The 5 Myths of the Nanny Tax
The COVID-19 pandemic accelerated the trend toward in-home care dramatically as families faced facility closures and sought viable care options that would limit exposure of the virus to them and their loved ones.
For decades, domestic employment has been plagued by unreported wages, but employees and employers had an awakening amid the crisis.
The 2020 crisis also made families and caregivers realize that most of the safety nets for caregivers are funded by the payroll system. In addition to long-term protections like Social Security and Medicare, short-term benefits like unemployment, paid sick Leave and even stimulus checks are only available to those with reported wages.
The American Rescue Plan (ARP) that was recently signed into law expanded dependent care tax breaks for taxpayers that report wages.
Here are five common myths about household employees like nannies to help you identify areas of risks and potential resolution.
Myth #1: The family can classify their employee as an independent contractor.
There is a lot of misinformation online about worker classification. This misinformation is compounded by the DOL and IRS tests, which are intentionally vague in order to serve hundreds of industries and allow adaptation over time.
As a result, many families assume that classification is simply a choice and, given a choice, calling the caregiver an independent contractor seems easier and cheaper than setting them up as an employee. The reality is both the DOL and the IRS have ruled consistently that the vast majority of domestic workers should be classified as an employee.
If a majority of your nanny’s working hours are spent with your family, they are should be classified as a household employee. If you hire a gardener or housekeeper that only shows up once a week and works for lots of other clients, they are an independent contractor.
Myth #2: The employee can be paid a salary to avoid overtime.
Nannies, senior caregivers and other household employees are considered non-exempt workers under the Fair Labor Standards Act (FLSA). That means families are generally required to pay overtime for all hours over 40 in a 7-day work week.
For domestic work, there are two potential exceptions to the overtime requirement:
Live-In Employees. Families of live-in workers are exempt under federal law. However, this is not a universal exemption because a few states require live-ins to be paid overtime, albeit sometimes at different weekly hour thresholds. “Live-in” is defined as situations where either 1) the employee permanently resides with the care recipient or 2) the employee works at least five (5) 24-hour shifts in a 7-day work week (120+ hours). In this second situation, the live-in status – and therefore the overtime requirement – can vary from week to week if the hours fluctuate.
Companion Care. For senior care, there is an exemption called the Companion Care Exemption, which allows families to avoid overtime payments if the worker’s primary function is to provide fellowship and protection. This is quantified as less than 20% of their time can be spent performing Activities of Daily Living (ADLs) such as bathing, dressing, meal prep, housekeeping, etc. The bulk of the time would be spent on social activities (playing cards, watching TV, going for a walk, etc.) and general oversight of the patient. Again, this is a federal exemption and there are a few states that have special requirements for companion care.
It’s not a “salary vs. hourly” issue; it’s an “exempt vs. non-exempt” issue. In the case of “non-exempt” domestic workers, a fixed salary is illegal if it exceeds 40 hours/week. Every hour of work must be paid and all hours over 40 in a 7-day work week must be paid at 1.5 times the regular rate of pay.
Overtime issues are particularly dangerous for families because a disgruntled former employee can file a wage dispute long after the relationship has terminated. Back wages plus back taxes, penalties and interest can make this a very expensive mistake.
The remedy is to have a working contract that details paystubs with every hour of pay documented as regular or overtime. If there is ever a wage dispute, paystubs are the employer’s best friend.
Myth #3: The employee can be paid on the practice payroll.
The IRS has ruled that household employees are not considered “direct contributors” to the success of a business. Therefore, businesses cannot include a household employee’s payroll expense on their payroll tax deduction.
Instead, it should be handled separately through the household employment reporting process. If the expense is for dependent care, the family can take the dependent care tax breaks associated with those wages, but it must be handled on their personal income tax return.
Myth #4: The family can wait until tax time to address their household employment taxes.
Unfortunately, busy families tend to think of this as “a tax thing that can be handled at tax time.” By then, unfortunately, there are usually oversights and omissions (i.e. missed state employment tax filing deadlines, incorrect withholdings, wage & hour law violations, etc.) that have grown into an expensive, time-consuming mess. To avoid these problems, families should view this as an employment matter rather than a tax matter. We strongly encourage you to use a specialized payroll system like Care.com to pay your nanny and file all the required payroll reports.
Myth #5: Paying legally is expensive
Paying “on the books” is much less expensive than most people think. Families do have employer taxes that are typically around 9-10% of the wages, but many will have access to tax breaks that can offset most of their employer-related costs. That is especially true in 2021 as both dependent care tax breaks were increased under the American Rescue Plan, as follows:
Child Care Tax Credit. The expense limit was increased from $3,000 to $8,000 for one child and from $6,000 to $16,000 for 2+ children. Additionally, the credit percentage was increased for most families, with some getting as much as a 50% credit. The percentage does start phasing out with an AGI of $125,000 and is phased out entirely with an AGI above $440,000.
Dependent Care FSA. The expense limit was modified from $5,000 per family per year to $10,500 per family per year.
As a result of these changes, most families will see their tax breaks for care-related expenses at least double and some will see them at least triple, and find it significantly cheaper to pay legally – and take advantage of the tax breaks – than to pay under the table. This budgeting calculator will help you run specific scenarios.