Your Money : Employ Domestics? This Tax Change Hits Home

The estimated 2 million Americans who owe so-called “nanny taxes” for household workers are in for a pleasant surprise.

Congress recently passed a bill that significantly simplifies the rules regarding paying and filing tax returns for household employees. President Clinton signed the bill into law on Oct. 22.

The revisions, which aim to increase compliance with the nation’s domestic employee tax laws, were spurred by the “Nannygate” scandal last year, in which President Clinton’s first nominee for attorney general, Zoe Baird, and a later candidate, federal Judge Kimba M. Wood, withdrew after disclosing they had hired undocumented domestics.

The media firestorm shed new light on 1950s-era regulations that had turned virtually every parent with a Friday-night baby-sitter into a tax cheat. It also put pressure on Congress to update the rules for the 1990s.

The Social Security Domestic Employment Reform Act of 1994 does just that. The law relaxes rules on high-school baby-sitters, raises filing thresholds and significantly reduces the requisite paperwork. It also provides a fairly simple way for individuals to go about paying the taxes. Better still, it’s retroactive--in effect for this year starting Jan. 1.

In other words, if you haven’t yet paid employment taxes for a domestic worker hired in 1994, you have not broken the law. If you have paid taxes on someone who earned less than $1,000 during the year, you could be due a refund.

Legislators say they expect compliance with nanny tax laws to soar because many of the hurdles to doing so have been removed. Only about 25% of those with household workers are believed to be in compliance with the previous law, partly because it was time-consuming and difficult to comply.

In the past, for instance, you needed to file between six and 18 forms--depending on where you lived and how much you paid domestic workers--on any household employee who earned more than $50 in three months. Under the new law, you will not be bothered with so-called nanny taxes until you pay someone $1,000 a year or more. Starting in 1996, the $1,000 filing threshold will be indexed for inflation.

In addition, the new law exempts teen-agers who baby-sit part-time from filing requirements. Taxes and forms are due only for adults over 18 or for those whose “primary occupation” is domestic work. (The primary occupation for most teen-agers is “student,” according to tax authorities.)

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Further, starting in 1995, the paperwork is cut dramatically. Now if you employ a domestic worker, you must file quarterly 942 forms with the federal government. These forms spell out the names of your workers, their Social Security numbers, their wages and the amount of Social Security taxes due. You must also remit a check for Social Security and Medicare taxes when you send the forms. Under the new law, there will be a new section added to the 1040--the standard tax form for anyone who itemizes deductions--that will ask about employment taxes for domestic employees. Although the precise wording for it isn’t known yet, the IRS anticipates that you’ll be able to note your employment tax obligation on the 1040 without filing an additional form, and you’ll be able to pay the tax through additional withholding or quarterly tax payments.

The law also requires the Treasury Secretary to compile and provide educational materials for domestic employers, explaining their rights and responsibilities under federal and state laws.

Still, some of the confusing elements of the previous law will remain. For instance, for many families the toughest hurdle is determining whether or not they really have an employee. Someone who works for you could either be considered your employee or an independent contractor. If that person is an independent contractor, you won’t owe Social Security taxes, nor will you have to file employment forms related to his or her work.

The IRS puts out a booklet, “Employee or Independent Contractor?,” that aims to help you determine with a set of 20 questions. Because of the variables involved, though, the questions may not make your particular case clear. (You can order the booklet from the IRS at (800) 829-3676.)

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In general, however, the determining factors have to do with control. Do you set the worker’s hours, provide him or her with supplies and give instruction on how the job should be done? Are you responsible for providing this individual with the bulk of his or her income? If so, he or she is probably an employee.

If the worker brings his or her own tools, sets his or her own hours, gets little or no instruction, and earns a substantial portion of his or her income from other sources, then that person is probably an independent contractor.

In addition, although the new law substantially reduces federal paperwork, employers must still grapple with the copious and confusing state forms and filing requirements. The amount of paperwork varies based on where you live and how much you pay. Generally, though, anyone who has a full-time nanny, housekeeper or, in some cases, gardener, needs to file state income and unemployment tax forms too.

The Changes in Baby-Sitting Taxes

How does the new nanny tax law differ from previous law?

* Old law: Social Security and Medicare taxes must be paid for any domestic worker who earns more than $50 in three months.

* New law: Social Security and Medicare taxes must be paid for any adult employee who earns more than $1,000 annually.

* Old law: Even high school baby-sitters are considered employees, required to pay Social Security and Medicare taxes.

* New law: Part-time teen-age workers are exempted from filing and tax requirements. Only adults, over the age of 18, or those whose primary occupation is domestic work must pay the tax.

* Old law: Federal filing requirements dictate that employers send in quarterly 942 forms and pay employment taxes in four annual installments. The taxes amount to 12.4% of wages for Social Security and 2.9% of wages for Medicare. The obligation is technically split, with the employer paying half and the worker paying half. But the employer is the one charged with sending the payments in to the government.

* New law: In 1995, employers must file annual statements with their 1040 forms, noting their status as domestic employers and listing their employment tax obligations. The tax needs only to be paid once annually, when the employer is filing his or her personal tax return. For 1994, a year-end 942 form must be filed. However, starting in 1998, employment taxes must be paid “ratably” throughout the year either through quarterly estimated payments or employee withholding.