The Value of Paying – and Being Paid – “On the Books”

One of the important conversations that we have with new clients to Town & Country is whether they have thought about how they will handle payroll for their new nanny, housekeeper or other household employee.  We don’t have reliable data on what portion of household employees in this country are paid “off the books” or “under the table,” but we suspect the percentage is pretty high.

So, probably because it’s so common, it may seem as if paying “off the books” is safe – or at least very low risk.  But doing so carries some important risks for the family who is employing someone in their home (and those risks can come to pass in some unexpected ways, and means that the employee could miss out on some important benefits.

First, here’s the basic law.  When a family hires someone to work in their home, they become a household employer.  Household employees include nannies, medical caregivers, housekeepers, gardeners, cooks, personal assistants, household managers, etc.  By law, these individuals cannot be classified as independent contractors (or, at least, the exceptions are very, very few).  As an employer, the household is required by law:

1.    To pay federal and state employer taxes, including Social Security, Medicare, federal and California unemployment insurance.  These are obligations of the employer, and they’re separate from the obligations that the household empoyee has.

2.    To withhold certain taxes from the employee’s wages, and report and remit those amounts to the IRS and California (or other state) tax authorities.  These amounts include the employee’s share of Social Security and Medicare, as well as disability insurance inmost states.  In addition, as employer you are obligated to withhold state and federal income tax on behalf of the employee, but that amount may be zero based on your employee’s W-4 elections.

3.    To carry workers’ compensation insurance.  This is a requirement in California and most other states.  Workers’ compensation insurance is meant to provide certain coverage if an employee suffers a work-related injury.

Payroll services can typically calculate and help a family with the first two items above, or you can calculate and pay those amounts to the appropriate government agencies.  Workers’ compensation for household employees may already be covered under the homeowner’s policy, or is likely available as a relatively low-cost rider.

(One exception to note:  If an individual household employee is paid less than $1700 (2009) in a year, then the household does not have any federal employer tax responsibilities.  You may still have state or other tax obligations.)

For potential employers, there are three main reasons we recommend paying household staff on the books – and many of these reasons apply to employees as well:

Tax Breaks for the Employer:  Household employers are entitled to certain tax breaks if their employee is paid legally.  If you have access to a Flexible Spending Account (or Dependant Care Account) through your own employer, you may use those pre-tax contributions to pay your own household employee’s wages.  If you do not have access to your own FSA, then you may claim the Tax Credit for Child or Dependent Care on your personal income tax return at the end of the year.  The after-tax benefits to you of these breaks can cover all or most of the additional costs otherwise associated with paying an employee “on the books.”  Check with your tax adviser for specifics.

These tax breaks will not be available to households that have not made the appropriate IRS and state tax filings.

Disability, Unemployment and other Important Benefits:  Depending on the state, if a household employee suffers a non-work related injury that prevents them from working, the employee may be eligible to receive financial assistance.  (Work related injuries would be covered by workers’ compensation insurance.)

In general, if a household employee loses their job through no fault of their own, they should be entitled to receive up to six months of unemployment benefits at up to 50% of their salary.

Often, household employees will be eligible for the Earned Income Tax Credit. Employees who are single parents may qualify for this federal tax break, reducing their tax bill by as much as $3,500 per year.  In order to receive this credit, the empoyee must, among other things, have earned some income that has been reported.

Employees paid on the books will receive retirement benefits and basic medical coverage through Social Security and Medicare contributions.  Research shows the average household employee for whom employee payroll taxes have been paid will receive $5 for every $1 they contribute.

People with reported incomes will be establishing a verifiable employment history, which is necessary to qualify for things like car loans, home loans, student loans, credit cards, etc.

Peace of Mind:  This is the important one.  At the start of this post, we said that the risks of non-compliance can come to pass in some unexpected ways.  It is true that IRS has been aggressively pursuing household employers who pay illegally.  It’s also true that in this tough economic environment the IRS is likely going to be stepping up its enforcement activities (and failure to meet these tax obligations is considered tax evasion and can result in expensive back taxes, penalties and interest).

But in our experience, getting audited is not the normal way for families to end up in trouble.  Instead, something happens during the course of the employee’s job that triggers a need for one of the benefits above – and if the employee has been paid off the books, then the needed benefit won’t be there.  The most common scenario by far: The family’s employee loses his or her job and files for unemployment insurance.  The state unemployment agency then checks to make sure that unemployment insurance has been paid, and if it hasn’t (i.e., because you were paying off the books), then the state unemployment agency will start a process that will typically result, in one way or the other, in the family having to make up for the unpaid unemployment insurance premiums, payroll taxes, etc. (plus interest and penalties).  Often, an employee does not realize that unemployment insurance has not been paid where they have been paid off the books. But in this tough economic environment, finding a new job is taking longer than ever, and the chances are good that an employee that has been let go will have to file for unemployment benefits.