Nanny tax implications.

One area of the law that has proven to be troublesome for many taxpayers (and not just high-income individuals) has been the tax treatment of housekeepers, babysitters, cooks and other domestic workers. In an effort to clarify the rules and simplify taxpayers' burdens, Congress passed the Social Security Domestic Employment Reform Act of 1994. With the start of the filing season, taxpayers and their CPAs must now address the issues this new law presents. (For a good discussion of what CPAs need to review with their clients, see "It's Time to Prepare for the Nanny Tax," JofA, Dec.95, page 32.)

WHAT'S INVOLVED

In general, for wages of $1,000 or more paid after 1994, household employers must report and pay Federal Insurance Contributions Act, Medicare and Federal Unemployment Tax Act taxes and withhold income tax on an annual basis when filing their form 1040s. (One major exception is for cash wages paid for domestic service by individuals under age 18 in the private home of an employer performed in any year--provided the service is not the employee's principal occupation). This will be done through the introduction of a new schedule H, which taxpayers will have to fill out and attach to their regular returns.

NEW PREPARER RESPONSIBILITIES

In the past, many CPAs dealt with the domestic worker situation simply by advising their clients of the applicable rules. The CPA had no other professional responsibility for the taxes in this situation, since they were not part of a return required to be signed by the preparer. Rather, it was the tax-payer's decision whether or not to file and pay these taxes; for a variety of reasons, many taxpayers did not file the forms and pay the applicable taxes.

The addition of schedule H to form 1040 changes this; now, much of the compliance burden is on the CPA preparer. The CPA may already have some knowledge of a client's household workers as a result of handling the client's affairs or consultations with the client about prior domestic employment rules. This raises several professional responsibility issues:

* The CPA may not be subject to the preparer penalties found in section 6694, since FICA, FUTA and withholding taxes are imposed under a different part of the Internal Revenue Code.

* While a preparer normally may rely on information furnished by the taxpayer, the aiding and abetting penalty could be assessed against a preparer who knew (or should have known) of a domestic employment situation and prepared a form 1040 without including schedule H. For example, if a taxpayer claims a credit for dependent care and provides an individual's Social Security number, the preparer might be considered as having knowledge of a domestic worker situation.

* The rules governing the practice of CPAs before the IRS (found in circular 230) require that a CPA who knows that his or her client has not complied with the revenue laws must promptly advise the client of this fact. (Failure to report and pay payroll taxes under the new nanny tax rules is clearly such a case.) The CPA should notify a client in writing of the noncompliance to prevent the client from later claiming ignorance.

* The CPA must carefully decide whether to sign a client's return if the client has not included schedule H and the CPA knows (or should know) that the client is employing domestic workers. Signing the return will be inconsistent with the preparer's declaration.

In addition, the CPA will be in violation of the American Institute of CPAs Statement on Responsibilities in Tax Practice no. 3, Certain Procedural Aspects of Preparing Returns. (While these rules are not enforceable, they do provide guidelines for CPAs in tax practice.) Under this rule, a CPA also should consider whether to terminate the professional relationship with the client. However, this decision will require careful analysis, since the domestic employment tax rules leave some unanswered questions about the employment status of some domestic and household workers.

For a discussion of the nanny tax and its ramifications, see "New Nanny Tax Pules Mean More Responsibility for Return Preparers," by L. Michael Gracik Jr. and Eileen Reichenberg Sherr, in the February 1996 issue of The Tax Adviser

Editor's Note 

The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.