most likely owes nanny tax. Even if the annual compensation is expected to be less than the threshold amount, it is a good idea to withhold the tax anyway. The employer can later refund the withheld taxes to the worker if wages are less than the filing threshold.

Employers cannot avoid their employment responsibilities by labeling a worker an independent contractor, even at the employees request or by signing a contract to that effect. The IRS has specific criteria for determining an employee relationship (see Rev. Rul. 87-41); it does not matter whether a worker is full- or part-time or paid on an hourly, daily, weekly or per-job basis. A worker is an employee if the employer controls not only the work done, but how it is done.

The Problem

Many employees are discovering that they are entitled to claim the earned income credit (EIC) based on their household wages. Most employees who learn about this credit will immediately request a Form W-2 from their employers, even if they previously agreed that no tax forms would be filed. Often this occurs after the tax filing deadlines, resulting in additional tax, interest and penalties.

The EIC is treated as a tax payment; any excess over the employees tax liability is refunded. Refundable credits can be significant, especially to a low-income individual, and provide quite an incentive for an employee to report wages on Form 1040.  

Example: M works as a housekeeper and is paid $200 cash per week; no tax is withheld. M has no other income or deductions. She has three children and is eligible to file as a head of household. If M files a 2003 tax return and reports $10,400 of taxable wages, she is entitled to a $4,160 refundable EIC (assuming she meets all other EIC requirements).

Additional costs employers face in this situation may include the following:

• Social Security and Medicare tax (FICA). Normally, an employer pays half (7.65%) of FICA and the other half is withheld from the employees wages, under Secs. 3101(a) and (b) and 3111(a) and (b). However, if no taxes were withheld, the employer is liable for the entire 15.3%.

• Federal unemployment tax (FUTA). Under Sec. 3306(b), FUTA is due on the first $7,000 of an employees annual wages (only if an employer paid $1,000 or more in wages in any calendar quarter for the current or preceding year). The rate is 0.8% if the state unemployment tax was paid by April 15 of the following year; see Sec. 3302. If state unemployment tax was not paid, the FUTA rate jumps to 6.2% of taxable wages.

• State unemployment taxes. These rates vary depending on the state and the employer. In addition to the taxes, the state will most likely assess interest and penalties for late filing.

• Underpayment penalties. FICA and FUTA are reported on an employers personal income tax return and deemed part of the individuals personal income taxes. Thus, if the employers taxes were underpaid because employment taxes were omitted, the IRS may assess underpayment penalties and interest.

• Form W-2 penalties. Failure to file Form W-2 timely may result in a per-form penalty up to $50, under Sec. 6722.

The news can get even worse. An employee may want to amend his or her prior-year tax returns to claim the EIC, so that the employer could be liable for three years worth of taxes, interest and penalties. The total cost can quickly escalate.

Conclusion

Tax advisers must be familiar with the issues and risks of household employment, and should encourage clients to comply with the filing requirements. Failure to do so can be costly. IRS Pub. 926, Household Employers Tax Guide, and the IRS website (www.irs.gov) are excellent resources for these issues.

From Rebecca J. Cardenas, CPA, Rodriguez Holland & Co., P.C., San Antonio, TX (Not affiliated with Grant Thornton LLP)