(MONEY Magazine) – You probably thought you had your child-care problems licked when you found the perfect nanny or babysitter, right? Little did you know your difficulties were just beginning. Unless you've hired a Mary Poppins who can magically make mounds of paperwork disappear, you will probably have to comply with the headache-inducing blizzard of payroll taxes and government regulations that apply to household workers. For example, if you pay someone more than $1,000 a year to care for your child in your home, you will likely owe Social Security and Medicare taxes for the caregiver. And if you pay a nanny or sitter more than $1,000 in one quarter, you will probably face a bill for federal and state unemployment taxes as well.

You may be tempted to ignore the whole messy business. A word of advice: Don't. Ever since President Clinton's nomination of Zoe Baird for U.S. Attorney General was derailed in 1993 after it came out that she had never paid Social Security taxes for her nanny, the Internal Revenue Service has been busy trying to finger folks who should pony up employment taxes for their household help.

Last year the IRS added a line to the 1040 tax form that 51% of all taxpayers use requiring filers to declare any employment taxes they owe for household workers. Before this change, such taxes were filed on a separate form. But now you calculate Social Security, Medicare and unemployment taxes due on a Schedule H and write in the amount due on your 1040. "The IRS switched to the 1040 so you can no longer say you 'forgot' to file the form," observes Kathy Webb, co-founder of Home/Work Solutions, a Sterling, Va. company that provides tax assistance to people who employ household help.

If you should file but don't, you could be hit with penalties as high as 25% of the taxes you owe plus interest that lately averaged about 7.5%. And late-filing fees for state unemployment tax returns that employers of household workers must typically file each quarter can run as high as $100 for each return plus interest on the taxes owed.

Fortunately, in return for paying these taxes, you get to take advantage of a tax break--either the Dependent Care Assistance Plan (DCAP) or the federal dependent-care credit. The DCAP, which is a flexible spending account offered by many employers as part of their benefits packages, allows you to set aside up to $5,000 a year in pretax dollars from your paycheck to pay child-care expenses. Families in the 28% or higher federal tax bracket (income above $40,100 for married couples, $24,000 for singles) generally fare best with the DCAP. By sidestepping federal income and Social Security taxes on five grand, filers in that bracket shave $1,783 off their tax tab; those in the top 39.6% bracket save $2,363.

If federal taxes consume less than 28% of your income--or your employer doesn't offer a DCAP--take the federal dependent-care credit. For families with taxable income below $28,000 a year, this break provides a credit of as much as 30% of child-care expenses up to $2,400 for one child and $4,800 for two or more kids. For families earning less than $10,000, that's a saving of as much as $1,440 for two children. Families with taxable income of more than $28,000 can qualify for a 20% credit.

To get these bennies, of course, you must pay taxes for your household worker and file all the proper forms. Here is a rundown of what's required, depending on the type of child care you use. (For information on where to go for help with these nettlesome forms and related services, see the box at left.)


Day-care centers and nursery schools take care of the taxes for their employees. To get your tax break, all you have to do is ask the center for its employer identi- fication number (EIN) and supply it to the IRS. Make sure the center is licensed by your state. Licensing doesn't guarantee top-quality care, but it assures you that the center meets some basic health and safety standards.


Some day-care providers take the children into their own homes. At least 18 states require that such individuals be licensed, which usually means the state conducts periodic health and safety inspections. That person pays her own taxes and, whether she is licensed or not, you can still qualify for tax benefits as long as you provide the IRS with her Social Security number. Occasionally, people who offer this type of child care want to be paid under the table, claiming that they can discount their fees because they avoid taxes. But then you must give up your child-care tax benefits, and it's unlikely that you'll save enough in fees to offset that loss. What's more, says Barbara Reisman, executive director of Child Care Action Campaign in New York City, "People who act as professionals tend to give the best care."


This is where the paper chase begins. Since you have become an employer, you will need an employer identification number, which you get from the IRS. You use it when you pay Social Security and Medicare taxes as well as federal and state unemployment taxes for your employee. You and your nanny split the 15.3% Social Security and Medicare tax (7.65% each), although you withhold her portion from her paycheck and then settle up with the IRS on your 1040. You pick up the full tab for federal and, for the most part, state unemployment taxes.

Most states also require that household employers carry workers' compensation insurance for their employees in the event of a work-related accident. For more information on workers' compensation, call your state workers' compensation agency. Some homeowners policies provide coverage if workers are injured on the job, so check with your insurance agent to see what your policy covers.

Sometimes nannies may ask you not to declare their earnings to the IRS because they don't want to pay taxes or are working illegally in this country. Again, you'll usually get a better level of care--and preserve the tax breaks you're entitled to--by keeping everything legit. If you're having trouble finding a nanny willing to be paid on the books, hire one through a nanny placement service. "Many services get a lot of candidates who want to be paid under the table," says Julie Pellatt, president of Beacon Hill Nannies, a national nanny placement service in Boston, "but we turn them away." Typical fee to match you with a nanny: $1,000 to $3,000.

You probably assumed the wages you pay to someone who occasionally baby-sits for your children were safe from the long reach of the IRS. Not necessarily. If you pay your sitter more than $1,000 during the year and he or she is 18 or older, you must follow the rules that apply to having a full-time nanny in your home. Say you have an arrangement with a 20-year-old college student to mind your children four hours a week at $5 an hour. You will owe Social Security and Medicare taxes on the entire $1,040 you pay her. Mercifully, you can avoid this obligation by rotating two or more sitters so that neither hits the $1,000 threshold.