Physicians are frequent targets of the IRS.  One reason is that your odds of being audited nearly triple in the $200,000-$500,000 income range that many physicians fit within compared to those earning under $100,000.  Another is that physicians and their spouses tend to get in side ventures such as private equity investments, rental properties and side businesses that increase their chances of being audited.

With that target on your back, it is important to understand that when your tax return gets chosen for audit, the IRS agent is likely going to ask certain questions as a matter of routine.  Do you have a large amount of cash at your house?  Did you give or receive any large amounts of money?  Did you barter goods or services with anyone? Did you pay any person more than $2,000 for household help?  If you tell the truth about your use of household help that you didn’t report on your tax return, there could be tax consequences, maybe including a penalty. Also, the IRS could look back three years or maybe even more to increase your liability.  If you do not tell the truth, well then you’ve likely committed a federal crime.

I’m sure most of you would prefer paying money over going to jail, but we would likely all prefer to not be put in this position in the first place.  As it relates to household help, this includes nannies (hence it being called a “nanny tax”), caregivers, house cleaners, yard workers, maids, etc., but not if the nanny, for example, performs the services in her own home or if the nanny works for an agency or other company that you work with directly.  If you pay any one nanny $2,000 or more in any calendar year, then you are required to treat them as an employee, withhold social security and medicare tax from the nanny and pay your share of those taxes, and likely pay state unemployment taxes as well.  You will owe federal unemployment taxes on payments to nannies over $1,000 in any calendar quarter too.  The IRS has a handy publication that lays out these rules and more.

With that background, let’s get to the three do’s and don’ts:

  1. Don’t fail to pay the tax if you owe it.  Just keep a log of the nanny’s hours and payments, pay the nanny by check or other form that you can track, and if the nanny is going to exceed the $2,000 threshold, then set her up as an employee, withhold her portion of employment taxes, pay your portion and her portion of employment taxes, and move on with life.  If you fail to do this correctly, the IRS could assess you the combined approximate 15% tax rate on all of the nanny’s wages for all years involved, plus penalties of 20% up to 75% of the tax, plus interest on the tax and penalties.  It can quickly add up.
  2. Do a cost/benefit analysis on whether it would be better to use a nanny service.  This should get you out of having to set up the nanny as an employee.  Although the service usually costs more per hour than hiring a nanny directly, it takes the stress, time and risk out of your hand and often provides other benefits such as a pool of backup nannies if the “go to” nanny quits or is sick.
  3. Do form a team of nannies/babysitters so that none of them go over the $2,000 per calendar year threshold, keeping in mind that there is also a $1,000 per calendar quarter rule for all nannies combined.  I think of babysitters somewhat like a pitching staff.  There is an “ace” who is your first choice and most reliable.  There are 2-3 more who are good enough to get the job done, and then there is the 5th starter who you only really use in a pinch.  It may not be possible to avoid having the “ace” subject to nanny tax, but you could possibly juggle the others to keep each of them below the $2,000 threshold (like an innings limit for pitchers).

The tax withholding rules along with the forms that you have to file at tax time can be overwhelming.  Consider using an accountant or tax attorney to assist you, at least the first year, so that you can handle things appropriately from the beginning.