You finally found the right person to welcome into your home to help care for your loved ones. Before you breathe a sigh of relief, you should consider a related item on your to-do list: payroll taxes.
When you hire a household worker, you may be required to withhold and remit payroll taxes from each paycheck—taxes collectively referred to as the nanny tax. Required taxes include Social Security and Medicare (FICA). You may also need to withhold and pay federal and state income taxes as well as local taxes, depending on where you live.
Some household employers find it tempting to pay their nanny or caregiver cash—which is legal if you pay and submit the required payroll taxes each payday. Other household employers consider the more problematic option of paying a household employee under the table, or paying the employee cash without making the required legal deductions.
Neither option is likely to make your life easier.
4 Risks to Paying Your Household Employee Under the Table
Under tax law, your nanny is considered a household employee because you control what work he or she will do or set requirements on how that work will be done. With that control comes payroll and other tax obligations.
Here are four risks to paying your household employee without making the required legal deductions.
Risk 1: IRS Penalties & Fines
Getting caught paying your household employee under the table could trigger an IRS audit—a time-consuming, intrusive, and frustrating process—that could lead to penalties, fines, and possible legal action.
You could face failure-to-pay and failure-to-file penalties that could total up to 50% of your unpaid taxes, plus back wages if you did not meet minimum wage and overtime requirements. You may also face state penalties for failing to pay unemployment insurance and provide workers’ compensation. Plus, you could incur fines for misclassifying an employee.
Risk 2: Lost Dependent Care FSA Savings
Families can save up to 30% on qualified out-of-pocket dependent care services by paying their household employee properly, thanks in part to the Dependent Care FSA.
The pre-tax dollars you contribute to a Dependent Care FSA are not subject to payroll taxes, so you end up paying less in taxes and taking home more of your paycheck. Contribution maximums for eligible participants range from $2,500 per year for married couples filing separate tax returns to $5,000 per year for married couples filing a joint tax return or for those who file as a single head of household.
Risk 3: Accounting, Bookkeeping and Possible Errors
Manually tracking hours worked, cash payments, taxes and more requires steadfast attention to detail—far more time than many household employers anticipate. Even a small error can multiply, causing considerable problems along the way.
When you pay an employee under the table, you have no official payroll records. Should your nanny, caregiver, or other household employee file a claim of any sort, you may lack formal documentation to help serve in your defense. Without documented payroll records, it’s your word against theirs.
Household employee claims could include:
- Improper pay
- Unpaid overtime
- Job-based injury, or a
- Termination dispute.
In addition, many states require workers’ compensation coverage for household employees depending on the number of hours worked, pay rate and other compensation factors. And multiple states mandate that small business owners provide employees with a retirement savings option or face potential penalties. Learn more if your state requires you to provide a 401(k)-retirement plan to your household employee.
Any work-related injury or illness suffered by a household employee could result in a workers’ compensation claim. Failure to provide workers compensation coverage when required could result in penalties and fines and possibly lead to a criminal conviction in some states.
Finally, your household employee must receive a W-2 by January 31. If they don’t, they can contact the IRS, provide their dates of employment, your contact information and an estimate for wages earned. The next time you open your mailbox, you could find an IRS notice, alerting you about back taxes and potential penalties.
Risk 4: Employee Retention
Many nannies, caregivers, and household employees expect to be paid legally. Employers who insist on paying under the table may struggle to attract experienced, professional candidates.
Paying employees under the table may contribute to a gap in their income history—a gap which could cause issues when applying for a mortgage, auto loan, or other major credit-based purchase. In addition, they may lose payroll contributions to Social Security, Medicare, and unemployment.
These financial security lapses can create frustration and resentment, leading to higher turnover and family care instability. A frustrated employee may also be more likely to report you to a state or federal tax agency if they feel they were treated unfairly or illegally.
The Bottom Line
Avoiding the nanny tax isn’t worth the risk. The savings some household employers hope to gain by paying a household employee under the table are unlikely worth the risk of potential tax penalties, time-consuming wage disputes, costly legal issues, and high employee turnover.
SurePayroll® By Paychex helps you care for the people who support your household. Our payroll services calculate and pay the necessary taxes and file the appropriate deductions for Social Security, Medicare, unemployment, and state taxes. SurePayroll can also produce multiple 1040-ES filings on behalf of the household employer and provide a signature-ready Schedule H to include with your annual 1040 filing.
