When considering the hiring of household help provided by a nanny, housekeeper, or gardener, first consider the tax status of the worker and what your obligations would be as the one paying for their services. The distinction between independent contractors and employees is very important, both for you and for the worker.
- Independent Contractors pay their own “self- employment” Social Security and Medicare taxes. They are responsible for paying both the employee’s and the employer’s shares.
- Employees pay their share of Social Security and Medicare taxes via payroll deductions. The employer matches the employee’s share and then must remit both their share and the employee’s share to the U.S. Treasury.
This combination of Social Security and Medicare taxes is referred to as FICA, which stands for Federal Insurance Contributions Act.
Contributions to Medicare total 2.9% and employees must pay half (1.45%), while employers pay the other half.). That applies to all taxable employment or net self-employment income, without an upper limit.
Contributions to Social Security are 12.4%, with the employee and the employer each paying half, or 6.2% each, on all taxable employment or net self-employment income up to a maximum amount that increases annually. For 2023, the maximum taxable employment and/or self-employment income subject to social security taxes is $160,200.
- For example, with a contract for services of $10,000, the independent contractor will deduct their expenses and remit 15.3%. For the sake of this example, let’s say that their expenses were zero, so they would remit $1,530 FICA as self-employment taxes on their annual tax return. The total cost to the payor (you) is only the contract amount of $10,000.
- If that same worker were an employee, they would receive pay of $10,000 minus the $765 employee share of FICA, for a net pay of $9,235. The employer would pay $765 + $765 = $1,530 FICA to the U.S. Treasury. The total cost to the employer in that example is $10,765.
We are ignoring workers compensation and unemployment insurance for the moment.
Worker Classification: Determine whether your worker qualifies as an independent contractor or an employee
An independent contractor operates an independent trade, business, or profession and offers their services to the general public. Per the IRS: “The general rule is that an individual is an independent contractor if the payor has the right to control or direct only the result of the work and not what will be done and how it will be done.” This issue of controlling the “what and how” of the services is central to the determination of a worker’s status.
Another test is whether the worker provides their own tools and pays their own expenses. In the housekeeping example, does the worker bring their own vacuum and cleaning supplies? An employee will use your appliances and ask for reimbursement for any cleaning products purchased for your home, whereas an independent contractor provides and pays for their own.
Furthermore, it’s prudent to document a written contract for services or provide an employment agreement co-signed by the worker. Make sure that the basis of the relationship is spelled out in writing to substantiate the position that you are taking.
If it can be determined that:
- you, the payor, are only controlling the result and not the specifics of what and how the result of the work is achieved, and,
- the business/worker is covering their own costs and FICA, and,
- you have a written contract for independent services, then,
- you likely have engaged an independent contractor to provide services. If the business/worker is offering their services to the general public, then the argument for independent services is stronger.
Otherwise, the worker is an employee, and you have all the obligations of an employer.
Are you engaging a business instead of an individual? If you sign a contract for periodic services from a company that maintains its own staff of housekeepers, pool service professionals, or gardeners, you are likely not their employer. The company is sending whoever they have available to fulfill that contract for services. The company is the employer and will be responsible for all payroll taxes for their workers.
It can be confusing when you use an agency to hire a nanny. The agency may just be screening applicants and helping you to engage the individual directly. Unless you are paying the weekly costs for nanny services directly to the agency, instead of to the nanny, you are the employer. But if the agency collects the fees for services from you and then pays the nanny, they are the employer.
When you are paying a worker directly but are in doubt as to their status, assume that they are your employee. A worker does not have to be full-time to be considered an employee; many employees in the household services sector are part-time. Part-time employment is still employment.
Okay. So, your household worker’s status has been determined. What’s next?
If you are hiring an independent contractor:
- Obtain a contract for services that spells out the services to be provided, the rate that they are charging you, and that they are responsible for their own costs, insurance, and taxes.
- Obtain a signed IRS form W-9 from your contractor. On this form, they will provide you with their U.S. tax identification number (SSN or EIN) and certify that they are not subject to back-up withholdings (24% tax for 2023). Be sure you have this signed form in hand before you pay the contractor anything. If they are subject to back-up withholdings and you have already paid them, then you are on the hook for that tax.
- If the contractor is subject to back-up withholdings, you would only pay them 76% of their fees. The other 24% you must remit to the U.S. Treasury.
- Issue an IRS form 1099-NEC (non-employee compensation) to the contractor and a copy to the IRS by the end of January of the following year. On this form you report the gross payments to the contractor and any taxes withheld and remitted. We will ignore state back-up withholding for this discussion.
If you are hiring an employee:
- Determine if your employee is eligible to work in the United States. If they are not, then find someone else who is.
- Apply for an Employer Identification Number (EIN) as a Household Employer. You will use the EIN instead of your Social Security Number (SSN) to withhold, remit, and report payroll taxes for your employee.
- Have a discussion with the employee to decide if you will only be deducting Social Security and Medicare taxes from their wages, or if they would like you to also deduct federal income tax. This is optional. You are not required to withhold income taxes on their behalf. The FICA and the taxes you withhold are considered “Trust Funds.” It is not your money, and you are entrusted with the responsibility under the law to remit it to the U.S. Treasury how and when required. Do not offer to withhold state income taxes as that would require another level of registrations and reporting.
- Obtain a signed IRS form W-4 from your employee. On this form, they are required to certify their Social Security number and legal name as it appears on the Social Security card.
- Pay the employee their wages minus FICA and any income taxes you have agreed to withhold.
- Set aside those withholdings and your share of FICA to be remitted either quarterly or on a Schedule H on your personal income tax return.
- Find out if the state where you live requires you to participate in unemployment insurance.
- Issue a W-2 to your employee and a copy to the IRS by the end of January of the following year. On the W-2 you will report gross wages and Social Security, Medicare, and income taxes withheld. These taxes will be due along with the balance of your personal income taxes for the year.
- File your personal income tax return and include a Schedule H (household worker). On Schedule H you will also calculate your contribution to the Federal Unemployment Tax Act (FUTA). This is a very nominal amount.
Most workers will want to be treated as independent contractors so that they will be able to deduct expenses on a Schedule C. Most employers would rather treat the worker as an independent contractor so that they don’t have to contribute to FICA on their behalf or have the higher standard of reporting that goes with being an employer. However, the determination is fairly objective, and the Internal Revenue Service can impose penalties on payors who incorrectly classify their workers as independent contractors.
The worst-case scenario for worker misclassification is:
- A worker claims to be an independent contractor and you don’t document that mutual understanding in writing.
- You pay them their full rate without withholding FICA.
- Several months later, your worker’s tax professional convinces them that they should have been treated as an employee, and they file their return with a substitute W-2.
- The IRS comes after you for both halves of the FICA (yours and employee’s), plus late penalties and interest.
This may all seem complicated and somewhat daunting; however it is rather easily manageable if planned for accordingly. There are even companies that will manage your nanny or housekeeper payroll and tax reporting for a fee. Given that each scenario is unique, we strongly suggest contacting a tax professional regarding your specific circumstances.
If you have any questions regarding any of the topics we have covered in this article, please reach out to Cardinal Point. The Private Wealth Managers at Cardinal Point are part of a robust team of cross-border investment, financial planning, and tax professionals.