This tax season, how parents pay a nanny may make the difference between receiving a child care tax credit and owing thousands in penalties.
Filers who shelled out for day care, summer camp or a babysitter may be able to scoop up a tax credit of up to $1,050 if they paid for one child under age 13. That credit rises to $2,100 for two or more kids.
Here's the catch: To qualify for this tax break, you need to identify all of the entities that look after your child and make note of their taxpayer identification number.
That means that if you're paying your care provider under the table, you won't be able to claim the credit unless you come clean to the IRS first.
"In general, if you file your return and you should've been paying your nanny legally and remitting taxes last year, all isn't lost," said Kerri Swope, vice president of Care.com's HomePay , a household employee payroll program.
"It's fixable, but it's a little painful to make it right for the 2017 tax year," she said.
Here's how to get right with the IRS and nab that child care tax credit.
On average, it costs about $29,000 a year — or $565 a week — to hire a nanny to care for one infant, according to Care.com.
If you paid your nanny — or any household employee — more than $2,000 in 2017 ($2,100 in 2018), then you are responsible for withholding Medicare and Social Security taxes, which add up to 15.3 percent of wages and are to be divided between the worker and the employer.
If you paid at least $1,500 in any quarter of 2017 or 2018, then you're also on the hook for federal unemployment taxes and potentially state unemployment taxes. That adds up to 6 percent of wages.
Using the example above, a parent living in New Jersey and paying a babysitter $565 a week in gross pay can expect to fork over another $62.68 per week in employer taxes, according to HomePay's calculator.
The IRS and state tax authorities tend to find out about illegal arrangements — and the back taxes owed — when household workers file for unemployment insurance between jobs, said Swope.
"If you're paying someone to provide you with services, they have to report it as taxable income," said Tim Steffen, director of advanced planning at Robert W. Baird, a wealth management firm.
"If you don't pay Social Security and Medicare taxes for your employees, you're subject to penalties and fines," he said. "It can be considered a felony if you don't pay, and this can lead to prison time if it's egregious."
You may also face penalties for failing to send your nanny a Form W-2, stating his or her wages and taxes withheld. The last day to do so for the 2017 tax year was Jan. 31.
Don't try to skirt the law by mischaracterizing your nanny as an independent contractor. If you control the work that is done and how it's done, then this person is your employee, according to the IRS.
Addressing back taxes, particularly if you've been paying your nanny under the table for years, is a messy affair.
When reporting to the IRS for past years, you would have to provide the gross wages for the employee's share of Social Security and Medicare, said S. Andrew Smith, principal at Baker Newman Noyes in Portland, Maine.
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Your nanny or babysitter would have to file an amended return for each of those years to reflect wages that were paid — and could be subject to interest and penalties.
You could be subject to interest and penalties, too.
"If the employer is amending a return to pick up the child and dependent care credit, that might generate a refund that could be larger than the payroll taxes," Smith said.
Here's what you need to make things official with your employee and the IRS:
It's also a good idea to have an employment contract with your employee so that you can address issues such as sick days and vacation time.
Be aware that you could be subject to additional state and local requirements in the form of minimum wages, mandatory paid sick leave and overtime pay.
"The tax side is probably the easiest thing," Swope said. "It's the human resources and labor side that's really difficult to keep up with."