The Costs of Household Employees

hile most CPAs are aware of the need to file payroll reports for household employees, clients may not fully understand the risks of not reporting wages paid to household workers.

OVERVIEW
Despite the publicity about the “nanny tax” (which includes Social Security, Medicare (collectively, FICA) and federal unemployment tax (FUTA)), many household employers still pay their babysitters and housekeepers in cash, without withholding taxes or filing the correct forms. Often, an employee specifically requests cash and the employer wants to avoid paperwork; sometimes, employers assume a low-income worker is not required to file a return (and, thus, does not need a form W-2) or employers want to save employment taxes by paying compensation “under the table.”

A taxpayer who paid a household employee more than $1,400 in cash wages in 2003 most likely owes the nanny tax. Even if annual compensation is expected to be less than the threshold for withholding, tax should be withheld—the employer can later refund the withheld taxes if the worker does not meet the filing threshold.

DILEMMA
Many low-income employees are discovering they can claim the earned income credit (EIC) based on their household wages. Most who learn about it will immediately request a form W-2 from their employers, even if they previously agreed no tax forms would be filed.

The EIC is treated as a tax payment; any excess over the employee’s tax liability is refunded. Refundable credits can be significant and provide quite an incentive for an employee to report wages on form 1040.

Employers may face the following additional costs in this situation:

FICA tax. Normally, an employer pays half (7.65%) of FICA and withholds the other half from the employee’s wages, under IRC sections 3101(a) and (b) and 3111(a) and (b). However, if no taxes were withheld, the employer is liable for the entire 15.3%.

FUTA. Under section 3306(b) an employer generally pays FUTA on the first $7,000 of an employee’s annual wages, at a rate that can be as high as 6.2% of taxable wages.

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

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

Form W-2 penalties. An employer’s failure to timely file an employee’s form W-2 each year may result in a per-form penalty up to $50, under section 6722.

SUMMARY
RCPAs 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.

For more information see the Tax Clinic, edited by Stefan Gottschalk, in the February 2004 issue of The Tax Adviser.

—Lesli Laffie, editor
The Tax Adviser