Over the past year, we’ve seen politicians will all sorts of tax problems.  Tim Geithner, Tom Daschle and Charlie Rangel have all proved that the tax man rarely giveth but frequently taketh away.  But don’t worry…even if you have no political ambition whatsoever, the IRS will be happy to investigate you for innumerable reasons…and maybe even ask you for some money.

One of IRS’ favorite tricks recently is to audit for unpaid employment taxes–that 15.3% of an employee’s wages paid one-half each by the employee who earns the wages and the employer that pays them–which are used to fund our Social Security and Medicare system.  Oh, and we can’t forget federal and state unemployment taxes paid solely by employers.  It turns out that businesses aren’t the only ones that need to worry about properly collecting and paying these taxes…you might too.

Why?  Well, I’m talking about the growing popularity, even among the non-wealthy, to hire domestic workers (nannies, housekeepers, etc.).  Most families hiring these types of workers normally don’t understand (or purposely avoid understanding) the tax implications.  So here goes…

First, it is vital to understand the difference between an employee and an independent contractor.  If you have an “employee” you are required to withhold and pay certain payroll taxes.  If you have an “independent contractor” you are not.  The test for whether a person is your “employee” is control.  The relevant question…do you have control over how the person does his or her job?  If you have control, you have an employee.  For instance, you call a plumber to fix the garbage disposal.  You have no control over how the plumber does this work, therefore, the plumber is not your employee.  Another example…you have a 30-hour per week nanny who comes into your home, watches your children and does some light housekeeping.  Every week you give the nanny a list of chores, you tell the nanny what the kids are to eat, you buy the food, and you give the nanny a schedule of each child’s activities.  You have control, so you have an employee.

The control test is necessarily dependent upon the facts at hand.  However, in the view of IRS, a nanny or housekeeper who works in your home at your direction is very likely to be considered an employee (whether or not full-time).  And therein lies the problem…because many families employing household workers fail to classify them as employees…IRS could audit, re-classify the worker as an employee, and require payment of back taxes, penalties and interest.  The expense could become utterly outrageous…some would say owing money to the mafia is preferable to owing money to IRS.

So what is the answer?  Well, first you have to make the determination of whether or not you have an employee.  You likely know whether you have sufficient control over the person so as to make that person your employee, but it may take some consideration of the facts.  If you have an employee, the law requires reporting, withholding and payment of the payroll taxes discussed above.  These taxes would not only be payable to IRS, but likely also to your home state’s Department of Labor.

The good news is that there are resources that can assist you with complying with the law.  IRS has a great publication on this issue which can provide guidance.  In addition, payroll professionals can make the payment and withholding of these taxes simple and painless.  Others, like lawyers and CPAs can readily help you to make the determination of whether you have an employee or not.

Following the law in this area can be expensive and it can be tempting to play the “audit lottery” but an unfavorable determination by IRS can be disastrous.

Clint Costa is a licensed attorney and registered CPA practicing in Chicago, Illinois with the law firm of Shaheen Novoselsky Staat Filipowski & Eccleston, P.C.  Besides reading the tax code for fun, Clint and his wife Julie live in the land of milk and bungalows on the northwest side of Chicago.  Clint can be reached at ccosta@snsfe-law.com or by phone at (312) 621-4400.  Tom McCue is a banking manager in Chicago’s Streeterville neighborhood with National City Bank, now a part of PNC.  Tom can be reached with questions about National City/PNC’s payroll services at (312) 755-0405 x 21336.