8 Ways to Avoid a Nanny Tax Nightmare

Want to know how people who pay domestic helpers under the table get caught for dodging the IRS? They run for office. Or get put on a list of potential nominees for a high-profile cabinet position.

At least that's what brought into spotlight the tax laws related to employing domestic workers -- as in, there are actually laws about this stuff: In the early 1990s, we were reminded that if you hire a home helper that qualifies as your "employee" (according to IRS rules) but fail to pay employment taxes, your nomination for U.S. attorney general is pretty much toast.

So learned Zoe Baird, Bill Clinton's nominee for the position, when it was discovered that she and her husband had employed undocumented immigrants as domestic workers and -- on top of that hot-button issue -- failed to pay employment taxes.

Baird's name was subsequently crossed off the short list, as was Clinton's second choice for the job for similar reasons.

The term "nannygate" entered the popular lexicon and eventually Janet Reno (who had no children and, evidently, did her own dishes and yard work) was confirmed.

"But everybody's doing it!" is not a good excuse in courtPerhaps you don't have political aspirations. Or you don't often apply for jobs where potential employers comb through your tax returns and probe into your household staffing business. Most people don't, and maybe that's why it's estimated that 75% to 95% of people who employ nannies, sitters, housekeepers, and home health aides don't bother paying employment taxes.

Still, it is the law. And even if the prospect of getting caught is slim, no one wants to intentionally run afoul of the IRS.

So, you need to figure out if the helpers you hire qualify as employees:

First, the good news: Your spouse, your parents, your child under the age of 21, and the neighbor's kid who is under the age of 18 generally aren't considered formal "employees" in the IRS's eyes, even if you pay them cash (on top of your deep gratitude and undying love) and they do the work of a small army.

Now, the other news: With respect to complete strangers, acquaintances, friends, and people who are old enough to vote: If in 2015 you pay someone $1,900 or more annually for household help, pay them directly (and not through an agency), dictate when and how they do the job and provide the tools they need for the work, and they are not operating as a small business, sole proprietorship, or contractor and don't offer the same services to the general public, then you, my friend, are an "employer." And like any employer, you're responsible for paying Social Security and Medicare taxes on the wages you pay your household help. (Here's more on what qualifies someone as a household worker and the rules straight from the source, IRS Publication 926.)

The price of breaking nanny tax lawsWhile many people inadvertently (or "unknowingly") ignore the rules and pay their home helpers under the table, you're doing yourself and your employee a disservice. And if weak moral fortitude and sleepless nights caused by living a life of lawlessness aren't reasons enough to follow the nanny tax rules, perhaps the following will change your mind.

According to Sittercity.com, failure to pay employment taxes (e.g., the nanny tax) can cost on average $25,000 in penalties and interest. Not only that, but when you don't report the wages you pay, your employee has a harder time building their employment history, will have a less comfortable retirement because they won't get all the Social Security and Medicare benefits they've earned, and when you no longer need their services, they may not qualify for unemployment benefits.

8 rules to prevent a personal nannygate scandalThe goal here is to avoid doing something stupid that will trigger an IRS audit, ignite tabloid headlines, or generate an exorbitant bill from the IRS for back taxes and penalties. Here are eight things to do to keep your hiring practices aboveboard:

Make your status as an "employer" official: Establish yourself as a law-abiding employer with the state and the IRS by applying for an Employer Identification Number via Form SS-4 to use for all employee-related paperwork, reporting, and tax returns.

Decide how you will pay Social Security and Medicare taxes: Uncle Sam's cut of employment taxes is 15.3% of cash wages. You are required to pay at least half of that tab (7.65%) with your employee paying the other half. However, many employers pay the worker's share. So determine if you want to do that and let your employee know so that they can square away their share when they file their taxes. Also, find out if you are on the hook for state income taxes.

Keep good records of when you paid and how much: Depending on when you pay your employee, you might owe more in taxes. IRS rules stipulate that if you pay $1,000 or more of their salary in any calendar quarter, you'll owe federal unemployment tax (and perhaps state unemployment tax) on top of the Social Security and Medicare taxes you're required to pay.

Fill out and file the right forms: Welcome to the world of being a boss! Part of the job is making sure Uncle Sam is kept in the loop. That means completing a bunch of forms for yourself and submitting some for your employee. All of these forms are available at IRS.gov's employment tax form area:

  • Form I-9:When you hire someone, have them show you their Social Security card and fill out this form to establish their employment eligibility. If they don't have a Social Security number, they must file Form SS-5 to get one.
  • Form W-2:This is the wage and tax statement. Copy A (along with Form W-3) gets filed with the Social Security Administration. Copies, B, C and 2 go to your employee for their records and to file with their tax return.
  • Form W-3: This is essentially a summary of what you, as an employer, paid out in wages during the tax year and also amounts that were withheld for (for Social Security and Medicare). The numbers should match what is reported on the W-2 (if you had only one employee) or, if multiple people were on the payroll, the totals from all W-2 tax forms should equal the amounts reported on the W-3 statement.
  • Schedule H:This lets the IRS know which employment taxes were withheld from the employee's paychecks (if you did not cover the full amount) and which ones you paid. File it along with Form 1040 when you send in your federal tax return.
  • Form 1040:This is the basic form where you report your annual income taxes. When you file your federal tax return, attach Schedule H to this form 1040.

Pay your tax tab to the IRS throughout the year: Yes, in most cases you can pay all the taxes you owe at one time. But a better idea to avoid underpayment penalties or getting socked with a bigger-than-expected tax bill is to pay the IRS its due throughout the year. You can do this either by withholding more from your paycheck if you're earning income (via your W-4) or making estimated tax payments during the year using Form 1040-ES.

Mark your calendar for January: Just like your boss mails you a W-2 showing what you earned and what taxes were paid for the previous year, you must provide the same for your employee so they can do their taxes. You must deliver this in a timely fashion so that your employee can complete their tax return by the April deadline. As noted above, you'll also send a copy of the W-2 and W-3 to the Social Security Administration.

Don't try to dodge the issue with Form 1099: Form 1099 is how employers report what they paid to independent contractors. Trying to pass off your live-in nanny as an independent contractor isn't going to fly. IRS rules are pretty clear that nannies are almost always employees, not contractors.

Don't assume you won't get caught: Look into the future to a day when someone who worked for you files for unemployment, Social Security retirement, or disability benefits or Medicare. That's when your nonpayment into those programs may come back to haunt you. And if they do come to light, you'll be forced to pay back taxes, penalties, and interest.

The article 8 Ways to Avoid a Nanny Tax Nightmare originally appeared on Fool.com.

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