When clients hire household help: CPAs can offer valuable compliance guidance.

CPAs can offer valuable compliance guidance.

The nanny tax problems that derailed several early Clinton administration nominees brought to national attention the tax issues involved when hiring household help. Some assume such problems are confined to wealthy taxpayers who can afford to hire live-in help, and others think the 1994 legislation passed in response to the Clinton nominees' troubles eliminated the problem. In fact, taxpayers who regularly hire baby-sitters or people to mow lawns may find they have federal or state obligations.

This article focuses on some of the issues that must be faced when CPAs' clients hire domestic help--Social Security, unemployment tax and withholding requirements--and examines some typical state law obligations. It also discusses recent changes in federal employment tax law, which shifted many reporting requirements from forms 942 and 940 to the taxpayer's own form 1040--typically prepared by CPAs, who may now be involved with clients who previously completed their own employment tax forms or relied on payroll services. (See exhibit t, page 47, for a listing of the titles and purpose of IRS forms, publications and notices.

IS THE CLIENT AN EMPLOYER?.

The first question for CPAs to consider is whether an employer-employee relationship exists. Taxpayers who hire independent contractors are not obligated to withhold or pay taxes. In contrast, taxpayers who are considered employers may have to pay Social Security taxes or make unemployment tax contributions based on the amount of compensation paid.

Various tests differentiate between employees and independent contractors. Generally, the focus is on the degree of control the hiring party can exercise over the performance of the services. Other factors include the nature of the services provided, the level of skill needed, the manner of compensation, the length of the employment relationship, the ownership of the equipment or facilities used to perform the services and the right to terminate the relationship.

A client who has the right to dictate how work is performed in addition to what work is done will be treated by the IRS as an employer and subject to employment tax obligations. In other words, someone who hires independent contractors has the right only to control the result of the work, but someone with employees also can control the manner of performance, whether or not that authority is exercised.

WHEN CLIENTS HIRE EMPLOYEES

When hiring a household employee, a client should be advised to verify the person can legally work in the United States. Form [-9, Employment Eligibility Verification, is available from the Immigration and Naturalization Service (INS) for this purpose. It requires an employer to review specified documentation--such as a birth certificate, driver's license or passport--to confirm employment eligibility. An employer keeps the I-9; it is not filed with the INS. An I-9 is not required for domestic work performed in a private home on a sporadic or intermittent basis. For example, a client who hires someone for one day to help wash the windows does not have to complete an I-9.

An employer also should keep a record of an employee's name and Social Security number exactly as they appear on the Social Security card. An employee without a Social Security number should apply for one even if no Social Security taxes will be owed based on the amount of wages paid.

Employers also must have employer identification numbers (EINs). Many mistakenly believe the nine-digit EIN is the same as a Social Security number; CPAs should cover this point carefully with clients. An EIN is issued by the Internal Revenue Service using form SS-4.

SOCIAL SECURITY AND MEDICARE OBLIGATIONS

For 1996, the taxable wage base for Social Security--the amount subject to old age, survivors, disability and hospital insurance (OASDI) taxes under the Federal Insurance Contributions Act--is $62,700. The tax rate is 15.3%, of which 2.9% is for Medicare. The wage base does not apply to Medicare; an employer who pays more than $62,700 in wages will pay 15.3% on the first $62,700 and 2.9% on the excess.

The employer must pay half of any Social Security taxes and may withhold half from an employee's wages. An employer may elect to pay the employee's share; this represents additional reportable income but is not treated as additional wages when calculating Social Security and Medicare obligations. Employment taxes paid by a household employer cannot be taken as an itemized deduction on the employer's own tax return.

Social Security and Medicare taxes apply only to "cash" wages; thus, benefits such as food, clothing or lodging are not taxable. For amounts paid after 1993, Social Security and Medicare taxes are owed only if the employer pays $1,000 or more in wages to an employee during the year. If a client pays $600 for child care to employee X and $500 to employee Y for yard work, no taxes are owed. Once the $1,000 threshold is met, all cash wages, including the first $1,000, are taxed.

Compensation paid to certain household employees is not subject to Social Security and Medicare. This exemption applies to a spouse or to the employer's child if the child is under age 21. Amounts owed a parent for domestic work (such as a grandparent who babysits) generally are exempt but may be taxed if the employer lives with an underage or disabled child and certain conditions are met. Generally, no taxes are owed on household employees under age 18 at any time during the year. This exemption, effective for 1995 and later, does not apply if the employee's principal occupation is domestic work. However, students under 18 are not considered principally occupied in domestic labor.

Beginning in 1995, Social Security and Medicare taxes are reported and paid with the employer's form 1040 using schedule H. Exhibit 2, page 49, is a sample schedule H prepared for a hypothetical employer, Fred  Dunkirk, who had one household employee in 1995 to whom he paid cash wages of $5,000. Dunkirk owes Social Security taxes of $620 (.124 X $5,000), as shown on line 2. He also owes Medicare taxes of $145 (.029 x $5,000), reported on line 4. Dunkirk withheld half of these amounts and will pay them to the federal government with the half for which he, as employer, is responsible.

As the example illustrates, payment of Social Security and Medicare taxes during the tax year a household employer is paying for services generally is not required currently. However, clients may wish to consider changing their own withholding or estimated tax payments to avoid a large balance due with form 1040. Beginning in 1998, estimated tax penalties will be calculated by including employment taxes. Clients who own their own businesses and have employees may report taxes for household employees on the forms 941 and 940 (or 940EZ) filed for the businesses. In such cases, amounts will have to be deposited according to the regular employment tax rules. According to IRS notice 95-18, these clients also can report and pay employment taxes for their household employees on schedule H.

INCOME TAX WITHHOLDING

Household employers are not required to withhold federal income taxes unless an employee requests it and the employer agrees. States that levy income taxes also may impose withholding requirements. Some states conform to federal procedures, meaning state withholding for household employees is optional. If the employer agrees to withhold, the employee must complete form W-4, as is the case for nondomestic workers.

Unlike Social Security and Medicare, wages subject to withholding are not limited to cash compensation. Thus, a client who withholds will have to take into account the value of clothing and other noncash items. Meals and lodging are included unless provided in the employer's home, for the employer's convenience and--in the case of lodging--as a condition of employment.

Any federal income taxes withheld are reported on the employer's form 1040 (schedule H, line 5). As with Social Security and Medicare taxes, a domestic employer who also owns a business may report the tax withheld on the returns filed for that business or may file schedule H. Income taxes paid by the employer that were not withheld represent additional compensation and count as wages for Social Security, Medicare and federal unemployment tax purposes.

UNEMPLOYMENT TAX CONCERNS

Unemployment insurance is provided jointly by the federal government and the states. In general, unemployment benefits are funded by employers without wage withholdings, although some states require employee contributions. The federal unemployment tax (FUTA) applies to the first $7,000 of wages paid. The current rate is 6.2%, although employers may be eligible for a credit of as much as 5.4% for amounts paid to state unemployment programs.

A household employer has FUTA obligations only if he or she paid more than $1,000 in cash wages in any calendar quarter of the current or prior tax year. This test is different from the $1,000 Social Security-Medicare threshold for domestic employees. For example, a client who paid $1,500 in cash wages in the last quarter of year 1 but paid compensation of only $800 in year 2 would have FUTA obligations in that year because he or she paid cash wages of more than $1,000 in the last quarter of year 1. However, the client would not be subject to Social Security and Medicare taxes in year 2 since wages paid were less than $1,000.

Noncash compensation is not included when determining whether the $1,000 threshold is met. Also, wages paid for household services to a spouse, a child under the age of 21 or a parent are not subject to FUTA. FUTA tax liability owed by household employers in 1995, and later, is reported on form 1040 unless the employer also has a business, in which case it may be shown either on the business' form 940 or 940EZ or on schedule H. State reporting and payment requirements may be more frequent.

The amount of state unemployment tax generally depends on factors like wages paid, prior employment and unemployment experience and the financial stability of the state's unemployment fund. An employer who pays less than the maximum rate may still be eligible for a full 5.4% credit against the federal liability if state unemployment tax payments are made on time. State exemptions may be different from federal ones. A household employee outside the FUTA system may be included under state rules; CPAs advising household employers on unemployment tax responsibilities should know state law.

Exhibit 2 shows the calculations that determine Dunkirk's FUTA liability. As a new employer, he is subject to a 4.4% New York state unemployment tax of $220. Since he paid his state taxes on time, Dunkirk receives a 5.4% credit to be taken against his FUTA. Therefore, he owes $40, or 0.8% of the $5,000 wages he paid. This is shown on line 17 of schedule H.

EARNED INCOME CREDIT

Household employers also may be subject to certain requirements because of the earned income credit (EIC) rules. The EIC is a refundable tax credit that can be claimed by low-income taxpayers. In some cases, household employers may be required to make advance payments of this credit to an employee over the course of a particular tax year.

For 1996, an employee can qualify for advance EIC payments if he or she has a qualifying child, anticipates being eligible for the credit and expects earned income and adjusted gross income will each be less than $25,078. (If the employee is married and expects to file a joint return, the spouse's income is included in determining whether the standard is met.) The employee's wages must be subject to Social Security, Medicare or federal income tax withholding. This means a household employee who earns less than $1,000 a year and whose employer is not withholding any tax cannot receive advance EIC payments.

A qualifying employee who wants to receive advance EIC payments must supply a form W-5. The amount of the advance depends on wages paid--among other factors-and is calculated using IRS tables. For domestic employees, wages paid generally are the same as the amount of compensation subject to Social Security and Medicare taxes. The advance EIC payment does not change the amount of income, Social Security or Medicare tax withholding.

Ira household employee is eligible to receive the EIC in advance, the employer will make payments first from withheld income tax, if any. If this amount is insufficient, Social Security and Medicare tax payments are used, drawing first on employee contributions and then on employer contributions. Payments to the employee are treated as having been turned over to the IRS when the wages were paid to the employee. In such cases an employer will owe less on April 15 (or when employment taxes are due).

If the amount of income and employment tax withheld and owing is less than the advance due the employee, the employer has two options: either lower the amount paid to the employee or make full payment. In the latter case, the employer is treated as having made an advance payment of his or her own tax liability.

The EIC rules also contain notice provisions. An employer of someone who had no income tax withheld during the year must notify the employee that he or she may be eligible for a tax refund because of the EIC. The notice rules can be satisfied by supplying the employee with

* A copy of IRS form W-2, which has a statement about the EIC printed on the back of copy C.

* A substitute form W-2 with the same information on the back of the employee's copy. * A copy of IRS notice 797.

* The employer's own written statement using the same wording as notice 797.

The timing requirements for the notification vary. An employer's obligations will be satisfied by supplying a timely form W-2. If a substitute W-2 is used that does not have the required statement on the back, notice must be given within one week of supplying the substitute W-2. If form W-2 is not timely, a copy of notice 797 or a written statement using the same language must be supplied by the date the W-2 was due. If no W-2 is required, the employee must be notified by February 7 of the following year.

WHAT STATE LAW MIGHT REQUIRE

In addition to unemployment and income tax withholding, state law may require household employers to obtain workers' compensation and disability protection for their employees. CPAs counseling clients must know applicable state laws.

Apart from workers' compensation and disability insurance, clients also should be advised to check their own insurance before hiring an employee. Serious accidents can occur around the house; a client without adequate coverage may face a substantial liability.

RECORDKEEPING

Each tax requires different records from a household employer. A complete list of what is recommended for each tax can be found in IRS publication 937. In addition to these lists, the employer should keep copies of all returns filed. It's also a good idea to have copies of documentation of required tax payments and deposits.

The IRS recommends records be kept for at least four years from the later of the due date of the return or the date the taxes were actually paid. State law and statutes of limitations, during which time clients are vulnerable to audit, may differ.

THE PROBLEMS OF NONCOMPLIANCE

Civil and criminal penalties under the Internal Revenue Code may apply when a household employer fails to meet his or her employment tax obligations. For a criminal conviction, there generally must be a showing of willfulness, defined as a voluntary and intentional violation of a known legal duty. This means a client who has only been negligent probably will not face criminal prosecution. However, the civil penalties that may be imposed are in addition to interest that accrues on the unpaid tax obligation. Also, a client who is not in compliance with federal requirements is likely to be violating state law as well, so the possibility of state penalties also must be considered.

SIGNIFICANT OBLIGATIONS

CPAs can offer a valuable service by helping clients understand and meet employment tax and related requirements. While recent changes have simplified the requirements imposed on taxpayers who hire household help, there are still significant obligations under federal law; state rules--which may not have been revised since the federal changes--also must be considered. Since the new federal law shifts much of the reporting obligations to the taxpayers' form 1040, CPAs, even those who don't wish to practice extensively in this area, must anticipate dealing with more employment tax issues in the future.

EXECUTIVE SUMMARY

* FEDERAL EMPLOYMENT TAX obligations for domestic employers were simplified by legislation that was enacted in 1994. However, there are still significant reporting obligations for those taxpayers who hire household help.

* FOR TAX YEARS BEGINNING AFTER 1993, Medicare and Social Security taxes are owed only if an employer paid $1,000 or more in cash wages during the year. For 1995 and later years, no taxes are owed on household employees under age 18 who are not principally occupied in performing domestic service.

* STARTING IN 1995, HOUSEHOLD employers report and pay federal employment tax obligations on their own form 1040s. No deposits are required, but beginning in 1998 estimated tax penalties will be calculated by including employment taxes owed.

* FEDERAL UNEMPLOYMENT TAX APPLIES to the first $7,000 of wages paid, provided the employer paid cash wages orS1,000 or more in any calendar quarter in the current or prior year. This $1,000 test is not the same as the $1,000 Social Security--Medicare test. State unemployment tax requirements may differ.

* THE EARNED INCOME CREDIT RULES MAY impose advance payment and notification requirements on employers of domestic workers.

* PENALTIES FOR FAILURE TO COMPLY with employment tax law requirements can include civil and criminal sanctions.

ARLENE M. HIBSCHWEILER, JD, is an associate professor at the State University. of New York College at Fredonia. She also serves as counsel to the law firm of Marcus, Knoer and Crawford, Buffalo, New York.

  Exhibit 1:  Internal revenue Service Forms, Publications and
              Notices


Form         Title and Purpose

940,940EZ    Employer's Annual Federal Unemployment (FUTA) Tax
             Return. Used to report FUTA for domestic employees
             (before 1995 and for all nondomestic employees.
             If the taxpayer also owns a business as a sole
             proprietor, FUTA for household employees continues
             to be reported on the form 940 filed for the
             business or may be shown on schedule H.

941          Employer's Quarterly Federal Tax Return. Used to
             report Social Security, Medicare and withheld
             income tax for non-household employees. When
             the taxpayer also owns a business as a sole
             proprietor, household employees may be reported
             here or on schedule H.

942          Employer's Quarterly Tax Return for Household
             Employees. Used to report Social Security,
             Medicare and any withheld income tax for 1994
             and earlier years.

1040         Schedule H, Household Employment Taxes. Used
             to report Social Security, Medicare withheld
             income and federal unemployment taxes for
             domestic employees in 1995 and later years.

SS-4         Application for Employer Identification Number.
             Used by employers to obtain an employer
             identification number.

W-2          Wage and Tax Statement. Used by employers to
             report wages, withholding and advance earned
             income credit payments.

W-4          Employee's Withholding Allowance Certificate.
             Used to calculate income tax withholding from
             employee wages.

W-5          Earned Income Credit Advance Payment
             Certificate. Used by eligible employees to
             receive advance payment of the EIC.

Publication
926          Employment Taxes for Household Employers.
937          Employment Taxes.
Notices
797          Possible Federal Refund Due to Earned Income
             Credit (EIC).
95-18        Household Employment Taxes.