Hidden Benefits of the ‘Nanny Tax’

By Jo Ann M. Pinto and Joseph L. Li Pari

In Brief

Compliance Need Not Be Costly

Even dutiful taxpayers deserve forgiveness for shuddering at the mention of the maligned, misunderstood “nanny tax,” the various federal and state taxes that employers of a nanny, babysitter, gardener, maid, chauffeur—any form of household help—are required to withhold. Because the likelihood of being caught is perceived as slight, many household employers and employees alike decide that there is little to be risked and much to be saved by not filing.

The authors, however, point to a case which demonstrates that the perceived downside of paying the employment tax might be significantly offset through options such as an employer-sponsored flexible spending account or a Form 2441 credit. For the “nannies” themselves, the benefits of tax-free income will often be offset by filers’ eligibility for the earned income credit, eligibility for the Hope or lifetime learning credits, or strengthened case for citizenship.

In recent years, the so-called nanny tax has received much bad press—witness a Wall Street Journal piece entitled “The Hand That Taxes the Cradle”—obscuring the responsibility incumbent upon all employers, even when the workplace is the household. The “nanny tax” refers to the various federal and state taxes that must be withheld, paid, and reported for domestic employees. Given the out-of-pocket expenses associated with these taxes and the additional costs of complying with several federal, state, and in some cases, local tax laws, many nanny employers take the path of least resistance: They simply dole out the nanny’s wages at the end of each work week—in cash off the books. It appears to be a win-win situation: The employer avoids paying taxes that typically total around 12% of the nanny’s gross wages while the nanny receives “tax-free” income. The practice of avoiding taxes on the wages of household workers appears to be widespread; many simply believe they will never be caught.

However, the 1993 Zoe Baird case underscored the larger costs of noncompliance. Baird’s U.S. attorney general nomination was effectively derailed when her failure to report and pay taxes on the wages of a Peruvian couple whom she had hired to perform domestic services was uncovered. Both Baird and her husband, also an attorney, should have known better; as should all high-net-worth individuals, many of whom employ nannies or other domestic help. Practitioners with high-net-worth clients should consider this opportunity to enhance tax compliance while adding value to the client relationship.

A Case Study

The Zoe Baird scandal did not go unnoticed by members of the legal community. Upon hiring a nanny in 1994, an attorney who had practiced law in both the public and private sectors engaged the authors to file all the necessary forms to establish him as a bona fide employer of household help. As an employer, he would also be responsible for withholding federal and state payroll and income taxes from the nanny’s wages. Although assuming the responsibility for paying the employer’s portion of the various taxes shown in Exhibit 1 would add more than $1,000 to his childcare expenses annually, as an attorney he understood that it was the right thing to do.

At year end, as a favor to his nanny, the client also engaged the authors to file her Form 1040. What pleasantly surprised the client, the nanny, and the authors was that the benefits of complying with the law actually outweighed the costs. (Exhibit 2 summarizes the nanny’s tax situation after filing Form 1040. As a word of caution, this scenario reports the total effect while using New Jersey taxes for the state component. Because the authors continued to prepare the attorney’s and nanny’s tax returns for several years after the “discovery,” 1999 tax rates are used for the computations in the illustration.)

The client also benefited from compliance through an employer-sponsored flexible spending account (FSA), which allows up to $5,000 a year of tax-free income to be channeled into a dependent care spending account (Exhibit 3 illustrates the client’s tax situation). In 1999 the net gain to both parties totaled $1,251.25, less compliance costs.

Benefits for the Nanny

Although the results in Exhibits 2 and 3 apply only to the individuals in question, their situations may be applicable to large segments of the population. Here’s why. In the United States, a nanny generally tends to come from one of three demographic groups: the “working poor,” students, or recent immigrants.

The authors’ evidence, though not scientific, is corroborated by anecdote and the related experiences of dozens of friends, colleagues, and high-net-worth clients. Due to the incidence of nonreporting, any official statistics on the matter might not be any more accurate than anecdote. Nannies belonging to one of these demographic groups should have strong incentives to file tax returns that report their earnings from domestic services.

As seen in the case above, the working poor can significantly boost their income by filing Form 1040 and applying for the earned income credit (EIC). While not all members of the working poor have dependent children, many do. The definition of “qualifying child” for the purposes of the EIC extends to natural children, grandchildren, stepchildren, adopted children, and even foster children. In addition, qualifying children can be up to 23 years of age if they are full-time students. In 1999, the EIC reached a maximum of $3,816 for taxpayers with two or more qualifying children.

Students should be interested in filing Form 1040 in order to reap the benefits of the Hope or Lifetime Learning Credits. These credits may be especially beneficial to students whose parents are unable to take the credit because their modified adjusted gross income exceeds $50,000 ($100,000 for married filing jointly). In such cases, the credits can be used by the students themselves. However, unlike the EIC, which is a refundable credit, the Hope and Lifetime Learning Credits are nonrefundable and can therefore only be used to offset tax liabilities.

The third segment of the population that has traditionally supplied the nanny labor pool, recent immigrants, should also have strong incentives for declaring their wages. The Immigration and Naturalization Service (INS) requires that tax returns for several years be presented when petitioning for U.S. citizenship. Failure to produce these documents could result in a denial of the application, so filing returns while working as a nanny can only help a bid for citizenship.

Nannies also benefit in a larger sense when their participation in the workforce is documented and all payroll taxes are paid or withheld on their behalf. The ability to collect various potentially valuable benefits such as unemployment compensation, Social Security benefits, and disability pay are all linked to payroll contributions. Being on the books also adds to an employment history, strengthens credit, and opens up possibilities for future employment.

Benefits for the Employer

Obviously, an employer of a nanny should comply with the filing requirements for one simple reason—it’s the law. Fortunately, there is also a strong financial case for compliance.

In the previously mentioned case, the client was fortunate enough to work for a firm that offered an FSA for dependent care purposes. Under current law, employees can funnel up to $5,000 per year of their earnings, before all federal taxes, into an FSA. The tax savings varies by bracket; for high-net-worth individuals in the top marginal bracket of 39.6%, the total tax savings can be as high as $2,363, including FICA savings. Not only does participation in an FSA plan help cover the costs of childcare directly, it also produces an indirect benefit: It reduces adjusted gross income (AGI). Many other types of tax-deductible items, such as IRA contributions, deductible rental losses, and miscellaneous personal itemized deductions, are a function of AGI. A lower AGI increases the tax benefit of these related deductions.

Taxpayers that do not have an employer-sponsored FSA have the option of claiming a credit for childcare expenses on Form 2441. Although the tax benefit derived in this case is usually lower than under an FSA, it can still range from $480 to $1,440, depending upon income and number of children—enough to underwrite a major portion of the employer’s payroll tax expense. However, in order to claim either type of childcare credit, one must furnish the IRS with the name and Social Security number of the nanny. This information can be cross-referenced by the IRS to the nanny’s tax return, so it is important that the nanny also file a Form 1040.

Facilitating Compliance

Complying with the federal portion of the taxes was facilitated in 1995 with the introduction of Schedule H, which eliminates the need to file quarterly federal payroll tax forms for wages of household employees. Schedule H filers can simply compute and pay all federal payroll taxes annually when they file their Form 1040.

For those truly short on time, even simpler reporting options exist. A number of companies offer nanny tax filing services. For fees ranging from around $30 to $45 per month plus set-up costs, an employer of domestic workers can simply delegate the record-keeping and reporting tasks—and even the preparation of the payroll checks—to services such as NannyTax, Inc., or GTM Associates (See Exhibit 4).

Careful tax planning on the part of both employer and employee can ease the compliance burden of the nanny tax. CPAs can help in this process by making their clients aware of the hidden benefits of complying with the law. For CPAs with a number of high-net-worth clients employing domestic help, nanny tax filing services could be a substantial practice opportunity.


Jo Ann M. Pinto, PhD, CPA, and Joseph L. Li Pari, CPA, are assistant professors of accounting at Montclair State University in New Jersey.


Note: The nanny’s federal tax calculation was based upon the following facts: 1) her filing status is head of household; 2) she claims her 13-year-old grandson, whom she legally adopted, as her dependent child; 3) she is over 65 years old and therefore qualifies for an addition to her standard deduction of $1,050. The nanny’s only other source of income was her old age Social Security benefits, which total $6,222 per year. In 1999 the maximum amount of earnings an individual aged 65–69 could earn without forfeiting Social Security benefits equaled $15,000; the limit was repealed effective in 2000 by the Senior Citizen’s Freedom to Work Act of 2000.



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