Avoiding Tax & Legal Landmines
by Tom Breedlove, Breedlove & Associates
When families become employers, they take on many of the same responsibilities that business employers do. But unlike businesses, families don’t have accounting, legal and HR departments to expertly handle all the employment details.
Having served that role for more than 20,000 families since 1992 – many of whom came to us after problems arose – we’ve made a list of the most common tax and legal mistakes made by household employers.
MISTAKE: Misclassifying the worker as an independent contractor.
If you hire an individual to work in your home and you have the right to control what, when, how or by whom the work should be performed, the IRS considers that individual to be your employee. It doesn’t matter how many hours she works, how much she is paid, or what is written in the contract – she’s an employee. Misclassifying the worker as an independent contractor (by using Form 1099) is considered tax evasion.
In addition, workers who are misclassified as independent contractors have a larger tax burden and fewer government benefits than they do if they are correctly classified as employees. To avoid tax and legal problems – and ensure that your employee receives all the take-home pay and government benefits to which she is entitled – families should follow the compliance process outlined in IRS Publication 926 (click here for the compliance checklist).
Note: The IRS recently announced a major enforcement initiative in conjunction with the Department of Labor. They are focused on collecting billions of dollars of lost tax revenue due to misclassification and have targeted several industries as major violators – one of which is the household employment industry.
MISTAKE: Failure to properly address overtime.
Nannies and other household employees are categorized as “Non-Exempt” workers under the Fair Labor Standards Act (FLSA). That means their employer is required to pay overtime for all hours over 40 in a 7-day work week (live-in nannies are generally an exception to this rule, although a few states such as Massachusetts, Maryland, New York, Minnesota and Maine have special overtime laws for live-in employees). Overtime hours must be paid at a rate that is at least 1.5 times the regular rate of pay.
Many families try to side-step overtime by offering a salary. In their minds, jobs that pay on a salary basis – instead of an hourly basis – are legally able to pay a fixed amount of wages regardless of how many hours the employee works. This is true for employees categorized as “Exempt” under the FLSA (generally, “white-collar” professionals) because workers in these types of jobs are considered “well compensated” and “generally not prone to abuse.” But it’s not true for protected workers – those categorized as “Non-Exempt” workers. In other words, it’s the type of job – not the type of pay – that determines overtime requirements. In the case of household workers, families must make sure to properly address overtime pay.
Note 1: If the worker and employer agree to a “salary” based on a schedule that regularly includes more than 40 hours, the family should protect themselves by addressing overtime in an employment agreement that is signed by the employee. For example, let’s say a family and nanny agree to $650 per week based on a 45-hour work week. The employment agreement should specify that the weekly compensation is comprised of 40 hours at the regular rate of pay of $13.68/hour plus 5 hours at the overtime rate of $20.52/hour. Additionally, it must be stated that any additional hours in a work week will be paid at the overtime rate of $20.52.
Note 2: Overtime issues are particularly dangerous for employers because there is no statute of limitations – allowing former employees to file a wage dispute years after the relationship has terminated. Back wages plus back taxes, penalties and interest can make this a very expensive mistake. The good news is a simple employment agreement makes all the worries go away.
MISTAKE: Putting a household employee on the company payroll.
This is a fairly common mistake for families who own a business. The IRS does not consider household workers to be employees of the company because they are not “direct contributors” to its success. And since businesses are entitled to tax deductions on payroll expense, it is an illegal tax deduction to include a domestic worker’s payroll expense as part of the company payroll and tax reporting.
Instead, personal employees should be handled separately through the household employment reporting process. If the expense is childcare related so that both spouses can work or go to school, the family can take the childcare tax breaks associated with those wages, but it must be handled on their personal income tax return.
Based on this same logic, it is considered insurance fraud to put a household employee on the company’s group health plan.
MISTAKE: Failure to properly withhold and report payroll taxes.
Household employers are required to administer the payroll tax withholding and reporting process. Sometimes employees will say – or imply – that they will “take care of their own taxes.” Families, especially first-time employers, sometimes conclude that they are absolved of the tax responsibilities. That is not the case; the state and federal tax agencies put the onus – and the liability – squarely on the employer.
MISTAKE: Failure to secure workers’ compensation insurance.
Workers’ compensation is not part of the tax process. It’s an insurance policy that provides financial assistance with lost wages and medical costs in the event that your employee has a work-related injury or illness. It also protects employers from lawsuits since workers who accept benefits forfeit their right to sue the employer, regardless of fault.
Workers’ Compensation insurance is required for household employers in some states and is optional in others (click here for the requirements by state). If you are required to carry a workers’ compensation policy – or if you elect to carry one – we suggest that you contact your homeowner’s insurance agent. If you’re not already covered, your agent can usually set up a policy over the phone.
Families who successfully handle these details don’t have to worry about potentially-expensive audits and lawsuits. Additionally, they’re able to take advantage of childcare tax breaks that can offset – sometimes even exceed – the employer’s tax costs. Finally, when paid correctly, the employee is entitled to important short-term and long-term benefits such as Social Security, Medicare, Unemployment, Disability and the ability to obtain loans and lines of credit.