Despite the past publicity about the “nanny tax, many people with household employees still pay their babysitters and housekeepers in cash, without withholding taxes or filing the correct forms. This is because oftentimes the household employee specifically requests cash and the employer wants to avoid the related paperwork. There are probably many instances where one might assume a low-income worker is not required to file a return (and, thus, does not need a form W-2) or employers want to save employment taxes by paying compensation “under the table.”

A taxpayer who paid a household employee more than $1,400 in cash wages in 2003 most likely owes the nanny tax. Even if annual compensation is expected to be less than the threshold for withholding, tax should be withheld—the employer can later refund the withheld taxes if the worker does not meet the filing threshold.

Individuals who employ household employees should be aware of the following two issues:

Earned Income Credit

Many low-income employees are discovering they can claim the earned income credit (EIC) based on their household wages. Most who learn about it will immediately request a form W-2 from their employers, even if they previously agreed no tax forms would be filed.

The EIC is treated as a tax payment; any excess over the employee’s tax liability is refunded. Refundable credits can be significant and provide quite an incentive for an employee to report wages on form 1040.

In this situation, one may face the following additional costs:

• FICA tax. Normally, an employer pays half (7.65%) of FICA and withholds the other half from the employee’s wages, under IRC sections 3101(a) and (b) and 3111(a) and (b). However, if no taxes were withheld, the employer is liable for the entire 15.3%.
• FUTA. Under section 3306(b) an employer generally pays FUTA on the first $7,000 of an employee’s annual wages, at a rate that can be as high as 6.2% of taxable wages.
• State unemployment taxes. These rates vary depending on the state and the employer. Also, the state most likely will assess interest and penalties for late filing.
• Underpayment penalties. FICA and FUTA are reported on an employer’s personal income tax return and deemed part of the employer’s personal income taxes. Thus, if the employer’s taxes were underpaid because employment taxes were omitted, the IRS may assess underpayment penalties and interest.
• Form W-2 penalties. An employer’s failure to timely file an employee’s form W-2 each year may result in a per-form penalty up to $50, under section 6722.

Household employee Files for Unemployment

There may be instances where a household employee might file for unemployment compensation, even though he or she never received a Form W-2. This most likely will result in an inquiry by the state’s unemployment or workforce commission, thus exposing the employer to unpaid state taxes, penalties, and interest.