Hiring household help is now less taxing.
In response to the criticism of the federal employment tax system, Congress passed the Social Security Domestic Employment Reform Act of 1994 (Act) on October 6, 1994. The Act reduces the paperwork burden on household employers and raises the wage threshold at which employment taxes must be paid by household workers. This article explains who is affected by the Act and how to comply with it.
Federal Employment Tax System
Under the federal employment tax system, employers of domestic workers in a private home may be liable for Social Security and Medicare tax (FICA) and federal unemployment tax (FUTA). Employers are not responsible for wage withholding but can agree to withhold federal income taxes if the domestic service employee makes a request on a Form W-4, Employee's Withholding Allowance Certificate.(3) Employees who are eligible can also request advance payments of the earned income credit.
Domestic Service Employees Defined
Household services include those performed by governesses, babysitters, housekeepers, maids, cooks, butlers, gardeners, caretakers, handymen, chauffeurs of automobiles for family use and companions for a convalescent. The services must be performed in or about the employer's private home.(4)
FICA and FUTA are due only on wages paid to household workers who are classified as employees, not on payments made to workers who are independent contractors. The common-law employee rules govern whether a household worker is an employee or independent contractor.
Household or domestic service workers can be classified as employees if the employer has the right to control what the worker does and how the worker does it even if the employer does not exercise the right. Other factors that influence whether a worker is an employee include whether the employer supplies the employee with tools and a place to work and whether the employer has the right to discharge the employee. In general, if an individual is subject to the control or direction of another person merely as to the result to be accomplished by the work and not as to the means and methods for accomplishing the result, the individual is an independent contractor.(5)
For example, if a babysitter comes to the taxpayer's home one day per week at a designated time and is given instructions about the care and feeding of the children, she probably will be classified as an employee. On the other hand, if a lawn care worker comes to the taxpayer's home one day per week but sets his own work hours and supplies his own tools and materials, he will be classified as an independent contractor.
If domestic workers are hired through an agency that pays the workers and is responsible for who does the work and how it is performed, the agency, not the homeowner, is the employer and is responsible for the employment taxes.(6)
Withholding and Paying FICA
FICA consists of two taxes, Old Age, Survivors, and Disability Insurance (Social Security) and Medicare, which are imposed on both the employee and the employer. For 1995, the Social Security tax is 6.2% of the first $61,200 of wages and the Medicare tax is 1.45% of all wages. An employer is responsible for deducting the employee's share of the taxes from the employee's wages and is liable for the employee's share even if he did not deduct the taxes.(7) The employer is also responsible for paying a matching share of FICA.
The wages of a domestic service employee subject to FICA do not include noncash compensation such as food, lodging, clothing and transportation. Cash compensation that does not exceed a threshold amount is also not subject to FICA taxes. The threshold amount for wages paid after December 31, 1993, was changed retroactively to $1,000 per calendar year.(8) Prior to the Act, employers were liable for FICA on wages of more than $50 per calendar quarter. For example, if a taxpayer pays a housekeeper $50 per month to clean his house in 1995, the housekeeper will not be subject to FICA since the total amount paid for the year does not exceed $1,000. Prior to the Act, the taxpayer would have been liable for FICA because more than $50 was paid in a calendar quarter.
The $1,000 threshold will be indexed for the average wage increase beginning in 1996. The indexed amount will be rounded to the next lowest multiple of $100.
Beginning in 1995, a person who is under the age of 18 for any part of the year will not be subject to FICA taxes on domestic services performed in a private home of the employer unless the individual's principal occupation is domestic service.(9) Therefore, if a taxpayer pays a 17-year-old high school student $2000 during the year to babysit her children, the babysitter will not be subject to FICA unless babysitting is her main occupation.
Domestic service performed by an individual under age 21 for his mother or father is also not treated as employment subject to FICA. In some cases domestic service performed by an individual in the employ of his spouse or child will also not be treated as employment subject to FICA.(10)
For 1994, employers who withheld and paid FICA were required to file Form 942, Employer's Quarterly Tax Return for Household Employees. The employer was required to file Form 942 by the end of the month following the end of the quarter and had to remit both the FICA taxes withheld from the employee and the matching taxes paid by the employer.
Beginning with calendar year 1995, an individual who employs only domestic workers will file a return of "household employment taxes" on a calendar-year basis.(11) The quarterly filing of Form 942 will no long be required. The annual employment tax return, new Form 1040, Schedule H, will be due on the 15th day of the fourth month after the close of the employer's tax year. Form 1040 has been revised to enable an employer to report and pay the household employment taxes on his own federal income tax return.(12) The employer will be permitted to pay the FICA taxes in a lump sum when he files his return.(13)
Refunds of FICA
Employers may begin to deduct FICA from the employee's wages before the threshold is reached. If the employee is ultimately not subject to the tax or an excess has been deducted, the employer must reimburse the employee the excess taxes.
Federal Unemployment Tax
Employers may be liable for federal unemployment taxes in addition to FICA. Federal unemployment taxes are assessed on wages paid for covered employment. The tax is 6.2% of the first $7,000 in wages paid each employee during the calendar year.(14) Generally, the employer can take a credit again the FUTA tax for contribution paid into state unemployment funds, although the credit cannot exceed 5.4% of the first $7,000 of wages.(15) The unemployment tax rate is scheduled to be reduced to 6% beginning in 1999.
Domestic service in a private home is considered covered employment for FUTA purposes only if the employer pays a total of $1,000 cash wages to all domestic employees in any calendar quarter of the current or preceding calendar year.(16) Since the FUTA criteria deal with the total wages paid to all domestic service employees and the FICA criteria apply to the wages paid to each employee, it is possible for an employer to be liable for federal unemployment taxes and not FICA taxes.
For example, assume in the last quarter of the year a taxpayer pays $600 to a housekeeper and $500 to a babysitter. Since the employer has paid at least $1,000 in wages for covered employment in that quarter, he is liable for FUTA taxes. He will not be liable for FICA since neither employee earned $1000 that year.
For 1994, employers who were liable for unemployment taxes had to file the Employer's Annual Federal Unemployment Tax Return (Form 940 or 940-EZ). Although the form was due on January 31, employers who owed more than $100 in unemployment tax at the end of a calendar quarter were required to deposit the tax by the end of the following month.(17)
Beginning in 1995, the annual Form 940 will no longer be required for domestic employees. Instead, individuals who employ only domestic workers will file Form 1040, Schedule H (Household Employment Taxes) which will be due on the fifteenth day of the fourth month after the close of the employer's tax year.(18) This form is the same form used to report FICA taxes. The employer will be permitted to pay FUTA taxes in a lump sum when his income tax return is filed.
When an employer hires a household employee, he should contact the state employment tax office for information about filing the state unemployment tax.
Changes in FICA and FUTA Payments in 1997
Employers will not be permitted to pay FICA and FUTA taxes in a lump sum at the end of the year after 1997. Instead, the taxes will be subject to the estimated tax payment rules.(19) These rules require that 25% of the required annual payment be made each quarter. If the estimated payments are not made, the taxpayer will be subject to an underpayment penalty. The underpayment penalty will not apply if the taxpayer's total tax liability is less than $500 or he has paid in at least 90% of the current year's tax or he has paid in an amount equal to at least 100% of the prior year's tax if a return was filed for that year.(20) If the employer is also an employee, he can avoid having to make estimated tax payments by increasing the withholdings on his own wages.
To illustrate, assume that the taxpayer is an accountant who earns $50,000 in gross income and has a tax liability of $7,500 on his taxable income. To avoid the underpayment penalty, the taxpayer must have $6,750 ($7,500 x .90) in federal taxes withheld from his paychecks. If the taxpayer pays a housekeeper $3,000 in wages during the year, he would be required to withhold $229.50 in FICA from the employee's paychecks and pay $229.50 in matching FICA (assuming the same FICA rates in 1997). The taxpayer's total tax liability for the year would increase to $7,959: $7,500 in federal income taxes on his own income plus $459 in FICA taxes for his household employee. To avoid an underpayment penalty, the taxpayer would have to increase the withholdings on his own paychecks to $7,163 (.90 x $7,959) or make quarterly estimated payments to pay the additional tax.
Advance Payments of the Earned Income Credit
The Social Security Domestic Employment Reform Act of 1994 did not change the rules affecting advance payments of the earned income credit. An employee who is eligible for advance payments can file a certificate with his employer requesting the payments. Form W-5 is used as the earned income credit advanced payment certificate. The employer must make the advance payments by adding them to the employee's paycheck each pay period once the certificate is in effect. The amount of the advance payments the employer is required to make in each period is determined by the employee's wages for the period and in accordance with tables provided by the IRS.
The advance payment of the earned income credit does not change the amount of FICA tax that must be withheld from an employee's wages. An employer treats the aggregate amount of advance payments as a reduction of the withholding taxes and FICA that he must remit to the federal government. If the total of the advance payments exceeds the total of the employment taxes, the employer can reduce the amounts of advance payments made to all eligible employees or treat the advance payments as an advance payment of any other tax he owes. An employer is permitted to stop advance earned income credit payments to employees whose earned income exceeds $10,000 for the calendar year.
Record Keeping Requirements of the Domestic Service Employer
Although the 1994 Act reduced the tax burden and simplified the tax reporting for some household employers, it did not eliminate the requirement that an employer must keep records for each covered employee. The records must be kept for at least four years after the due date of the return or the date the tax is paid, whichever is later, and must include the employer's identification number (EIN).
Household employers need an EIN to file Forms W-2 and Schedule H. An employer identification number can be obtained by filing Form SS-4, Application for Employer Identification Number. Although a note at the top of page 2 of the instructions to Form SS-4 states that household employers need not file Form SS-4, that note should be disregarded for 1995.
The employer's records should also contain copies of returns filed including dates and amounts of payments made; the name, address and social security number of each employee; dates of each employee's employment; copies of each employee's Form W-4 and W-5; amounts of FICA collected; and, if applicable, the reason why the amount of wage payment and amount subject to FICA, FUTA or federal tax withholding are not equal.
An employer is responsible for providing each employee with a Form W-2 by January 31. If an employee stops working before the end of the year, the employer can give him the W-2 at any time after employment ends but no later than January 31 of the following year. An employer must also send a copy of the Form W-2 to the Social Security Administration's (SSA) Data Operations Center in Albuquerque, New Mexico, by February 28. If the employer had only one employee during the calendar year, he can send the SSA just Copy A of Form W-2. If he had more than one employee the previous year, he must remit Form W-3 with the Copy A.
Employers are also required to provide written notice to employees that they may be eligible for a refund because of the earned income credit. Employees who receive W-2 forms have the notices included on the back of the form. Employees who do not receive W-2 forms must be given or sent a copy of Notice 797.
1 "Inman May Have Problems Resembling Zoe Baird's," Wall Street Journal, December 21, 1993, A 14.
2 Jasen, Georgette and Tom Herman, "Is There a Way Around the Nanny Tax?" Wall Street Journal, February 12, 1993, C1.
3 Reg. Sec. 31.3402(1)-2(a)
4 Reg. Sec. 31.3401(a)(3)-1(a)(2)
5 Reg. Sec. 31.3121(d)-1(c)(2)
6 Code Sec. 3506(a)
7 Code Sec. 3102
8 Code Sec. 3121(a)(7)(B)
9 Code Sec. 3121(b)(21)
10 Code Sec. 3121(b)(3)
11 Code Section 3510(a)(1)
12 Code Sec. 3510(e)
13 Code Sec. 3510(b)(4)
14 Code Sec. 3306(b)
15 Code Sec. 3302
16 Code Sec. 3306(c)(2)
17 Reg. Sec. 31.6071(a)-1 and 31.6011(a)-3(a)
18 Code Sec. 3510(a)(2)
19 Code Sec. 3510(b)(1)
20 Code Sec. 6654(d)(1)(B)
21 Code Sec. 3507(a)
22 Code Sec. 3507(c)(1)
23 Code Sec. 3507(d)(2) and (3)
24 Reg. Sec. 31.3507-1(b)
25 Reg. Sec. 31.6001-2(b)
26 Reg. Sec. 31.6001-1(e)
27 Code Sec. 6051(a) and Reg. Sec. 31.6051-1(b)(1)
28 Reg. Sec. 31.6051-2
29 Reg. Sec. 31.6051-1(h)(3)
Hans J. Dykxhoorn, PhD, CPA, and Kathleen E. Sinning, PhD, are professors of accounting at Western Michigan University in Kalamazoo.
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|Author:||Dykxhoorn, Hans J.; Sinning, Kathleen E.|
|Publication:||The National Public Accountant|
|Date:||Jan 1, 1996|
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