New nanny tax rules mean more responsibility for return preparers.

The "nanny tax" rules require more from return preparers than just an inquiry as to whether a client has paid domestic workers $1,000 or more and filling out Schedule H; as discussed in this article, it may invoke a host of other Federal and state tax and nontax filing requirements. The effect of the new law on administrators, executors and trustees is also addressed, as are preparer penalties that may apply when the preparer omits preparing Schedule H.

The Social Security Domestic Employment Reform Act of 1994 (the Act) attempts to simplify the rules relating to employment taxes and income tax withholding for household employees. The Act makes two major changes in the rules applicable to household employers: [] Effective for wages paid in 1995 and thereafter, there is mandatory calendar-year basis reporting and payment of (1) Social Security and Medicare taxes under FICA, (2) the tax imposed under FUTA, and (3) any withheld income tax. [] Effective for wages paid in 1994 and thereafter, household employers are not liable for FICA taxes for any household employee to whom the employer pays less than $1,000 during the year.

Starting in 1995, the Act also provides an exception from FICA, taxes with regard to cash wages paid for domestic service in a private home of the employer performed in any year by an individual under age 18 during any portion of such year (provided the service is not the employee's principal occupation).

Also beginning in 1995, household employers no longer file Form 942, Employer's Quarterly Tax Return for Household Employees, the return for reporting and paying FICA and withheld income taxes on such workers. Instead, employers will report these taxes on new Schedule H, reproduced on pp. 86-87, which is to be filed with their individual income tax returns. FUTA taxes will also be reported on Schedule H.(1)

Additional Filing Requirements

Although the Act simplifies the reporting and paying of FUTA, FICA and withheld income taxes, CPAs should review with clients other Federal and state filing requirements that apply to hiring household workers. Penalties may be assessed against a client for failing to comply with such requirements. Some of the forms and requirements are as follows: [] Form 1-9, Employment Eligibility Verification, used to prove an employee's identity and eligibility to work for purposes of U.S. immigration law. This form is not required for domestic work in a private home on a sporadic, irregular or intermittent basis.(2) [] Form SS-4, Application for Employer Identification Number. Household employers need to obtain an employer identification number (EIN) no later than January 31 for Forms W-2 they will be filing for their household employees, as well as for any Schedule H to be filed with their Forms 1040. Despite the fact that the current version of Form SS-4 (revised Dec. 1993) states that household employers need not file it to obtain an EIN, it should be filed to obtain one.(3) [] Form W-4, Employee's Withholding Allowance Certificate. Domestic employers do not have to withhold income taxes for household employees, but, if the employee so requests, die employer may voluntarily do so by having the employee complete Form W-4. [] Form W-5, Earned Income Credit Advance Payment Certificate. This form is used by employers to make advance income credit payments to eligible employees. [] Form W-2, Wage and Tax Statement, must be furnished to any domestic employee who received $600 or more in wages, despite the fact that domestic employers are not liable for FICA tax for wages under $1,000. A copy of the W-2 must be given to the employee by January 31 of the year following the year of such earnings. Copies of Form W-2 must be submitted to the IRS by February 28 of the year following the year of such earnings (with Form W-3, Transmittal of Income and Tax Statements, if there is more than one employee). [] State tax forms, which may be needed to pay state unemployment taxes, state workers' compensation or disability insurance and to withhold state income taxes. Such forms may impose quarterly filing requirements and the wage threshold for imposition of taxes may be different from the Federal threshold contained in the Act. [] Income tax withholdings may have to be increased or additional estimated tax payments made to avoid a large balance due. The due date for paying FICA, FUTA and withheld income taxes is the due date (excluding extensions) of the employer's individual income tax return. There is no estimated tax payment penalty for employment taxes reported on Schedule H until 1998.(4)

Effect on Administrators, Executors and Trustees

For FICA, FUTA and income tax withholding purposes, an administrator or executor of an estate who maintains a home as a private home for the decedent's family, or a trustee of a trust that maintains a home as a private home for a trust beneficiary of the trust, is considered a household employer of any employee who performs domestic service in the home. Thus, beginning in 1994, if the administrator, executor or trustee pays cash remuneration to a household employee of less than $1,000 in a calendar year, he is not required to pay FICA taxes for that employee for that year. For purposes of determining whether cash remuneration of less than $1,000 has been paid to the household employee, the cash remuneration paid to a household employee by an administrator, executor or trustee in a calendar year will be aggregated with the cash remuneration paid to the household employee in the same calendar year by the household of the decedent or beneficiary for whom the administrator, executor or trustee is acting.(5) Currently, there is no published guidance as to how administrators, executors and trustees report and pay these taxes. AICPA representatives have consulted with the IRS National Office and received the following guidance--new Schedule G of Form 1041, U.S. Income Tax Return for Estates and Trusts, will have a line to use for domestic employment tax payments made by administrators, executors and trustees. However, the Form 1040 Schedule H must be completed to calculate the employment taxes due, and this calculation must be tied into the Form 1041 Schedule G.

Therefore, an administrator, executor or trustee should attach Form 1040 Schedule H (which shows the calculation of employment taxes) to the Form 1041 Schedule G when filing die trust's or estate's income tax return. (Form 1041 has its own Schedule H that addresses a different issue.

Effect on Return Prepares

The addition of Schedule H to Form 1040 places much of the burden of complying with the provisions of the Act on the shoulders of the CPA tax return preparer. In the past, many CPAs have advised their clients on the rules for paying and reporting employment taxes relating to domestic workers. Having properly advised clients as to these rules, the CPA had no other professional responsibility for these taxes, because they were not part of a return required to be signed by the preparer; rather, it was the client's decision whether or not to file and pay these taxes. Even with proper advice regarding the requirement to file and pay taxes on domestic workers, many taxpayers nevertheless chose not to file because of the fear of losing a good worker, because the worker was an illegal alien or because of the perceived burden of filing the required forms.

Many CPAs will prepare 1995 individual income tax returns for clients who employ household workers; in some cases, practitioners may have knowledge of the employment status of their clients' household workers as a result of their knowledge of the clients' affairs or consultations with clients regarding the pre-Act domestic employment tax rules. Many of these clients will still be reluctant to file and pay these taxes, because of the reasons noted above.

What is the CPA's professional responsibility with respect to such clients? First, the CPA should not be subject to the Sec. 6694 preparer penalties. According to Sec. 6694(e) and Regs. Sec. 1.6694-1 (a), these penalties are imposed only with respect to taxes imposed by Subtitle A of the Code. FICA, FUTA and withholding taxes applicable to domestic employment are imposed by Subtitle C of the Code.

However, the Sec. 6701 aiding and abetting penalty could be assessed against a return preparer who had (or should have had) knowledge of a domestic employment situation and prepared a Form 1040 without including Schedule H. The penalty is $1,000 per return and applies to any understatement of tax liability, not just to understatements of income tax liabilities. Unlike the Sec. 6664 preparer penalties, the burden of proof is on the Service to show that the Sec. 6701 penalty is properly imposed.

Circular 230, which governs the practice of CPAs, attorneys and enrolled agents before the IRS, poses additional problems for return preparers.6 Section 10.21 requires that a CPA who knows that his client has not complied with the revenue laws must promptly advise his client of the fact of such noncompliance. Failure to report and pay payroll taxes under the new nanny tax rules is clearly a case of such noncompliance. The CPA should notify a client in writing of the noncompliance to prevent the client from later claiming that he was not aware of it.

More importantly, Circular 230, Subpart C, gives the Treasury Secretary authority to suspend or disbar a CPA, attorney or enrolled agent from practice before the IRS for disreputable conduct. Under Section 10.51 (d), a CPA could have IRS practice privileges suspended by knowingly omitting from a return a required Schedule H.

In addition, CPAs need to make a careful determination as to whether or not to sign a client's return if the client has indicated that he will not include Schedule H and the CPA knows (or should have known) that the client is employing domestic workers. The preparer's declaration on the return states that the information contained therein is true, correct, and complete to the best of the preparer's knowledge and belief "based on all information of which the preparer has any knowledge." A CPA's signature on a return the CPA knows is not in compliance with the FICA, FUTA and withholding rules related to domestic employment will be inconsistent with this declaration. The CPA will also be in violation of AICPA Statements on Responsibilities in Tax Practice (SRTP) No. 3, Certain Procedural Aspects of Preparing Returns (1988 rev.).(7)

Under SRTP No. 3, the CPA should also consider whether to terminate the professional relationship because of the client's failure to comply. In many cases, this decision will require careful analysis, because the domestic employment tax rules leave some unanswered questions concerning the employment status of certain types of domestic and household workers. A determination will have to be made as to whether an employer-employee relationship exists or whether the worker is an independent contractor.(8)

Editor's note: Mr. Gracik is a member of the AICPA Tax Division Individual Taxation Committee. Ms. Sherr is the Committee's technical manager. Ms. Sherr's views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

(1) See Notice 95-18, 1995-1 CB 300, Q&A-2. (2) See Instructions to Form 1-9. (3) See Ann. 96-71, IRB 1995-35-22. (4) Notice 95-18, note 1, Q&A-6. (5) Id., Q&A-4. (6) See generally, Gardner and Willey, "The Tax Practitioner's Guide to Circular 230 (Parts I and II),"(26) The Tax Adviser 647 and 711 (Nov. and Dec. 1995). (7) Although the SRTPS are not enforceable, they provide guidelines for CPAs in tax practice. (8) See Tax Clinic, "The Nanny Tax," 26 The Tax Adviser 530 (Sept. 1995).