The unexpected costs of household employees.

• Author: Cardenas, Rebecca J.

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 employee's request or by signing a contract to that effect. The INS 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 employee's 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...