Side-Stepping the Nanny Tax: What are the Downsides?

A physician who is having trouble finding a nanny who is willing to be paid "on the books" wants to know the downsides of not paying the so-called nanny tax.

Q: Many nannies we’ve interviewed want to be paid off the books. What are the downsides?

A: Doctors who depend on an in-home caregiver for their children or a parent should be paying the so-called “nanny tax.” In reality, though, most don’t: Household-employment data for nannies and other domestic workers show tax payments on the decline, according the most recent Internal Revenue Service reports. (This is during a time when the number of domestic workers were actually increasing.)

There are two main barriers to compliance, say experts -- paying the tax is expensive and wading through the tax code to figure out what you owe can be a pain. (Tip: If the nanny is your spouse, your parent, a dependent child under age 21, or a non-family member under 18, you’re off the hook for the nanny tax.)

The reason workers often demand to be paid "off the books" is obvious: In competitive markets they can ask for higher wages, and keep more of their salary. Often, workers want to avoid having their income reported due to their immigration status. But by not being paid on the books, these workers lose out on federal and state benefits, such as Social Security and unemployment insurance. (Ironically, household employers are often caught when former workers apply for benefits they aren't entitled to receive because nanny taxes weren't paid.)

For employers, the penalty for not paying the tax can be steep — employers who are caught must pay both the nanny's share and the employer's share of back payroll taxes, plus interest and penalties.

The nanny tax is actually a couple of taxes. The biggest is FICA, which includes both Social Security and Medicare taxes. If you paid a nanny, cleaning lady or other domestic worker more than $1,700 last year, you owe FICA taxes. (The pay threshold is the same in 2010.) FICA taxes are 15.3 percent of wages. As the employer, you’re supposed to pay half of this amount (7.65 percent) and withhold the other half from the employee’s wages. If, like most people, you pay the worker in cash and don’t withhold any FICA taxes, you pay the full 15.3 percent.

There’s more. The first $7,000 in wages that you pay your nanny is subject to the Federal Unemployment Tax (FUTA), but only if you pay total cash wages of more than $1,000 in aggregate in any one calendar quarter. The FUTA rate is a hefty 6.2 percent and, while you may get credit for any state unemployment taxes, you will still have to pay it in full.

To figure out your nanny-tax payment, this calculator from SmartMoney.com can help. If you’d prefer not to deal with all the calculations and paperwork some companies, such as Breedlove and HomeWork Solutions, have made a business out of helping harried employers deal with the nanny tax. Finally, you can find more information about the nanny tax from this IRS guide.

There is financial help available to ease the pain of paying the nany tax. You can save with pre-tax dollars using a flexible spending account for up to $5,000 in eligible child or elder care expenses each year. Barring that, you may qualify for the federal dependent care tax credit.a