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Navigating the revised nanny tax.

It "decriminalized baby-sitting," according to Senate Finance Committee Chairman Daniel Patrick Moynihan.(1) Others were less flattering in their analysis, saying it expelled "tens of thousands of the most miserably compensated workers" from the social security network.(2) Whatever else it does, the Social Security Domestic Employment Reform Act of 1994 (the "Act") will undoubtably affect millions of households and domestic workers.

Before its revision, the so-called "nanny tax" required households paying housekeepers and baby sitters more than $50 in a calendar quarter to withhold, pay and report Social Security and Medicare tax (FICA) on those wages and unemployment tax (FUTA) if wages in aggregate were $1,000 or more in any calendar quarter. Failure to comply with this requirement had a disturbing effect on the careers of several prominent government appointees and, after extensive media coverage, Congress moved quickly to revise what it considered to be an overly burdensome law. Essentially the Act, signed by President Clinton on October 22, 1994, increases the amount of wages that can be paid to a domestic worker before payroll taxes are required, establishes a minimum age under which domestic workers are not subject to payroll taxes, and simplifies reporting payroll taxes for domestic workers.

Who Is Subject to the Nanny Tax?

The nanny tax is a common term referring to four potential tax obligations faced by homeowners who hire employees to perform domestic services: FICA, FUTA, income tax withholding and advance payments for the earned income credit. Although less cumbersome than prior law, the new nanny tax is far simple. Understanding the tax requires perspective on how it interrelates with payroll taxes in general and a knowledge of how its several exceptions work. The flowchart with this article maps the provision's relationship to other employee payroll situations and to independent contractor status. It is a guide for determining when the nanny tax applies and what tax obligations are triggered by its rules.

Business or Personal?

Any time wages are paid to a worker in the employer's home, the nanny tax may apply. However, if the wages are paid for services provided on behalf of the employer's trade or business, it is not the nanny tax that applies but rather the normal business reporting rules.

Example: Joe paid Fran $1,800 in 1994 to assemble cellular phones in Joe's living room. Joe sells these cellular phones at the local swap meet. Fran is working for a business and is not subject to the nanny tax. Fran is, however, subject to the normal payroll tax requirements that apply to people working for a trade or business.

Example: Joe paid Lori $1,800 in 1994 to watch his children while he worked on his cellular phone business. Lori is not working for a business and may be subject to the nanny tax.

Employee or Independent Contractor?

An employer paying wages to an independent contractor (whether or not the services are provided in the employer's home) is generally not responsible for payroll taxes or for payroll tax reporting. If the independent contractor is providing services to the employer's trade or business and the payments are over $600 during the year, the employer is responsible for reporting the payments on Form 1099.(3) If the independent contractor providing services for non-business projects at the employer's home, then no reporting is required.

The determination of whether a worker is an independent contractor or an employee involves statutory rules and 20 common law factors developed by the IRS. The 20 common law factors are nearly always the sole criteria used for work done in the employer's home and generally provide that every individual who performs services subject to the will and control of an employer, as to both what must be done and how it must be done, is an employee. It doesn't matter that the employer allows the employee to act freely without direct supervision as long as the employer has the legal right to control both the method and the result of the services.(4)

Example: Mary hires a handyman to make repairs around her house on a regular basis during the year. The handyman supplies his own tools and materials, sets his own hours and determines the best way to make the repairs. The handyman is an independent contractor.

Example: Mary hires a worker to clean the yard and house on a regular basis during the year. Mary provides the cleaning supplies and directs the worker on what and how to clean. The worker is an employee.

If the employer is paying wages to an employee of his or her business (whether or not the services are in the employer's home), the employer is required to comply with normal payroll tax requirements and withhold income tax and FICA tax from the employee's wages and to contribute FUTA and additional FICA tax on behalf of the employee.(5)

If the wages are paid to an employee for services in the employer's home and the services are not in connection with the employer's trade or business, either the nanny tax or other special reporting tax requirements may apply depending on whether the services are "domestic services" or "casual labor."

Domestic Service Versus Casual Labor

Payroll tax requirements for workers providing services in the employer's home that are not for the employer's trade or business depend on the type of services provided. Domestic services are potentially subject to the nanny tax, whereas casual labor is subject to more stringent employment tax requirements.

Domestic services are defined as services of a household nature including services performed by cooks, waiters, butlers, housekeepers, governesses, maids, valets, baby sitters, caretakers, gardeners, grooms and chauffeurs. The services must occur in and about the private home of the employer. A private home also includes a second home, apartment, hotel or similar establishment if used as an abode of the employer.(6)

Casual laborors--employees such as a private secretary, tutor or librarian--are not subject to the so-called nanny tax but instead are subject to even more burdensome rules. Wages for casual labor are subject to FICA on cash compensation of $100 or more per calendar year. Casual labor is subject to FUTA and income tax withholding if the employee receives $50 or more in cash in a calendar quarter and works 24 or more days in that quarter or in the preceding quarter.(7)

Domestic Workers Supplied by Agencies

All domestic service workers who qualify as employees are subject to employment tax provisions; however, this does not mean that the homeowner is automatically responsible for withholding and reporting. If the domestic worker is supplied by an agency which sets and collects the fee, pays the worker and exercises control over the worker, the agency is responsible for employment taxes and reporting. If, however, the agency merely provides a list of workers without exercising control, then the homeowner remains the legal employer and is potentially subject to the nanny tax provisions.(8) Although using an agency rather than directly hiring the worker effectively transfers the employment tax burden from the homeowner, it is generally more expensive.

Nanny Taxes and Exceptions

Households employing workers who provide domestic services must be concerned with four tax obligations: FICA, FUTA, income tax withholding and advance payment of the earned income credit.

FICA

The Act increases the FICA wage threshold for domestic service in a private home to $1,000 per year for services performed after December 31, 1993.(9) FICA wages for domestic service only include cash wages.(10) If FICA was paid on 1994 wages and the wages were less than the retroactive $1,000 threshold, refunds of 1994 FICA taxes will be given.(11) However, the employer is still required to file a 1994 Form W-2 for the employee to report the 1994 FICA paid. The employee will be given credit for 1994 social security coverage even though receiving a refund of 1994 FICA taxes.(12) The $1,000 FICA threshold will be indexed for inflation beginning in 1996.(13)

Example: Joe paid Mary $750 in cash and $800 in other property during 1994 for housekeeping services. He properly paid FICA of 15.3% on the $750 of cash wages during the year. Joe is entitled to a refund of the FICA paid in 1994. If Joe withheld FICA from Mary's 1994 wages, he must refund the withheld FICA to Mary. Joe must file a Form W-2 for Mary's 1994 wages showing the entire $750 as social security wages. Mary will receive credit for $750 of 1994 social security wages.

FICA taxes have been eliminated for domestic service workers who are under 18 years old for any part of the calendar year beginning in 1995 unless the employee's principal occupation is domestic service.(14)

Example: Joe pays Mary $750 in cash and $800 in other property during 1995 for housekeeping services. Mary is a full-time student and turns 18 years old on January 15, 1995. No FICA is due on Mary's wages since she is under 18 years old for part of 1995 and domestic services are not her principal occupation.

Example: Joe pays Mary $750 in cash and $800 in other property during 1995 for housekeeping services. Mary works full-time providing housekeeping services to private homes. She turns 18 years-old on January 15, 1995. FICA is due on the $750 of Mary's cash wages. Although she is under 18 years-old for part of 1995, FICA is due because providing domestic services is her principal occupation.

FICA taxes are not due for domestic services if the employee is the employer's spouse, the employer's child under 21 years old or the employer's parent (with one exception). The employer's parent is subject to FICA for domestic service cash wages if: 1) the parent cares for the employer's child (living at home) who is either under 18 years old or requires the care and supervision of an adult for at least four continuous weeks during the calendar quarter in which the service is rendered; and 2) the employer is divorced, widowed or has a spouse incapable of caring for the child.(15)

Example: Joe paid his mother $1,800 cash evenly throughout 1994 to babysit Joe's eight-year-old daughter because both Joe and his wife work full-time. FICA taxes are not due on the mother's wages. If Joe were widowed or if his spouse was not capable of caring for the daughter during 1994, then his mother's wages would be subject to FICA.

FUTA

FUTA coverage was not changed by the Act. FUTA tax is applied to wages of domestic service employees if the aggregate cash wages paid by the employer to all domestic service employees is $ 1,000 or more during any calendar quarter of the current or preceding calendar year.(16)

Example: Susan paid $800 in cash to her housekeeper, Jim (20 years old), and $400 to her at-home babysitter, Martha (19 years old), during the first quarter of 1995. No other domestic service wages were paid by Susan during 1995. None of the cash wages are subject to FICA since less than $ 1,000 of cash wages were paid to any one domestic service worker during 1995. All of the wages ($ 1,200) are subject to FUTA since the total wages are more than $ 1,000 and were paid in one calendar quarter.

Income Tax Withholding

There is no requirement for an employer to withhold federal income tax on wages for domestic service in a private home (provided the house is not used primarily to supply board or lodging as a business enterprise) unless both the employee and employer agree.(17) A domestic service worker can request his or her employer to withhold federal income taxes by giving the employer Form W-4, Employee's Withholding Allowance Certificate. If an employer and employee agree to withhold income taxes, both cash and non-cash wages are subject to withholding.(18)

Advance Payment of the Earned Income Credit

An eligible employee (including a domestic service employee) who has a qualifying child is entitled to receive advance earned income credit (EIC) payments with his or her pay during the year. To get the advance EIC payments, the employee must:

* have a qualifying child as defined on Form W-5;

* have an expected earned income and adjusted gross income (including the spouse's income) of less than $23,755 (1994 amount); and

* expect to qualify for the EIC when filing their tax return.

Advance EIC payments are paid first from income tax withholding, second from withheld FICA and third from the employer's share of FICA. If advance EIC payments are more than the payroll taxes due, then the employer has the option of either reducing the EIC advance payments or making the excess payments and considering them a prepayment of employment taxes.(19)

It is important to note that employers (including those who employ domestic service workers) are required to notify employees that have no income tax withheld and do not claim "exempt" on Form W-4 that they may be able to claim a tax refund because of the EIC. The notification requirement can be met by giving each employee the official IRS Form W-2, which contains the notification on the back of Copy C; by giving each employee Notice 797, Possible Federal Tax Refund Due to the Earned Income Credit (EIC); or by giving each employee a written statement that has the exact wording of Notice 797.(20)

Reporting and Collecting Nanny Taxes

The Act creates a simplified reporting and payment system for FICA, FUTA and withheld income taxes on wages paid to domestic service workers after December 31, 1994. Most people who employ domestic service workers will report and (until 1998) pay any FICA, FUTA and income tax withholding with their own federal tax returns on April 15.(21) The Act authorizes the IRS to revise Federal Form 1040 to accommodate the new system.(22) Beginning in 1998, most employers of domestic service workers will continue to report payroll taxes on their federal Form 1040 but will be required to treat payroll taxes as taxes subject to the underpayment of estimated tax penalty.(23) This means that employers of domestic service workers will have to include nanny taxes as part of their overall federal tax liability for purposes of estimating their own withholding and quarterly tax payments. Employers who are not otherwise subject to wage withholding or to making estimated tax payments will not have to make estimated tax payments simply because of the nanny tax.(24)

Example: Joe is not an employee so he does not have wage withholding. His federal income tax liability for 1998 is $200. Since this is less than the $500 minimum amount for making estimated tax payments, Joe would not otherwise be required to make estimated tax payments. If Joe hires a housekeeper who in 1998 generates an FICA, FUTA or income tax withholding liability, Joe is not required to begin making 1998 estimated tax payments.

The Treasury has been authorized to write regulations that would require an employer of domestic service workers--who is also a sole proprietor with employment taxes related to the sole proprietorship--to combine all payroll tax reporting and payments under the normal payroll tax requirements.(25)

Summary

For better or worse, the payroll tax system for domestic workers has changed. The changes should be welcomed by households employing babysitters and housekeepers because the payroll reporting requirements have been greatly simplified. Tying reporting and payment to the employer's Form 1040 and regular estimated tax payments shifts a large part of the compliance responsibility to the family's professional tax preparer. This will likely boost compliance and payroll tax revenues in general. Because of recent high profile cases involving the nanny tax, most taxpayers who employ domestic workers are eager to avoid problems and will welcome a simple, convenient payroll tax system for domestic workers.

Domestic service workers may have mixed feelings about the new provisions. Fewer housekeepers and babysitters will be eligible for social security coverage with the higher threshold limit. For example, a housekeeper who earns $900 per year at each of 10 separate households will not be eligible for social security even though her total annual wages are $9,000. The children of the parents who employ her can earn as little as one dollar working at a fast food outlet and still earn social security credits. On the other hand, many domestic service workers avoid paying tax on wages because their employers do not report the wages to the IRS. With the new system increasing compliance by employers, more housekeepers and babysitters may be forced to report income and pay taxes.

Tax preparers must be aware of the new provisions in order to properly prepare the returns of clients employing domestic service workers. Beginning in 1995, preparers will have to make reasonable inquiries about their client's domestic hiring practices. This could be a sensitive area for many clients given that some housekeepers may be illegal aliens. Because of the extensive use of housekeepers, babysitters and other domestic help, however, tax practitioners must become familiar with these rules and advise their clients on how to properly comply with the new provisions.

Footnotes

(1) Kirchheimer, B. end J Godfrey. 1994. Nanny Tax Bill Wins Passage; GATT, Expiring Provisions Less Fortunate. Tax Notes 65 (October 10): 143-144.

(2) Linder, M. 1995. What Hath Zoe Baird Wrought? The New FICA Amendments on Domestic Service Employees. Tax Notes 66 (January 2):113-118.

(3) IRC Sec. 6041A(a).

(4) IRS Publication 937, Employment Taxes and Information Returns.

(5) Reg. 31.3402(a)-1(b); IRC Sec. 3101(a); IRC Sec. 3101 (b); IRC Sec. 3111 (a); IRC Sec. 3111(b); IRC Sec. 3301.

(6) Reg. 31.3121(a)(7)-1(a)(2).

(7) IRS Publication 937, Employment Taxes and Information Returns.

(8) IRS Publication 926, Tax Information for Household Employers.

(9) IRC Sec. 3121(b)(7)(B); IRC Sec. 3121 (x); Social Security Domestic Employment Reform Act of 1994 Sec. 2(a)(3)(A).

(10) IRC Sec. 3121(a)(7)(A)

(11) Conference Report 103-842, p. 13.

(12) Social Security Domestic Employment Reform Act Sec. 2(a)(4)

(13) IRC Sec. 3121(x)

(14) IRC Sec. 3121(b)(21)

(15) IRC Sec. 3121(b)(3)

(16) IRC Sec. 3306(c)(2)

(17) IRC Sec. 3401(a)(3); IRC Sec. 3402(i); Reg. 31.3401(a)(3)-1(a)(1); Reg. 31.3402(i)-2

(18) IRC Sec. 3121(a)

(19) IRS Publication 15, Circular E, Employer's Tax Guide

(20) IRS Publication 15, Circular E, Employer's Tax Guide

(21) IRC Sec. 3510(a), IRC Sec. 3510(b), IRC Sec. 3510(c)

(22) Conference Report, p. 10, Report 103-842

(23) IRC Sec. 3510(b)

(24) IRC Sec. 3510(b)(2)

(25) IRC Sec. 3510(d)

Tom Dalton is a professor in the School of Business Administration at the University of San Diego.
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Date:Nov 1, 1995
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